Market Insights Podcast – 27 June 2022
The S&P 500 rallied more than 3% on Friday to wrap up a big comeback week for the stock market that followed the worst weekly decline since the start of the pandemic. Investors’ expectation was raised by economic data that included better than expected new home sales for May and a slight improvement in inflation expectations from the latest University of Michigan survey of consumer sentiment, which was seen as potentially reducing the urgency for steeper interest rate hikes by the Federal Reserve. The question now is whether the markets have found a bottom or starting a bear market rally off oversold conditions.
Many recent economic data in the United States showed weakness. The newly released U.S. Markit manufacturing Purchasing Managers’ Index (PMI) in June hit a 23-month low, the manufacturing output index fell below the 50 dividing line for the first time in two years and the initial PMI of the service sector hit a 5-month low. Economists said that the PMI survey showing U.S. Gross Domestic Product (GDP) grew at an annualised rate of less than 1% in June. The data also prompted traders to believe that the U.S. rate hike cycle would end by the end of the year and that market expectations for future rate increases had fallen sharply.
Will interest rates be raised by another 75 basis points next month? Federal Reserve officials speak in unison: do whatever it takes to reduce inflation. The market is heavily repricing – traders expect the Fed to raise interest rates by 175 basis points for the rest of 2022, according to the latest data. That means the market expects the Fed only need to raise interest rates by a whopping 75 basis points and then policy will not be as aggressive as before. The remaining 175 basis points in 2022 means two possible scenarios for raising interest rates: one is to raise interest rates by 75 basis points, 50 basis points, 25 basis points and 25 basis points respectively in July, September, November and December; the other is to raise interest rates by 75 basis points, 50 basis points and 50 basis points in July, September and November, respectively and suspend interest rate hikes in December.
However, it seems that Fed would rather risk a recession than tolerate persistently high inflation. They need the market to decline for inflation to also come down. The reason as a downturned market will curb spending and keep people in the labor market. Chairman of the Federal Reserve of Philadelphia said that the U.S. GDP may have negative growth for several quarters. The central bank should reach the neutral rate of 2.5% “quickly” and the federal funds rate above 3% by the end of the year. The 2-year U.S. Treasury yield is also trading at around 3% at the present. Raising interest rates by 75 basis points will help the U.S. to reach neutral interest rates. (Note: the neutral interest rate refers to the theoretical federal funds rate in which monetary policy neither expands nor contracts.) If demand slows faster than expected, it might be good to hike 50 basis points in July. Any signs of weak demand would be exactly what the Fed “wants to see”.
Powell finally uttered the “most hawkish” phrase in the Fed’s semi-annual monetary policy report – “the commitment to fight high inflation is unconditional”. He said that he would be reluctant to change his stance on monetary tightening unless there is clear evidence that inflation is cooling. This sends a signal that the United States will continue to raise interest rates aggressively. He also said that the U.S. financial market is functioning well and the banking sector is in a good state of capital; the U.S. housing market is emerging from a very hot state and is slowing down. The pace of interest rate increases in September and beyond needs to be based on economic data and changing prospects. As he repeatedly reiterated the Fed’s hawkish stance, markets continued to worry that aggressive interest rate hikes would inevitably plunge the economy into recession. However, given the strength of consumer and bank balance sheets, even if the economy does fall into a recession, it should be a mild recession. Last week, the International Monetary Fund (IMF) cut its 2022 U.S. economic growth forecast to 2.9% from 3.7% and its 2023 growth forecast to 1.7% from 2.3%. They said that the U.S. economy is likely to slow in 2022 and 2023 but will “barely avoid recession” as the Fed tightens interest rates to curb inflation.
Abandon gradualism and take stronger action to shake up inflation. As Jamie Dimon at J.P. Morgan said recently, the elephant in the room is use of quantitative easing (QE) over the past 15 years and now the first ever use of quantitative tightening (QT) to unwind this QE – which is the primary driver of the current stock market and pretty much all other asset bubbles. Global goods demand now substantially below trend; high inventories also raise risks to Asian GDP.
The latest study by the San Francisco Fed shows that supply constraints are the main culprit for soaring inflation in the United States while 1/3 can be attributed to demand growth. As supply shocks raise prices and dampen economic activity, the prevalence of supply-related factors increases the risk of entering a period of low growth and high inflation. The “domino fall” effect in the credit and property markets would heighten fears of a recession.” The 24% decline in the stock market shows that the market has digested the 72% probability of recession. The S&P 500 hitting at the 3,200 level will reflect a 100% recession. A more damaging recession usually helps eliminate extreme inflation and overinvestment. The latest data from the U.S. rental market show that the real Consumer Price Index (CPI) level in the U.S. is much more than 8.6%. The median U.S. rent has breached the USD2,000 mark for the first time in the past month and rent prices have soared 15% to 20% year-on-year in the past year, depending on the region. Therefore, according to the calculation method before the 1990s, the real inflation rate in the United States is already close to 17%.
Looking forward, we do not think that it is appropriate to underestimate the upside of U.S. interest rates and be cautious about the outlook for the U.S. economy. One possibility is that the continued tightening by Fed could trigger a recession at the cost of price stability, which would also exacerbate market volatility and lead to a higher risk premium. If we extrapolate at this rate, coupled with the toughness of the core CPI, we do not rule out the fact that the growth rate of CPI in June is even higher than that in May. We believe that the Fed may continue to raise interest rates by 75 basis points at its The Federal Open Market Committee (FOMC) meeting in July and the rate increase will not be low for the rest of the year.
Crude oil prices plunged below USD105 last week as investor fears of a coming recession continue to rise and as President Joe Biden’s administration called on Congress to implement a summer gas tax holiday. A recession would lower consumer demand for oil as travel activity falls, which would likely lead to lower oil prices as concern supply is able to play catch-up after a year filled with shortages. On the supply side, relations between the United States and Saudi Arabia have “warmed up” ahead of Biden’s Saudi trip in the mid of July and the situation between Russia and Ukraine has revealed signs of easing, causing market concerns about the release of crude oil supply and suppressing the trend of oil prices.
First of all, we need to understand the core logic of the rise of the current round of oil prices is the mismatch between supply and demand, and this problem has not been solved at present. Looking at the supply and demand situation, there are two major supply sides in the market: OPEC and Russia. OPEC released a report last week, revealing that their production in May indicated that they had not fulfilled their commitment to increase production in May, 1.04 million barrels per day less than originally planned. Russia is limited by sanctions and is expected to export less than 250,000 barrels per day per month but the U.S. shale oil production has increased by 1.3 million barrels per day. In fact, the U.S. has taken the share of OPEC and Russia and the total output has not changed. (Simple formula: volume (unchanged) x oil price (surging) = huge profits for oil companies)
Looking at the consumer side, summer is the traditional peak travel season in Europe and the United States. Europe and the United States have basically returned to normal. The global average daily supply and demand gap for crude oil in the third quarter is expected to further expand to 1.5 million barrels. When the total supply has not changed and the consumption side has grown, it is difficult to understand the logic of talking about the decline in oil prices. Even a short-term decline due to political reasons will not change the trend in the medium and long term. Moreover, the U.S. has recently released a lot of strategic reserves of oil. These strategic reserves are unlikely to be in low level all the time. Therefore, in the near future, the U.S. will slowly replenish this part of the oil reserves from the market.
Let us refer to some historical data, that is the trend of oil prices in the interest rate hike cycle: in the early part of the Fed’s interest rate hike cycle, oil prices have maintained an upward trend. Then oil prices could surge higher or plunge lower depending on what happens next in global markets. Mounting fears of a recession have sent crude prices to their second consecutive weekly decline but they remain above USD100 per barrel amid still-high demand and constrained supply, while inflation, hawkish central banks and war still loom. Surging inflationary pressures from food to energy to services, coupled with fast paced interest rate hikes, suggest oil demand will struggle to fully recover to pre-pandemic levels until next year. A recession, however, would trigger a pullback in fuel consumption and oil prices could crash more than 30% from current levels. If European sanctions push Russian oil production below 9 million barrels per day, then oil prices could spike again to previous high. Indeed, the long-term consequences of such supply disruptions have not been fully appreciated. Therefore, oil prices may still stay high and enter a high volatile market.
On 24 June, the China Securities Regulatory Commission formally issued the announcement that traded open-end funds will be formally included in interconnection. Investors of mainland China and Hong Kong can buy and sell shares of stocks and traded open-end funds listed on each other’s exchanges through local securities companies or brokers. According to the preliminary calculation, for overseas investors, the exchange-traded fund (ETF) interconnection mechanism is expected to include more than 80 ETFs in the mainland market, with a scale of more than RMB600 billion; while for mainland investors, the Hong Kong market is expected to include 6 ETFs, with a scale of HKD360 billion. Under the background that interconnection has become the main way for foreign investors to allocate A shares, after further enriching the varieties of foreign investment and improving their investment convenience, the ETF market is expected to usher in incremental funds, promoting the continuous expansion of the market scale of ETF. The Hong Kong Stock Exchange will be the obvious beneficiary.
As U.S. inflation hits record highs, there is more and more discussion in the United States about reducing inflation by abolishing tariffs and liberalizing trade. The views are mainly divided into two categories: one is that lower tariffs are conducive to reducing inflation, and the United States should abolish the tariff measures imposed since the Trump era; the other is that reducing tariffs is not conducive to the decline in inflation. This view is either that tariff reduction can only reduce a small part of the inflationary pressure, or that tariffs have nothing to do with inflation and given the security of the U.S. supply chain, it is unwise to abolish tariffs. The removal of U.S. tariffs on steel, aluminum and Canadian softwood lumber in all countries will reduce U.S. CPI inflation by 1.3% from base levels. Price change will be a one-off event. Abolishing tariffs will only lower prices in the year in which they are cancelled. Although the elimination of tariffs will not solve the macroeconomic problems associated with sustained or accelerated excess demand, it could have a temporary downward impact on prices, which could help dampen inflation expectations.
If the above mentioned happens, it will have positive impact for Chinese equity market. Investors are becoming more optimistic recently about the Chinese stock market. The challenges facing the People’s Bank of China (PBOC) are different from those of central banks in Europe and the United States. Policy makers are changing their attitudes and changing policy direction. Compared with other central banks in Europe and the United States, the PBOC has more flexibility to support the economy. More importantly, the direction of fiscal policy is also changing. Support of government is growing. Given that benchmark mortgage rates have been cut, the PBoC can be expected to ease monetary policy further. Credit growth has always been a positive indicator of the stock market and credit growth in China is showing strong signs. China added RMB1.89 trillion in new loans in May, an increase of RMB392 billion from a year earlier, higher than the RMB1.5 trillion expected by the market. At the present, the price-to-earnings ratio of the Chinese market is 20% lower than the long-term average, so a lot of news has been fully digested.
The G7 summit was held in Germany from the 26th to 28th June. The G7 is expected to assess the effectiveness of the sanctions against Moscow so far and discuss further financial and military assistance to Ukraine. It was reported over the weekend that the G7 Group will ban on the import of Russian gold. The ban on gold imports from Russia is designed to prevent Russia from participating in precious metals trading. Biden quickly tweeted, “The United States has made Putin pay an unprecedented price, preventing him from getting the funds he needs for the war against Ukraine. The G7 will jointly announce that we will ban the import of Russian gold and gold exports bring tens of billions of dollars to Russia.” Russia accounts for about 10% of the world’s gold production. Spot gold rose about USD10; gold futures rose 0.5% to USD1,836 an ounce.
Meanwhile, Russia is poised to default on its foreign debt for the first time since the 1917 Bolshevik Revolution, further alienating the country from the global financial system following sanctions imposed over its war in Ukraine. The country faces a Sunday night deadline to meet a 30-day grace period on interest payments originally due May 27 but it could take time to confirm a default. How much does Russia owe? About USD40 billion in foreign bonds, about half of that to foreigners. Before the start of the war, Russia had around USD640 billion in foreign currency and gold reserves, much of which was held overseas and is now frozen.
Investors have expected Russia to default for months. Insurance contracts that cover Russian debt have priced an 80% likelihood of default for weeks and rating agencies like Standard & Poor’s and Moody’s have placed the country’s debt deep into junk territory. Western sanctions over the war have sent foreign companies fleeing from Russia and interrupted the country’s trade and financial ties with the rest of the world. Default would be one more symptom of that isolation and disruption. Russia default would not have the kind of impact on global financial markets and institutions that came from an earlier default in 1998. Back then, Russia’s default on domestic ruble bonds led the U.S. government to step in and get banks to bail out Long-Term Capital Management, a large U.S. hedge fund whose collapse, it was feared, could have shaken the wider financial and banking system. Holders of the bonds, for instance, funds that invest in emerging market bonds could take serious losses. Russia, however, played only a small role in emerging market bond indexes, limiting the losses to fund investors. According to the International Monetary Fund (IMF) expressed that while the war itself is having devastating consequences in terms of human suffering and higher food and energy prices worldwide, default on government bonds would be “definitely not systemically relevant.”
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