Investors should be ready to capitalise on the dips

Andrew McAuley

Credit Suisse

The focus of markets in the last month has been the direction of interest rates in the US, new regulation in China and the possible failure of the second largest Chinese property developer Evergrande. We now have some clarity as to what the Fed are thinking and how the Evergrande situation will unfold. Although, the Chinese regulatory uncertainty remains.

On Wednesday night Australian time, the US Fed announced they expect to begin tapering bond purchases in November. This is potentially earlier than expected but otherwise no great surprise. What was new, is that they believe the wind-down of quantitative easing (QE, or money printing) will be done by mid 2022. The Fed also reiterated its confidence that inflationary pressures in the US are temporary, as bottle necks are resolved and the initial rush of the post lock down recovery has passed. They see inflation falling to 2.2% in 2022, after peaking at slightly above 4% in 2021. The market reacted positively to this news for two reasons. First, the Fed has done a very good job managing market expectations. Secondly, the bond market is more confident the current heightened inflation is in fact due to transitory factors such as used cars and airline fares. 

At the same time as announcing likely tapering, the Fed now believes the chance of a rate rise in 2022 is now higher. 

Normally, this may be seen as negative, but so far it has been interpreted as a sign the US economy is recovering well, and will continue to do so. However, we believe the Fed will continue to err on the dovish side. As the following chart shows, employment has been consistently improving, but the ratio of employment to population is still below the pre-Covid level. This indicates people have left the workforce. Based on Fed analysis those that have left are minorities in lower paid service jobs. The Fed wants job creation to continue to encourage these employees back to the workforce.

US Employment to Population Ratio – Not Yet Full Recovery

Source: Bloomberg, Credit Suisse

Turning to China, and the possible failure of Evergrande has seen a risk off tone globally, but with a much more significant impact in China. The heavily indebted Evergrande has operations across the Chinese economy owing hundreds of millions to bond holders and mostly Chinese banks, having pre-sold thousands of unfinished apartments to residential purchasers and not being able to meet redemptions on managed fund products linked to the performance of the business. The fear has been that the Chinese Government would allow it to collapse as a lesson for speculators and over indebted companies to reduce risk. A key interest payment was due on Wednesday night, which we now know was paid, much to the relief of investors. Although the Chinese authorities have not spelt it out, it is apparent they have engineered an orderly work out of Evergrande’s obligations.

Even if Evergrande failed completely, we don’t believe it would be a systemic issue as occurred when Lehman Brothers failed as the GFC started. First, property prices aren’t actually falling in China, rather they are flat. Secondly, most Chinese debt is internally funded, as is the case with Evergrande. The Peoples Bank of China (PBOC) could undertake QE to support debt markets. Thirdly, despite the turmoil, Chinese high yield bond markets have generally been well behaved. Finally, if property prices do fall as they have done in the past, China has been well able to manage the consequences. Our analysis indicates China would need to see property prices fall 20% for there to be systemic issues. Again, given most debt is internally financed, and the PBOC theoretically has access to unlimited funds, this is unlikely.

Another key event, has been increased regulation of listed companies in China. 

In particular, the authorities have zeroed in on what they refer to as the three mountains, education, health and housing. The government has made it clear they are unhappy with profiteering in these sectors. That is because they see it as creating inequality between those who can pay and those who can’t. As a result, they have made it illegal for tutoring to be provided for core subjects, they have clamped down on charging for certain medical procedures and there are various initiatives in housing to ensure developers provide a proportion of discounted properties for the social good. But it didn’t finish there. The government has also regulated technology companies. New rules around the collection of data, how that data is used, limiting gaming and limiting access to foreign capital markets all saw stocks like Tencent and Alibaba hit hard. Where regulation goes from here, and for how long will changes be made, only the Chinese authorities know. What we can be sure of is the regulators resolve. Quoting state media, “this is a return from the capital group to the masses.” No one can predict what further changes are install, what is certain is it has caused a significant correction in the Chinese stock market.

Unfortunately for China, these issues are adding to a slowdown in the economy. The authorities had already began a process of reducing industrial activity to reduce pollution, promote environmental sustainability and in preparation for the winter Olympics. The effect can be seen in the PMI Manufacturing Index compared to developed markets. China is underperforming.

Manufacturing PMI – China Slowing, Developed Markets Stronger

Source: Bloomberg, Credit Suisse

Despite recent volatility our positive bias in portfolios remains. We believe portfolios should be fully invested and investors should be ready to add on any dips as we approach the end of the year. The Chinese will not sit on their hands and let the economy deteriorate too far. Particularly, as the winter Olympics wrap up and they approach an important Communist Party planning session in April 2022. That’s good news for the falling iron ore price and so Australia. Forced cuts to steel production will eventually wash through. Unfortunately, in the meantime it is hard to see a catalyst for the big miners. Australia is also in the grip of lockdowns on the East coast. But the vaccine roll out is progressing well, and we expect the Australian economy to bounce back in the December quarter. The US, Europe and even Japan have economic momentum which should continue to build as the post Covid recovery continues, and spending which has been focused on goods, switches to services. The conditions are being built for solid share market returns in 2022.

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Data Sources: Credit Suisse, unless otherwise specified.

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Andrew McAuley
Chief Investment Officer
Credit Suisse

Andrew McAuley is a Managing Director of Credit Suisse Wealth Management Australia. As Chief Investment Officer, he is responsible for developing discretionary and advisory investment strategies across multi asset class portfolios for clients in...

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