China stocks bounce

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Good morning. Yesterday we read in several respectable news outlets that the era of low inflation is over. Unhedged is heading into its concrete bunker, sure, but we wouldn’t be surprised if when we emerge in 2024 that CPI is back to 1.5 per cent. Send us your thoughts: robert.armstrong@ft.com and ethan.wu@ft.com.

China: better, sort of 

The US inflation/Federal Reserve story has become so big that it threatens to drown out everything else. But the China story just keeps on running: the Covid response; the political transition; the hyper-regulation of the tech industry; the slow-motion real estate crisis; the secular decline in growth.

Last time we wrote about China, six weeks ago, the theme was the failure of economic stimulus to offset the Covid lockdowns. Limp demand for loans means government efforts to encourage activity by expanding credit fall flat. At some point, we said, the lockdowns will ease and there will be a reopening trade, but how to time it?

We should have timed it for right then, as it turns out. Here is a chart of the CSI 300 index of mainland stocks, the Nasdaq Golden Dragon China index of US-listed stocks with businesses based in China, and the S&P 500, since mid-May:

Line chart of % return showing Opening up

Keep this in perspective. The CSI 300 and the Golden Dragon index remain down 23 per cent and 62 per cent, respectively, from their peaks in February of last year. Still, a nice bounce. What has changed, and will it stick?

There has been a clear positive economic effect from the easing of the lockdowns. Industrial production rose slightly in May from a year ago, after falling in April. Exports rose 15 per cent in Rmb terms in May after growing just 1.9 per cent the year before. On the consumer side of the economy, though, the news is less good. Retail sales, which had fallen 11 per cent in April, were down 7 per cent in May. Construction starts, and the housing market broadly, continues to tank.

Here is a chart from Gavekal Dragonomics which shows what they described as a “lopsided recovery”.

And here, from Pantheon Macroeconomics, is a snapshot of housing demand:

This is all fairly old news at this point. The pressing question — as ever for investors in China — is what the government plans to do. There are signs this week that Covid cases are falling and the burdens of lockdown are easing. Will the government push monetary or credit stimulus to take advantage of the opening?

A speech this week from People’s Bank of China governor Yi Gang, that promised its policy would “continue to be accommodative to support economic recovery in the aggregate sense”, raises some hope. But like premier Li Keqiang in his all-hands-on-deck comments about the economy at the end of May, Yi mentioned few specific measures.

I asked Unhedged’s favourite China economist, Michael Pettis of Peking University, if concrete and significant measures are on their way or not. He said:

I expect that assuming no more major lockdowns (a big if) they will expand infrastructure spending aggressively. That’s because consumption growth will be extremely weak this year, and even though exports are fine, business investment (which follows consumption and exports) is also likely to be very weak. With the property sector struggling, this means that the only lever Beijing has to boost growth and reduce unemployment is local-government spending on infrastructure projects.

Given the extent of the reduction in local-government revenues, the only way they can fund an expansion in infrastructure is with more debt and more government transfers. Debt will rise a lot this year relative to GDP (indeed it already has).

Eventually, if unevenly, the lockdowns will ease. When they do, it is sensible to assume that the government will lean heavily into stimulus. When this happens, it is likely Chinese markets will continue their recovery. Whether its economy is solving the problems with weak demand and over-dependence on property is another question altogether.

A break-up in break-evens

It is not obvious that US inflation break-evens, the bond market’s rough guess of what inflation will be in the future, should correlate closely with crude oil. Oil prices affect inflation, of course, but are far from the only factor. Yet the relationship is often tight enough that it demands attention (it is “puzzling” and “unusual”, in the words of Federal Reserve researchers):

Before the financial crisis, the relationship was looser but well known. Ben Bernanke noted the link in a 2004 speech. After the 2015 shale revolution, markets began factoring structurally lower oil prices into inflation break-evens, and the correlation between the two leapt to 85 per cent between January 2015 and March 2019. The pandemic reopening only tightened the link. Between April 2020 and June 2022 the two lines moved almost in lockstep.

But now, with the Fed ready to engineer an inflation-busting recession, oil and inflation break-evens have come apart:

There is a clear story here. Oil is the biggest driver of headline inflation. But few people see oil coming down soon. Blame whatever you want — sanctions on Russia, pandemic refinery closures, climate uncertainty or Opec’s slow oil pumping — but the story is the same. So the Fed is in effect prying inflation expectations from the crude price, by promising to depress demand for everything else. Snapping so sturdy a relationship will be a painful task. The market believes the Fed will succeed. (Ethan Wu)

A bit more on the short end

Most of our correspondents said “amen” to Jim Sarni’s case for short-to-medium term high-grade bonds as a good place to ride out this crisis (though a few pulled for high yield rather than investment-grade bonds). When the curve is as flat as it is, shorter bonds offer all the yield of the long end with less rate sensitivity. Duncan Lamont of Schroders has put the point graphically, showing the increase in yields for various classes of fixed income, and the additional increase in rates that would force their returns down to zero.

One good read

Ron DeSantis is seizing the moment.

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