Markets Weekly podcast – 13 March 2023

Henk Potts (HP): Hello. It’s Monday, 13th March and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets. 

My name is Henk Potts, Market Strategist with Barclays Private Bank, and each week I’ll be joined by guests to discuss both risks and opportunities for investors. 

This week, we’ll take a step back from the turmoil of the markets to take you through our updated view of the Chinese economy, given the rapid developments that we’ve seen over the course of the past couple of months, after which, I’ll be joined by our Cross-Asset Class Strategist Dorothée Deck to discuss investment implications of the rapid reopening. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead. 

First of all, let me take you back to last year, when China, of course, had a miserable 2022, by its own standards, given the rigorous enforcement of COVID restrictions, the collapse that we saw in terms of property markets and weaker external demand, all of which conspired to drag down GDP growth.

Remember, China officially only grew at 3% during the course of last year, the second weakest reading that we’ve seen in half a century and well short of that official 5.5% growth target. However, 2023 is looking like a year of significant recovery after officials dramatically abandoned its economically damaging zero-COVID policy, implemented a comprehensive plan to shore up the housing market and boosted stimulus measures. 

We should remember that after nearly three years trying to enforce some of the strictest COVID-19 rules anywhere in the world, its leadership appeared utterly unwavering in its commitment to the aggressive containment tactic until just a few months ago, despite most other countries accepting the virus as being endemic.

China’s rationale for sticking with the coronavirus suppression policy was based on lower efficacy rates for its domestically produced vaccine, and poor vaccination rate amongst vulnerable groups, specifically the elderly. Authorities continued to proclaim that the restrictions were required to prevent the national health service from being overwhelmed and to avoid a surge in the death rate.

However, as we know, at the end of last year, authorities abruptly abandoned their pledge to maintain a zero-COVID strategy. So, what does that mean in practice? Well, officials have now stopped the restrictive quarantine rules, they’ve finished mass testing, they’ve ended the practice of snap citywide lockdowns and, after more than 1,000 days, authorities have finally reopened China’s border and international travel has resumed. The dramatic policy pivot, we think, should be positive for domestic activity, international supply chains and, of course, global growth prospects. 

The good news is that the health fears over ending the zero-COVID policy have proved unfounded. The removal of those restrictions did see China suffer the world’s largest COVID wave, driven primarily by the highly transmissible Omicron variant. At the end of last year, daily infection rates surged into the tens of millions. However, official data suggest that hospitalisations have proved to be manageable and fears of millions of deaths have, thankfully, proved to be unfounded. We believe that the point of peak infections has now passed and the population is rapidly approaching herd immunity status.

In terms of the economy, well, historically, of course, the Chinese economy has been driven by the expansion of credit and investment and, more recently, exports and property have become the main drivers. However, as the economy reopens from the depths of the pandemic, we would expect a broader-based recovery, with a strong emphasis on improving levels of domestic consumption.

The removal of travel and leisure restrictions had led to an unleashing of pent-up demand across the services sector. If you look at recent mobility data, for example, it’s highlighted the sharp recovery in transportation usage and recreational visits. We forecast that services output will more than triple during the course of this year compared to 2022, with growth of 7%.

We also predict that retail sales will recover. In fact, we expect retail sales to grow between 9% and 10% during the course of this year, following last year’s period of stagnation. And manufacturing is already bouncing back. If you look at February’s PMI numbers, they showed that output expanded at its fasted pace in more than a decade. So, real evidence that you’re starting to see that recovery playing out in terms of the economy.

Beyond the reversal of COVID-19 restrictions, authorities are also promoting growth by initiating, as we say, a comprehensive plan to shore up the property market and pledging to offer a more supportive monetary and fiscal backdrop.

As we’ve been talking about, the Chinese housing market has slumped over the course of the past year as developers defaulted on their debt, investment dried up and buyers boycotted mortgage payments. In fact, home sales declined 40% year-on-year in January. Given the importance of the housing market to the economy, accounting for around one-quarter of GDP, policymakers have instigated a broad range of measures to prop up the sector, including credit support for housing developers, financial assistance to ensure the successful completion of projects and the loosening of restrictions on property purchases.

Whilst unlikely to be an instant panacea for the troubled sector, we think that the responses will start to stabilise the market. We now see a shallower recession playing out in terms of the Chinese market, but still expect that property investment and home sales across the economy will contract by around about 5% during the course of this year.

Credit expansion and infrastructure investment should continue to support growth as well. The People’s Bank of China has urged banks to frontload loans to the real economy. Credit growth should hold up at around 9.5% in 2023, and infrastructure investment will probably remain robust with growth of around 6% to 8% during the course of this year.

Policy remains supportive. Remember, last year we saw the People’s Bank of China cut the policy rates, reduce the reserve requirement ratios and relax credit criteria. The central bank has indicated that it will keep monetary policy relatively loose in an effort to further aid the recovery. And, in an effort to boost credit, we’d expect authorities to continue to use structural tools. We also expect a further cut in the reserve requirement ratio, but we don’t think there’ll be a further reduction in terms of interest rates.

So, what could infringe upon the recovery? Well, clearly, there are concerns over escalating diplomatic tensions, particularly between China and the West. The US and China have clashed over trade tariffs, data transparency and, of course, in February, the ‘spy balloons’ incident over America. The US has also encouraged the governments of the likes of Japan and the Netherlands to impose restrictions on the exports of advanced semiconductor production equipment to Chinese companies. 

However, despite these current hostilities, trade between the US and China actually accelerated during the course of last year, in fact, getting up to $691 billion. However, a further souring of the relationship between those two superpowers could start to impact upon growth prospects. 

But, in terms of conclusion, China has set a growth target of 5% this year. That, actually, looks a little bit conservative to us, considering the rapid reopening of the economy, the stabilising of the housing market and the ongoing policy support. So, we’ve upgraded our GDP growth forecast for this year to 5.3%, but we think, actually, there’s potential for a further upgrade to come.

Looking beyond this year, long term, we believe that China will be able to transition to become a sustainable, high-tech, domestically focused economy, which should be positive for its people and investors in the region.

So, in order to discuss what the more optimistic outlook for the world’s second-largest economy could mean for investors, I’m pleased to be joined by Dorothée Deck, as I say, Cross-Asset Class Strategist for Barclays Private Bank.

Dorothée, great to have you with us today. We’ve talked about the impact of the China reopening on the global economy. What are the main implications for Chinese equities? And do you think the pullback that we’ve seen over the course of the past four weeks represents an attractive entry point?

Dorothée Deck (DD): Good morning, Henk. Good to be with you. So, clearly, the reopening of the Chinese economy is not only positive for domestic consumption and global growth. It’s also a positive development for risk assets in general.

Now, as we’ve seen in recent months, a lot of this has already been priced in and the question now is how much more upside there is after the recent rebound. Our view is that the medium-term outlook for Chinese equities has significantly improved, and we continue to see merits in having exposure to the region.

The recent pullback does provide a better entry point. However, we expect the next leg of the rebound to be slower and more volatile.

HP: OK, Dorothée, let’s get into a little bit more detail on those points. Please could you highlight some of the specific opportunities and outline some of the potential risks, but also discuss over what timeframes investors should be considering those areas?

DD: Absolutely. So, as you mentioned earlier, we’ve already started to see a positive impact on the economy. The first signs were a strong rebound in mobility measures in January, and those were confirmed in February by a strong improvement in business conditions. The latest Chinese PMI data, which were released earlier this month, were ahead of expectations. They showed a significant and broad-based pickup in manufacturing activity, services and construction.

Of course, those PMI numbers are influenced by seasonal factors, but, generally speaking, they were encouraging. So, the economy probably bottomed in the fourth quarter and should gradually recover over the course of the year. Now, economists have been very quick to raise their GDP growth forecasts, to a consensus of 5.3% this year, but equity markets have also been very quick to reprice this more encouraging outlook.

The MSCI China Index jumped by close to 60% between early November and late January, outperforming global equities by 40%. Since then, Chinese equities have underperformed due to a combination of rising geopolitical tensions and US dollar strength, but they still remain 40% above their November lows. So, a lot of the positive news is already reflected in the price, but, after the recent pullback in February, we think there is more upside.

So, on the positive side, Chinese assets remain very much under-owned, following years of underperformance, which leaves room for further upside. Sentiment on Chinese equities was quite bearish going into the fourth quarter and this should continue to normalise. 

And finally, despite the strong performance, valuations remain attractive. Based on MSCI indices, Chinese equities are currently trading at a 33% forward P/E discount to global equities, versus a 19% discount on average over the past 20 years. That’s 0.8 standard deviation below the long-term average. But, while the long-term outlook has significantly improved, a lot of uncertainty remains in the coming months, which should create some bull activity in the markets.

Firstly, the strength and pace of the economic recovery is difficult to estimate, so there is always a risk of disappointment on that front. At the National Party Congress last week, China unveiled a new GDP growth target of 5% for 2023, which was, actually, lower than expectations of 5.5%. It also seemed a bit conservative, to us, for a country that is reopening after three years of strict COVID restrictions, but it probably reflects the intention of the Chinese authorities to under-promise and over-deliver after missing their growth target by a wide margin in 2022.

Secondly, the large-scale stimulus that the market was hoping for may turn out to be lower than expected. The targets announced at the National Party Congress last week were also underwhelming. And, finally, we could see an escalation of geopolitical tensions between China and the West.

So, to summarise, we remain positive on Chinese equities over the medium term. However, we expect the next leg of the rebound to be slower and more volatile, and, in that context, it makes sense to maintain exposure to the region, but with downside protection through option strategies or structured products.

HP: OK. Let’s try and broaden out the conversation a little bit. You’ve certainly highlighted the domestic opportunity, but will the reopening of the Chinese economy have positive implications across emerging market equities as well?

DD: Yes, we believe so. But I would also point out that, this time around, the reacceleration of growth in China is probably going to have a more muted impact on other emerging market economies compared with previous cycles. And that’s because this recovery is primarily driven by domestic consumption and services as opposed to investments.

In addition, when it comes to emerging market equities, their relative performance has historically displayed a strong inverse correlation with the US dollar. So, emerging markets tend to outperform developed markets in periods when the dollar weakens, but with US rates expected to be higher for longer, the US dollar could stay well supported in the coming months, which could act as a headwind for emerging market equities in the near term.

HP: OK. So, moving beyond equities, China is a very big consumer in terms of commodities. Following the recent price movements that we have been seeing, which commodities are best placed to benefit from the reopening?

DD: So far, the market has been playing the China reopening story primarily through industrial metals. They have gained 16% from their September lows, with copper and iron ore up as much as 20% and 31% respectively. We haven’t seen much evidence of an increase in industrial metal demand yet, but manufacturing activity is expected to pick up as the year progresses.

China represents about 50% of the global demand for metals and as much as 65% of the demand for iron ore. So, it’s not a surprise to see a strong rebound, but it also means that the metal prices are very sensitive to Chinese growth, and they would be vulnerable to any disappointment in the recovery process.

Within the commodity complex, we actually think that energy’s best placed to benefit from the reopening. As we were discussing earlier, travel has been one of the main beneficiaries of the reopening, so far. Domestic and international travel has already rebounded quite strongly, and it has started to improve the demand for oil. Yet, energy prices have not benefited yet. They’re down 3% over the same period.

So, to summarise, while all commodity prices should benefit from the reopening process, we believe that energy is best positioned at this stage.

HP: Well, thank you, Dorothée, for your insights today. We certainly appreciate you outlining how investors should be positioned as that recovery plays out in China.

Let’s move on to the week ahead, where it’s set to be a massive week for investors as they navigate the latest US inflation report, the European Central Bank interest-rate decision and the budget in the UK.

Starting with the US, where we expect headline CPI to have risen 0.37% month-on-month and 6% year-on-year in February. This would actually be the lowest annual rate since October 2021. We estimate that core CPI will have risen 0.38% month-on-month, or 5.5% year-on-year in February, holding on to most of the acceleration in price pressures seen in January. We look for another month of inflation in core goods, amid an expected pause in used-cars deflation, and still see strong core services inflation shining through.

In terms of Europe, well, inflation moderated less than expected in February and core price pressures rose to a record high, certainly keeping that pressure up on the European Central Bank. To remind you, headline inflation came in at 8.5% last month. Remember, that’s more than four-times the official targeted level, although it has decelerated for four consecutive months. We’d expect inflationary pressures to ease as the year progresses, helped by lower gas and electricity prices and benefiting from government support, which is offsetting the impact of higher energy costs.

However, increases in the minimum wage and higher pay demands from unions is certainly putting some upward pressure on wages. We project that euro area inflation will average 5% during the course of this year. 

What does that mean for the European Central Bank? Well, they recently guided that rates still have to rise significantly, and at a steady pace, to reach levels that are sufficiently restrictive. We, therefore, look for a 50-basis point increase at this week’s meeting, a similar 50-basis point rise coming through at the May meeting, after which we then expect the ECB to step down to 25-basis point increases. We think they’ll do that in June and July. We, therefore, forecast a terminal deposit rate of 4% in the summer, which, we should remind ourselves, would be an all-time high.

In terms of the UK budget, which is delivered on Wednesday, the positive is that the near-term fiscal position has actually improved over the course of the past two months. Tax receipts have come in above forecast, central government spending has been lower, driven by lower net investment, lower debt interest and lower energy support subsidies. Public corporations’ and local authorities’ borrowing has also been lower relative to the forecast.

There is some pressure, therefore, from elements, you could argue, of the Conservative party on the chancellor to promise tax cuts in a bid to boost growth, with policies perhaps focusing on cancelling the rise in the corporation tax rate, from 19% to 25%, that’s due to occur in April, and perhaps cutting the rate of income tax by one pence.

We don’t think that’s likely. We believe, at this stage, the chancellor will resist a material permanent fiscal loosening and is more likely to focus on temporary measures, including keeping the Energy Price Guarantee unchanged at £2,500 in the second quarter, freezing the fuel duty for another year, offering more money to government departments to allow them to offer a 5% pay rise in 2023/24, so that would be ahead of that 3.5% that’s currently budgeted. We may also see labour-market reforms, in an effort to boost labour force participation, but we think that’ll come at limited fiscal cost. 

So, we wait to see what the chancellor delivers midweek, but, for now, we’d like to thank you once gain for joining us. We hope that you’ve found this update interesting. We will, of course, be back next week with our next instalment. But, for now, may I wish you every success in the trading week ahead.