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Issue 192022.05.14
China's lockdown impacting Global Markets
Mr. Hou Zhenhai
Straits Financial (China) CHIEF Strategist
Review of Last Views:
The Russian-Ukrainian war may impact the global supply chain, and the domestic pandemic outbreak risk will increase from March to April. Therefore, stocks are still short-term risk-off and this applies to European, and the US markets as well as Hong Kong stocks and A-shares. Commodities with relatively inelastic downstream demand are relatively good, and considering domestic regulatory requirements and the government's stronger price control capabilities, the fluctuation range of overseas commodities may exceed their domestic counterparties.
Main Points:
FOMC meeting announced plans to raise interest rates and launch QT. Until we see a significant improvements to headline inflation in both US and Europe, it's hard to argue that the stock market has reached the bottom to buy.
The current round of the pandemic outbreak in China may cause further inflationary pressures on overseas consumer goods importing countries such as Europe and the US.
We see the negative impact of the current Chinese lockdown on the domestic economy to exceed that of the Wuhan pandemic in early 2020 with lockdowns expecting to last longer. April to Mays lockdown may see a drag of about 4 percentage points to China's GDP growth this year.
We see Chinas loosening monetary policy slowing down, while the US Fed's continuous rate hikes and QT have weakened the domestic monetary policy space and its effectiveness. On the other hand, private enterprises and the consumer households, which have been hit hardest by the lockdown, will find it difficult to benefit from the monetary policies.
We continue to be cautious about the short-term global equity market as a whole. For commodities, we may see further divergence going forward. Some commodities with clear supply bottlenecks and low inventory constraints, such as agricultural products and crude oil, may still be relatively strong. But for commodities related to domestic consumption and property markets, there may be a risk of price decline due to the lack of demand in peak seasons.
I
The Feds tightening has been implemented, but there are still uncertainties in the future.
On May 4, the FOMC meeting decided to raise policy rates by 50 bps, and it is expected that in the next two FOMC meetings, it will continue to raise rates by 50 bps each time. At the same time, the Fed is preparing to start in June, shrinking its balance sheet by $47.5 billion per month, and it may increase to $95 billion per month starting September.
The Fed's move to hike rates and launch QT is well expected and is lower than the most hawkish scenario, which is to raise rates by 75bps and immediately start a $95 billion monthly QT. However, we believe this does not mean that the Fed's overall hawkish monetary policy stance has changed. It should be said that while the Fed is taking into account the downward pressure on the economy, the current main focus is still on the issue of controlling inflation. Therefore, we can see that after the FOMC meeting, although stocks had a short-term relief rally, the US Treasury bond yields have continued to rise, and the most important 10y US Treasury bond yield has exceeded two important levels of 3% and 3.1% and reached 3.12%, the highest level in recent years (Figure 1). The rapid rise in the U.S. Treasury bond yields has caused a greater impact on the prices of various risk assets around the world. It also drives the dollar stronger again.
Source: Bloomberg, CEIC, Wind
In addition, the rapid rise in U.S. bond yields has also pushed up the financing costs in the US real economy. Take the US mortgage rate as an example: the US 30-year fixed mortgage rate was still at a historical low of about 3% at the beginning of this year, but it has risen rapidly in the past two months, reaching 5.27% by the beginning of May, which is the highest level since 2010. The pace and magnitude of the rise in US mortgage rates over the past four months have been the fastest and largest since the 1980s. Therefore, this rapidly rising mortgage rate has also led to a rapid decline in the number of weekly mortgage applications in the US (Figure 2). A similar situation also occurs in consumer loans. Therefore, we believe that the rapid rise in US bond yields will impose certain constraints on future US consumption.
Source: Bloomberg, CEIC, Wind
But will this consumption restraint bring US inflation down soon？ We believe the answer remains uncertain. Because in addition to consumption, the supply problem is also the main problem causing this round of rising inflation in Europe and the US. Due to the impact of the pandemic, the Ukrainian war and sanctions on Russia, the global supply chains from chips to energy and raw materials have experienced serious disruptions and shortages, which is an important factor behind current inflation. Due to the ongoing fierce Russian-Ukrainian war and deepening WESTERN sanctions against Russia, these supply problems may get even worse. At the same time, the recent outbreak of the China Omicron pandemic has severely restricted production and logistics in China. Therefore, as the world's leading producer and exporter, the lockdown in China may have an impact on the global supply chain no less than that of the Russian-Ukrainian war. These supply factors may further raise the costs of consumer products in importing countries in Europe and the US, thereby making the high inflation environment there last longer.
Therefore, judging from the above, it is still too early to judge that the Fed's monetary policy has been priced in and there is no possibility of further tightening. Likewise, until we see a significant month-on-month improvement in headline inflation in Europe and the US, it's hard to argue that the stock market has reached the bottom to buy.
II
Previously we mentioned that the current round of China's lockdown due to the Omicron pandemic outbreak may cause further inflationary pressures on overseas importing countries. But we think this is only one side of the problem. We believe that the current lockdown in China may have a relatively long-term and sustained impact on the global economies and markets.
First of all, we must realize that the current Omicron pandemic in China is a very difficult problem to tackle, based on the Chinese government's requirement for a “Dynamic Zero-Covid Policy”. This is because the R0 of Omicron BA2 now prevalent in China is as high as 9.5, while the R0 of previous viruses such as Delta is only around 3. In addition, there is still a high risk of further mutation of the Omicron virus. For example, the newly discovered Omicron BA2.12.1 variant in Europe and the US has an R0 that is more than 23% higher than that of the previous Omicron virus. Therefore, for China, which adheres to the dynamic zero-covid policy, the challenge is still very great even after achieving zero-covid now. To meet that challenge, it may have to continue to adopt measures to limit people's public gatherings, cargo transportation and logistics to a certain level.
Regarding the density of people gathering and logistics, we can use the number of subway turnovers and the national truck flow index to observe its high-frequency changes. First, judging from the number of daily subway turnovers in the 10 major Chinese cities in Figure 3, the average daily turnover in April was around 28 million people, a decrease of 44% from the 50 million people in April 2021. Even if we exclude the loss of nearly 10 million peoples daily turnover in the total lockdown city of Shanghai, it still shows that the number of subway passengers in the 9 cities other than Shanghai also declined by about 30% in April YOY. Compared this with the Wuhan pandemic in early 2020, although the situation in Wuhan from January to April was more severe, as it was in the off-season of the Spring Festival holiday, and that pandemic was quickly brought under control in the country after April, and the subsequent impact continued to weaken. But judging from the current situation in the country, it is difficult to say that the impact of the Omicron pandemic and subsequent lockdown on the economy in May will be recovered soon.
Source: Bloomberg, CEIC, Wind
From the truck flow index, we can see more clearly that the impact of the current lockdown on the national cargo transportation is greater than that of the Wuhan pandemic in Q1 of 2020 (Figure 4). The average national truck flow index in April was 84.7, which was not only 27% lower than the 115.5 in April 2021, but also lower than the reading of 109.3 in April 2020. To conclude, the current lockdown may have a similar impact on people gathering compared with the Wuhan pandemic in 2020, but its impact on national logistics is much more serious than in the same period in 2020.
Source: Bloomberg, CEIC, Wind
And we know that the flow of people and cargo transportation are both important factors that constitute an economic activity. But in comparison, changes in cargo logistics in China are more closely related to its real GDP growth. Therefore, we have reason to believe that the current round of China's lockdown will have a greater negative impact on China's overall economy this year than in 2020. Although we cannot make accurate predictions development of the pandemic, weknow that such a highly contagious virus will not immediately lift its impacton logistics. Even if an optimistic assumption is made that the current pandemic can be controlled by the end of May, the done loss in national logistics can be known in that the truck flow index has fallen by 27% year-on-year in April, and the year-on-year decline in May is expected to be around 15%. Moreover, since April to May is the main peak season for production and consumption in H1 of the year, the GDP of these two months accounts for about 20% of the whole year, so a back of envelope calculation can be drawn here: the drag from GDP in April and May could be as high as around 4 percentage points. Therefore, if China's reasonable GDP growth rate this year would be around 5.5% without the current lockdown, the real GDP growth rate this year may fall to 1.5% without considering other policy stimuli. But if the pandemic and lockdown may last longer after May, it means that the downward pressure on real GDP may be greater.
From this analysis, we can infer that the pressure to stabilize economic growth this year will be enormous, and in addition, to achieve zero-covid as soon as possible, more pro-growth policies are also badly needed to ensure that the economy does not have a major slump. In addition, stable growth will inevitably require more and earlier resumption of work & production, so how to promote the resumption of work & production and the lift of lockdown, but at the same time ensure that infection does not recur in various places？
That will be a difficult policy conundrum that is inherently contradictory to each other and requires very careful and detailed planning and implementation.
III.
Which policies are more conducive to restoring market confidence？
From the perspective of Chinese policymakers, monetary policy, fiscal policy, and industry-specific policy are all available options that can be used to stimulate economic recovery. However, from a purely market-preference perspective, we believe that stimulus policies toward private enterprises and fiscal stimulus policies toward residential households are the most favourable policies to restore market confidence.
Although we are not saying that monetary policy is ineffective, considering the current situation, the marginal efficiency of monetary policy in China is declining significantly. This is because: First, the Fed is currently in a tightening cycle, which curbs the room for substantial easing of China's monetary policy. For example, we saw that the 10-year Treasury bond spread between China and the US turned negative for the first time (Figure 5, Note: Chinese Treasury bond yield minus US Treasury bond yield). Although we believe that the PBOC's monetary policy is very independent, the widening of the negative interest rate gap between China and the US treasuries will lead to the pressure of CAPITAL outflow and the depreciation of the RMB, thereby causing certain potential risks to the domestic investment environment and financial stability. Therefore, China's current monetary policy space and effectiveness are weakened. Secondly, there are certain problems in the current transmission mechanism of China's monetary policy, that is, though the interbank and SOEs loan interest rates are relatively low, it is still difficult for private enterprises and households to access more financing support and interest rate concessions. This resulted in a structural shortage of loan demand, due to China's property rights mechanism and banks' preferences, therefore, it is difficult to solve it in the short term. We believe that it is difficult for the current monetary policy to play a fundamental role in supporting the private enterprises and the household sector that have been most severely impacted by the lockdown.
Source: Bloomberg, CEIC, Wind
However, we believe that industrial specific supporting policies for private enterprises, such as further opening up and reducing policy restrictions, as well as fiscal stimulus policies for the household sector, such as providing subsidies and consumer coupons, loan interest or tax relief, to low & middle-income people and those affected by the lockdown, are all measures that are more conducive for the market participants to restore confidence. These policies may cause certain pressure on the fiscal balance, but considering that the current cost of government bond issuance in China is relatively low and social liquidities are affluent as a whole, this move will not cause too much financial risk. At the same time, judging from the results of the consumption stimulus policies implemented in Europe, the US and Hong Kong, the overall effect is still very obvious. Although we do not need to engage in such a large-scale household consumption stimulus as in the previous two years in the US, a certain degree of financial subsidies is still achievable and will be the most beneficial way of economic recovery.
IV.
Market Strategy
We believe that the market still underestimates the impact of the pandemic and lockdown impact in China. On the one hand, China's consumption and exports may continue to be lower than expected. Similarly, due to a declining supply capacity in China, the price of consumer goods imported in Europe and the US may rise further, thus prompting the Fed to further increase its monetary tightening policy. This, in our view, will be unfavourable to the global stock market. Therefore, we continue to be cautious about the short-term global equity market as a whole.
For commodities, we may see further divergence going forward. Some commodities with clear supply bottlenecks and low inventory constraints, such as agricultural products and crude oil, may still be relatively strong. But for commodities related to domestic consumption and property markets, there may be a risk of price decline due to the lack of demand in peak seasons.
The future changes of the Chinese pandemic and the corresponding domestic measures to stabilize growth are the core variables for investors to evaluate when to enter into the stocks and commodities on dips in the future. The market's sensitivity to monetary & credit policies may continue to weaken, but only when there are more policies to support the resumption of work & production of private enterprises and help household consumption, then the window of buying opportunity for stocks and commodities may occur.
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