Key Points:
- Overseas markets are overly optimistic about the fall in inflation. Although oil prices have fallen significantly recently, the main core inflation driving factor is the rapid rise in wage costs coupled with a tight labor market, which shows no sign of improvement.
- Overseas markets overestimated the possibility of a substantial US economic recession.
- We believe that the Fed can only continue to put inflation control as its main target, and the probability of the Fed raising interest rates to 4% is high.
- The problem of China’s slow economic recovery has not been resolved. The domestic property market weakened significantly again in July.
- We believe US stock market rebound due to the fall in oil prices may end soon. And once the market’s expectations that the Fed may hike rates to 4% rises again, the US stock market may face downward pressure again. For A shares, the short-term market sentiment after the geopolitical risk event is expected to recover. However, subject to weak fundamentals, the overall A-share index will have limited rebound space. But the domestic market liquidity is very loose. This situation means that even if the A-share index does not perform, it will not lack chances for individual stocks and sectors, especially tech and growth stocks with sure growth and some conceptual speculative stocks.
- The current domestic commodity rebound is a typical sentiment repair after over-pessimism in July. Therefore, the rebound in the black and non-ferrous metals with large and deep declines last month are also relatively strong.
Hou Zhenhai
Straits Financial (China) Chief Strategist
I. Market expectations for a declining inflation are too optimistic.
Since the beginning of July, overseas stock markets have rebounded, mainly benefiting from the market’s optimistic expectations for a decline in inflation due to a fall in commodity prices, and the resulting optimistic judgment on a slowdown in the pace of future Fed rate hikes. But we think such expectations may have now entered into over-optimism territory, which in turn may face a challenge of reversion again in the coming month.
It is true that oil prices have fallen significantly recently. Taking the US retail gas price as an example, it has fallen from a high of US$5.1 per gallon in mid-June to US$4.3 in early August (Figure 1). But this does not mean the inflation problem is done. First of all, because the global crude oil supply problem has not been truly solved, and crude oil inventories in Europe and the US are still at historically low levels, meanwhile, the US still needs to continuously release strategic oil reserves to maintain a short-term supply and demand balance in the market. On the other hand, as crude oil prices fall, the willingness of OPEC producers such as Saudi Arabia and the UAE to increase production is also likely to decline.
Source: Bloomberg, CEIC, Wind
Even if oil prices no longer rise significantly in the future, the current inflation pressure in Europe and the US may still run at a high level for a long time. This is because this inflation is not only driven by the rise in oil prices. The pressure of rising wages in Europe and the US due to labor shortages is a more important cause of this round of inflation. As it can be seen from the US employment data released on August 5, the U.S. unemployment rate in July has dropped to a historically low level of 3.46%, and the continuous jobless claims in the US was only 1.42 million, almost the same level as the 1970s. (Figure 2), but the total US population was only 200 million in the 1970s and 330 million today.
Source: Bloomberg, CEIC, Wind
Such a low level of unemployment has caused the US labor market, especially the service industry, to be inflexible, which in turn has pushed up the level of wage growth. And we know that the most important factor driving inflation, especially core inflation, is the level of wage growth, known as the “wage & inflation spiral growth model”. Due to the impact of globalization in the past 30 years, wage inflation did not show up in the US. This is also the main reason why the current market focuses inflation mainly on oil prices rather than rising labor costs. But in fact, the growth rate of hourly wages in the US in the past three years has continued to be at an elevated level over 5%, while the July hourly wages announced last Friday still increased by 0.47% month-on-month, an annualized level of 5.6% (Figure 3).
Source: Bloomberg, CEIC, Wind
We believe that the market is too optimistic about the future inflation trend in Europe and the US out of oil prices. The current drop in oil prices can only help the inflation in Europe and the US drop from 9% to 5-6% year-on-year gradually, while the decline in core inflation is even limited. And at this level of inflation, the Fed is obviously unlikely to slow down or even stop hiking rates.
II. US recession probability is low, and inflation control is still Fed’s main target.
Another main reason why the market traded in July for the Fed to slow down or even stop hiking rates is that the US GDP growth in Q2 was negative again MoM. Since the Q1 US GDP growth was also negative, the market believed that the US economy may have fallen into a technical recession, and based on it, the market expected that the Fed would soon slow down the rate hike.
However, we believe that the negative MoM increase in US GDP we are currently seeing is not a typical economic recession, but just a return to normal of the US economy from an abnormal point of high commodity consumption growth due to excessive fiscal stimulus in the past 2 years. First, the negative contribution to US GDP mainly came from the increase in imports (Q1) and inventory adjustment (Q2). Due to the impact of the Omicron in Q1, the US relied more on imports to meet domestic consumption. Consumption growth remains strong, but the increase in imports became a larger negative contributor to GDP. The main economic drag in Q2 was inventory adjustment. This is because the growth rate of durable goods consumption in the US began to decline since Q2, and companies began to destock. By sector, US consumption can be mainly divided into three categories: durable goods, non-durable goods and services. From the perspective of their respective trends, due to the strong fiscal stimulus implemented by the US government during the pandemic, the growth rate of US durable and non-durable goods consumption in the past two years has been significantly higher than the normal level before Covid19. With the end of the fiscal stimulus, and also due to the cyclical nature of durable goods consumptions (such as automobile, appliances), it is normal for this part of consumption to experience negative growth this year. However, the growth rate of service consumption, which was suppressed during the lockdown and accounts for two-thirds of total US consumption, continues to grow significantly quicker than pre-pandemic levels (Figure 4).
Source: Bloomberg, CEIC, Wind
Therefore, we believe that the current economic downturn in the US is more likely to occur in the manufacturing and construction industries that are determined by the durable goods consumptions. But for the service industry, which accounts for a larger proportion of the service consumptions, it is still far from being under a recession. Similarly, we can also prove this in the trend of the PMI index in the US. The July US PMI new order index released at the end of last month showed that the manufacturing PMI new order index fell below the 50 reading for the first time in two years. But Service PMI new order was a different story, it rose above 60 again (Figure 5). Therefore, in the current situation of divergence in the manufacturing and service industries, investors need to pay more attention to the changes in the demand of the US service industry. Because the weight of the US service industry is much higher than that of the manufacturing industry in terms of both GDP and employment, and historically, the PMI new order index of the US manufacturing industry falling below 50 did not always mean that the US economy is in recession, but a dip of the service industry index below 50 corresponds almost exactly to a US recession.
Source: Bloomberg, CEIC, Wind
It is precisely because we believe that the market is currently overestimating the possibility of a substantial recession in the US economy, and thus underestimating the room of the Fed rate hikes and QT. This expectation has been adjusted again since last week and may continue. Judging from the trend of federal funds rate futures, the market significantly raised expectations for the rate hike by the Fed against the backdrop of significantly higher-than-expected inflation from mid-May to mid-June, which led to a sharp drop in US stocks at that period. Throughout July, due to the significant increase in expectations for a US economic recession, the market’s expectations for the Fed’s future rate hikes have fallen sharply, and this stage also corresponds to a significant rebound in US stocks, especially heavily sold US tech and growth stocks. However, we noticed that in the past week (July 27th to August 4th), due to the much higher-than-expected impact of PMI service industry data and employment data, recession expectations have fallen sharply, which has led to the market’s rate hike expectations have picked up again (Figure 6). And we believe that this move in expectations may have only just begun. As we mentioned earlier, if the year-on-year wage growth rate in the US continues to remain above 5%, it will be difficult for the core inflation level in the US to fall below 5%, which means that the Fed will still need to raise interest rates next year until 4% or even higher levels. Because with unemployment at record lows and inflation well above the Fed’s 2% target, the Fed obviously can only continue to put inflation control as its main policy objective. The market’s assumption that the Fed will tolerate high inflation is clearly unrealistic.
Source: Bloomberg, CEIC, Wind
III. China’s economic recovery still faces mounting headwind pressure.
China’s own economic problems still exist. Although some measures to stabilize growth have been introduced in China recently, due to the effect of dynamic zero Covid policy and the continuous downturn of property market, we believe that the downward pressure on China’s economy is still large. The brighter parts of the economy are the growth rate of infrastructure construction has rebounded due to the government’s increased issuance of special project bonds, as well as the growth rate of exports. But the export that supported China’s economic growth in the past two years may slow down as durable goods consumption in Europe and the US declined and their own supply chain capacities began to recover. It is difficult for exports to become a bigger positive contributor to China’s economic growth. The decline in residential consumption and willingness to buy houses are the main factor leading to the continuous sluggish domestic economic recovery. After a slight rebound of property sales in June, due to the drama of “unfinished houses” and “loan suspension” happened in July, residential interests on property purchases dropped significantly again. At the same time, the willingness of residents to increase leverage also dropped significantly. Although the government is also actively coordinating and solving the problem by guarantying housing construction and handover recently, it will take a long time for the housing confidence of the residential sector to recover. Among the many factors that affect the willingness of Chinese residents to increase leverage, we believe that the current high residential debt ratio, especially the high ratio of residential debt to disposable income, is the core factor. At present, that ratio in China exceeds 120%, which is already higher than that of other major countries including the US, the EU countries and Japan (Figure 7). In 2008 and 2015, the proportion was only 40% and 80%, respectively. This means that over the past 10 years, China’s residential sector has increased leverage very quickly. And at current high level, it got worse due to the impact of Covid19 since 2020, when the growth rate of residential disposable income has dropped significantly. The further increase in leverage of the entire Chinese residential sector has been greatly impacted. Therefore, although China still adopts loose monetary and credit expansion policies, unlike in 2009 and 2016, neither the overall consumption nor the willingness to buy houses can be significantly improved again, resulting in a very slow recovery of domestic demand.
Source: Bloomberg, CEIC, Wind
In the short term, it is very difficult to change this trend. Of course, China can also learn from the practices of European and US governments during pandemic, and forcibly increase residential incomes through dispersing financial stimulus to the residential sector, but that situation may also cause certain problems, such as the serious inflation together with the declining job participation willingness faced by Europe and the US now. Judging from the CCP Politburo meeting held at the end of July, the Chinese government does not have such willingness. The Politburo meeting did not put forward the economic growth target requirements for this year again. Therefore, we believe that the Chinese government will play down the economic growth rate requirements this year, and instead focus on maintaining basic social stability while continuing to adhere to the dynamic zero Covid policy and avoid any large systemic risks. Under this mindset, we believe that the further easing of the overall domestic monetary and credit policies is likely not to be very large, and the government may turn to special project bonds and government backing to stabilize infrastructure and real estate constructions.
IV. Market Strategy
We believe that this round of US stock market rebound due to the fall in oil prices is soon coming to a stop. And once the market’s expectations that the Fed may hike rates to 4% rises again, the US stock market as a whole may face downward pressure again. But on the other hand, the probability of a significant recession in the US economy is not high, hence it is unlikely that the US stock market will plummet again in the short term. Therefore, our current attitude towards US stocks is neutral to slightly bearish.
For A shares, we believe that the short-term impact of Taiwan visit drama has come to an end, and the market’s short-term sentiment is expected to recover. However, the slow recovery of the domestic economy and reducing probability to see stronger stimulus policies are likely to be the norm for the fundamentals of the domestic economy in near future. In this context, the rebound of the overall A-share index will be relatively limited. However, due to the sluggish corporate investment and residential willingness to consume, a large amount of funds stays within banks, and market liquidity will still be quite loose, which is reflected in the inter-bank interest rate. And the interest rate on wealth management products also continued to remain at a low level of less than 2%. This situation usually means that even if the A-share index does not perform, it will not lack the activity of individual stocks and sectors, especially the technology growth stocks with sure growth and the conceptual speculative stocks. The commodity market has rebounded recently after a sharp decline experienced in July, but in general, we believe that the upward rebound space for commodities is limited. The current domestic commodity rebound is more of a sentiment mean reversion after the market became over-pessimistic in the previous period. Therefore, the rebound in the black and non-ferrous metals with large and deep declines last month are also relatively strong. Overseas investors can pay attention to whether oil prices are also likely to have a wave of oversold rebound opportunities.
About the Author
1998 – 2004, Chief Representative Assistant of GKN Group in China.
2006, obtained MBA degree from Wisconsin School of Business at University of Wisconsin–Madison.
2006 – 2007, served at the Wisconsin Foundation.
August 2007 – July 2013, served at China International Capital Corporation (CICC) as the leader of the overseas strategy team and A-share strategy team. He is also the main report writer and contributor. Mr. Hou and his team received many honors including the top team for the New Fortune Sell-side Strategy Research in 2008, and the top team for the Asia Money China Strategy Research in Hong Kong in 2009 and 2012, etc.
September 2013 – December 2019, served at Discovering Group and was responsible for the Group’s macro strategy research. During the period, the company has accumulated absolute returns that far exceed the market level.