Key Points:
- The US Congress passed the 2023 Fiscal Responsibility Act and raised the debt ceiling to 2025. Seemingly the impact of the US debt ceiling seems to have come to an end, but we believe that, in fact, the possible impact of the new US fiscal bill on the future economy and market liquidity has just begun.
- The US fiscal spending expansion in the past three quarters may have come to an end. We expect the non-defense spending in the rest of FY2023 will be $330billion less than FY2022 and it will further contract by $100billion in FY2024. Furthermore, as interest payments have rising quickly, the discretionary non-defense spending can drop at a faster pace.
- The 2nd impact of debt ceiling raise is on market liquidity. Treasury will rebuild its TGA and spending by issuing more debt, together with Fed’s QT program, we expect a net supply of $1.2trillion treasury debts will be on the market before the end of FY2023. Among them, there will be roughly $400billion T-notes and T-bonds.
- Even ONRRP could absorb part of the T-bill supplies, we expect that provided that the Fed does not cut or stop its QT, the incremental supply of treasury debts will drain around $800billion liquidity from the market by the end of this FY.
- Due to economic data weakening in China, the market’s expectations and call for more policy stimulus have picked up again. However, we believe that we still have a certain distance from a new round of economic stimulus by Chinese policymakers. China can still reach 5% growth target without more stimulus. If we will have more stimulus in the future, the precondition could be: 1. further economic slowdown that may endanger financial system or social stability, 2.Export surplus slumps due to recession in the US and EU, 3. Fed and ECB begin to cut rates.
- We maintain a bearish outlook on US stock market due to weakening fiscal spending and liquidity concerns. But if the long term treasury yields reaches above 4% because of heavy treasury debt offerings, we think it is a good opportunity to buy on the higher yields.
- We hold a neutral view on A-shares. We believe that after the recent quick selloff, the overall A-share valuation has fallen to near the nadir of last year, and short-term market risks have been mostly priced in. However, in the short term, there may not be a good market catalyst to drive a significant and tradable rebound.
Hou Zhenhai
Straits Financial (China) Chief Strategist
Previous Views:
If the US congress reach a debt ceiling agreement in June, it means that the US Treasury will drive a net liquidity around 800billion USD out from the market, which may cause a short-term liquidity crunch. Therefore, we believe that investors must pay attention to a possible negative impact on the financial markets. We believe that in the context of the lack of economic drivers and incremental inflows, the A-share will continue its range-bound trading and shifts quickly among different thematic sectors. But we expect the rising household willingness to save and the decline in investment return expectations will continue to support a Chinese treasury bond bull market with a flattening yield curve.
Views in June:
I. Debt ceiling agreement reached, but the market liquidity problem may have just begun.
After arduous discussions between the two parties, the US Congress passed the 2023 Fiscal Responsibility Act and raised the debt ceiling to 2025. Seemingly the impact of the US debt ceiling seems to have come to an end, but we believe that, in fact, the possible impact of the new US fiscal bill on the future economy and market liquidity has just begun.
This is because: First, the new FRA2023 has made new revisions to the budget for fiscal years 2024 and 2025. The non-defense budget deficits are now at $703.6 billion and $710.7 billion respectively. That’s actually a significant drop from the $800 billion non-defense budget for FY2023. And we believe that since the second half of 2022, the re-expansion of the US fiscal deficit was the most important factor that supported the US economy to maintain its positive growth in the past three quarters. Fiscal is also a factor relatively neglected by the market, because the market focused on the Fed’s rate hikes and quantitative tightening. Of course, the Fed’s monetary policy has indeed had a certain tightening effect on the US economy, but it is notable that the current rolling 12-month total fiscal deficits in US bottomed out at the level of $1 trillion in July 2022 and after that, it has risen again 2023 to $1.94 trillion by the end of April, which is about 8% of the US GDP (Figure 1). In other words, in the past three quarters, the US was in a rare policy mixture of tightening monetary and fast expanding fiscal policy. The result of this combination is that the US avoided a recession so far, but at the same time the job market has remained strong, and core inflation came down at a very slow pace.
Source：Bloomberg, CEIC, Wind
With the raising of the US debt ceiling and the passage of the new budget bill, what we need to pay attention to is whether the fiscal deficit rebound in the past three quarters has come to an end. If the answer is yes, then the US macroeconomic policies in the future may change from “monetary tightening +fiscal expansion” to “monetary tightening +fiscal contraction”. This new combination, if happens, will not only increase the risk of recession, but also help the US to tame inflation and eventually end the Fed’s monetary tightening cycle. But we think that might still be two to three quarters away from now.
Specifically, according to the current new US budget plan, the remaining non-defense fiscal expenses in the FY2023 (till the end of September this year) may contract by about $330billion compared to the same period last year, that is, down about 10% from last year’s $3.39trillion to about $3.06trillion this year (the total non-defense expenditures in FY2022 will be $7.87trillion, and the current estimated non-defense expenditure budget in FY2023 will be around $7.69trillion). That is roughly equal to about 1.3 percentage points of US GDP (Figure 2). As long as other conditions remain unchanged (for example: the Fed does not cut interest rates, does not stop its QT in this FY, etc.), we believe that this will significantly increase the risk of a recession in the US economy around the year end 2023. In the FY2024, which will start in October this year, according to the new agreement, the US non-defense budget deficit will be further reduced by about $100billion compared with FY2023.
Source：Bloomberg, CEIC, Wind
In addition, another point that cannot be ignored is that in the non-defense expenses, due to the increase in both total treasury debts and interest rates, the level of interest payments has increased significantly. For example, as of the end of April, the interest expense in FY2023 has reached $473.1billion, while the interest expense by the end of April in FY2022 was only $361.3billion, an increase of $111.8 billion year-on-year (Figure 3). We expect the interest expenses may further increase to $900billion in FY2023, $164billion more than in FY2022. Therefore, in fact, the discretionary non-defense fiscal expenditures of the US will decline more significantly after deducting interest expenses and other compulsory outlays like medicare and social security. Therefore, to sum up, we believe that if the new US budget act is strictly implemented, the US fiscal will gradually return to a tightening status, which may have a negative impact over the US economy in 2H2023 and 1H2024.
Source：Bloomberg, CEIC, Wind
Beside fiscal contraction, the second important impact of the FRA2023 will be on market liquidity. With the depletion of the US Treasury TGA deposits and raise of debt ceiling, the US Treasury will begin to auction debt at a very fast pace. But what is different from before is that the current Fed is carrying out QT instead of QE now. That is, reducing its holdings of US treasury debts by about $60billion per month. We project that the US Treasury will issue $800billion incremental debts in the next two months, and that number will go to $1trillion by the end of September. Coupled with the Fed’s QT, there are about $1.2trillion incremental supply of government bonds needs to be taken by the bond market. We have already elaborated on this point in our monthly report last month. However, our conclusion has not changed, that is, with the massive incremental issuance of US debt, the liquidity of the US capital market will tighten again, which may have an adverse impact on risk asset prices.
At present, there is a belief in the market that the new supply of $1.2trillion treasury debt can be absorbed by the approximately $2.1trillion overnight reverse repurchase(ONRRP) currently deposited on the Fed’s balance sheet. And we think that this scenario will be unlikely. First of all, in the case of large-scale issuance of treasury debt due to raised debt ceiling at the beginning of 2022, we did not observe a significant decline in the US ONRRP funds, which were also as high as $1.6trillion at that time, and the ONRRP interest rate at that time was only 0.05%. The current ONRRP interest rate is as high as 5.05%, so first of all, it is impossible for ONRRP money to invest in medium and long-term US Treasury notes and bonds with a maturity over one year. Therefore, it is necessary to first assume that the new supply in the future are mostly bills with a maturity of less than one year, but we think this possibility is very low, though Treasury may choose to issue more bills at first place. According to our projection, we expect that by the end of September, the new supply of treasury bills will be at most about $800billion, and the remaining at least $400billion will be treasury notes and bonds. Moreover, the $800billion treasury bills will not be totally absorbed by ONRRP. In the best-case scenario, ONRRP may take nearly half of the newly T-bills. Therefore, the incremental treasury debts have a negative impact on the overall financial market liquidity of about $800billion by the end of this FY.
II. China’s economic data is still within the tolerance range of its policymakers.
Recently, due to the weakening of various economic data in China, the market’s expectations and call for more policy stimulus have picked up again. However, we believe that we still have a certain distance from the introduction of a new round of economic stimulus policies in China. First, the economic data has been poor, mainly in real estate and consumption demand. For example, we can see that housing sales in China have continued to weaken (Figure 4). Thanks to the very low base effect on domestic consumption due to Covid19 lockdown last year, the overall yoy retail growth looks good, but calculating its sequential growth and annualized growth compared to 2021, its growth has decelerated significantly since this April.
Source：Bloomberg, CEIC, Wind
In addition, China’s export growth has also shown signs of further slowdown. Among them, the growth rates of China’s exports to developed markets such as the US, EU and Japan were -18.2%, -7.03% and -13.31% respectively. Exports to ASEAN countries, which performed relatively better before, also fell to -15.9% yoy in May, the worst growth rate since the epidemic in February 2020. Only Africa (+12.9%) and Russia (+114%) are the only bright spots that have maintained positive export growth in May (Figure 5). And the total exports to Africa and Russia reached $25billion, more than half of the $42.5 billion exports to the US in the same month.
Source：Bloomberg, CEIC, Wind
However, the rapid increase in exports to Africa and Russia cannot completely offset the downward trend in overall export growth due to the decline in global demand. At the same time, according to our previous discussed projection on the fiscal situation of the US in the 2H2023, we believe that the overall demand in the US may further slow down, so the downward trend of export growth this year is likely to continue in 2H this year. Therefore, whether it is domestic demand or external demand, the overall economic demand situation will continue to be weak.
That said, we still believe that the current situation of weak domestic economic aggregate demand is still within the tolerable range of Chinese policymakers. First of all, the domestic GDP target set this year is relatively conservative, only about 5%. Considering the very low base in 2022, it is of high probability that this year’s overall consumption could maintain a positive 7-8% yoy growth. Meanwhile, though the exports has declined, China’s trade surplus still widened year to date due to a declining import of lower domestic demand and commodity prices. China’s total trade surplus from January to May last year was US$281billion, while China’s total trade surplus in the first five months of this year reached US$360billion (Figure 6). This is a recessionary trade surplus widening due to a faster decline in domestic demand than external demand. In Q2, because of the impact of last year’s lockdown, the year-on-year growth of various domestic economic data will still look good. Therefore, only from the perspective of economic indicators, the pressure and urgency of domestic policymakers to maintain growth are still not very big so far.
Source：Bloomberg, CEIC, Wind
Of course, policymakers are not totally neglectful on the weakness of the domestic economy. However, we can see that the overall weak demand of the current domestic economy is due to many deep structural problems. Therefore, although some temporary stimulus measures may improve the economic performance in the short term, these structural problems cannot be resolved and may even aggravate further, such as local government debt and property problems. Therefore, Chinese policymakers have become relatively more cautious to rely on the past monetary and credit stimulus policies.
In addition, mounting global geopolitical uncertainties, coupled with rate hikes by the Fed and ECB, put a greater pressure on the RMB exchange rate. This makes it more difficult for Chinese policymakers to adopt a more aggressive stance to stimulate aggregate demand. Therefore, we believe that Chinese economy will continue to “recover on yoy basis, but weaken on mom basis and slow down on a long-term trend”.
If there might be a more significant change in future Chinese policymaker stance, we believe that at least one of the following conditions must be met: 1. The downward pressure on the domestic economy continues to exceed expectations and may begin to impact the Chinese financial system or its social stability. 2. If the US and EU falls into recession, and China’s trade surplus drops sharply. 3. If the Fed and ECB begin to cut interest rates. At present, we believe that there is still a certain time distance from the above three pre-conditions.
III. Market strategy
We maintain a bearish outlook on US stocks. In the 2H this year, the US economy may face a higher risk of recession as its discretionary fiscal outlays slow down. At the same time, with the increase in treasury debt offering, market liquidity may have an inflection point and lead to a decline in market risk appetite. The recent rise in US stocks is mainly driven by several individual mega-cap tech stocks, and most stocks in the market have actually performed mediocrely. However, if the level of liquidity and risk appetite may decline in the future, we expect this trend to change to some extent. For US Treasury bonds, we believe that the pressure of large-scale debt offering may cause short-term interest rate rises, but we believe that the decline in fiscal spending will help the US economy and inflationary pressure to slow down. Therefore, we believe that the medium and long-term US treasury yields still have a good long-term value, so investors can consider to buy on the recent rising treasury yields.
We hold a neutral view on A-shares. We believe that after the recent quick selloff, the overall A-share valuation has fallen to near the nadir of last year, and short-term market risks have been mostly priced in. However, in the short term, there may not be a good market catalyst, policy stimulus or incremental funds to promote a more significant tradable rebound in A share. The market may continue to consolidate at the bottom.
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.