As the Fed and the ECB corrected their communication mistakes and pushed up expectations for tightening monetary policy during August and September, bonds and equities sold off dramatically. In October S&P 500, along with other equity markets, reached new lows for the year. This was, however, far from the case in all markets, as seen in Figure 1 below. Emerging markets in general and in particular, Chinese equities, as measured by the respective MSCI indices, continued to decline. Following the Chinese Communist Party’s congress, we now know that Xi Jinping in his and his party’s mind is a great leader, and that the Chinese should prepare for struggles and tough times ahead according to his advice. We don’t know much about the former president Hu Jintao who was escorted out during the congress, but the spectacle was anything but dignified and more than anything reminded of something from a cold war documentary about communist regimes. For investors in Chinese equities, tough times started some time ago and, in our opinion, it will require a turn in Chinese politics to reverse that situation. Seen in a broader perspective, declines in the emerging market equities asset class is a fairly normal phenomenon when the USD strengthens, when the Fed tightens and when growth slows down. Following the November FOMC meeting these trends are also likely to continue. Still in a way emerging market weakness can be seen as a reassuring sign, in the sense that many investors will be looking at such signs of capitulation before they will be convinced that a bottom in the market can be found.
Figure 1: Global Equity Market Return and Losses over the recent 5-years. China Stands Out
In the parts of the world where capital can flow freely in and out, which is not the case in China, India and Russia, central banks have again re-set hiking expectations and market rates have adjusted accordingly. Parallel to this, inflationary pressures as seen in early indicators - like freights rates, USD base money growth and oil prices - have eased. Global growth momentum has come down, even if US and Chinese GDP was reported as slightly stronger in Q3 than in Q2. Chinese and European PMIs have continued their downward trends, indicating further weakness of demand in both manufacturing and services. Tighter financial conditions are seen in corporate bond market activity and spreads. At the same time, the US housing market has decelerated meaningfully on the back of mortgage rate increases and both prices and activity are now trending down.
Financial markets have taken comfort from the apparent return of relatively normal economic relationships, whereby tighter monetary policy and a more mature business cycle have led to easing of economic demand and less inflationary pressure. Helped by the outlook for a deceleration in the pace of monetary tightening, some stability has thus returned to financial markets. As the risk of a self-fulfilling collapse has declined, our algorithms have turned around and are now trending upward. It is therefore time to move back to balanced portfolios. Should central banks prove to be able to lead the economy through a cooling down period without a recession or only a small recession, it is likely that financial conditions will ease, and a more positive investment strategy will be warranted. This will depend, however, on the evolution of general economic conditions. Should the slowdown in the US housing market spiral out of control or inflationary pressures prove to be persistent in the US labour market, a return to more defensive strategies is likely to be warranted. In terms of our more specific positioning, we have made the following allocation changes across our strategies.
In our dynamic allocation strategies, with up to 100% equities, we have increased our equity allocations to 50-70% with a US overweight which to some extent is unhedged in Euro portfolios.
In our balanced multi-asset strategies, we have increased equity allocations to levels between of 30% to 50% and have significant increase holdings of high yield bonds.
Across our Global Fixed Income Opportunities portfolios, we have significantly increased high yield positions. In the more defensive mandates, we have scaled down cash positions.
A gradual change with a dramatic acceleration
In China, Xi has now concentrated power in the extreme and turned the ideology around from the decade long focus on market friendly reforms to eliminate poverty via economic growth and catching up technologically with the west. Now the focus is on the party, national revival, and a common prosperity, apparently built on a communist foundation. It looks like it is inspired by Xi’s nationalistic and communist articles and speeches, but in reality, it is unclear what exactly the intended changes are apart from the larger role of the communist party, the president and national interests. For that reason, we doubt very much that anyone will be able to predict how this experiment will play out. The leadership might be crossing the river by feeling one stone at the time or they might accelerate changes in the coming months. A positive if unlikely outcome would be if the party, led by Xi, celebrated its almost absolute power concentration by turning around and focussing more on making the Chinese version of market economy function more freely. This is not very likely, however, and Xi has not given any indication that he would like to see that. The current process started years ago, moreover, and is difficult to reverse. We have seen in Chinese history, and in Russia as well, the dynamics of concentrating power often gains its own momentum and risks spiralling out of control. These are long term considerations and there is no sign of an imminent collapse of either the Chinese state or the economy, or the equity market, but the risk is inching up. The latter has underperformed and declined so much in recent years, in terms of both price and valuation, that it can easily rebound forcefully if we get an easing of cyclical fears. Independently, of whether it is related to Covid restrictions or based on signs of an easing of real estate stress or global liquidity constraints.
It is also worth noting that Chinese economy cannot and therefore will not be disentangled from the global economy quickly or even close to fully. China simply does not have the natural resources to do that, and probably no desire to do so either. On the other hand, the rest of the world is still highly dependent on Chinese production and consumer demand. What we are predicting is that the trend in Chinese growth will decline to less than half of the levels seen during the boom years while performing a gradual drift away from the rest of the world in trade and policy terms. During this process, the country in the middle will have to deal with the uncomfortable fact that growth is slowing at a lower GDP per capita level than the medium in OECD countries and with a declining labour force. A very different scenario from when Japan experienced the end of its growth boom and by implication a trajectory towards less absolute and less relative economic power than what was expected a few years ago. In the short term, two other forces are of more significance. One the one hand, China’s slow growth, due to low domestic demand and Covid closures, is currently a source of disinflation and as such is a positive source of easing of financial tensions. On the other hand, the long-term lingering risk of over construction and a collapse in the Chinese real estate sector has now reached a point where is seems as though either the government will need to do something more coordinated and decisive or there could be a hard landing of the property market and the economy. According to research from Goldman Sachs and from Yang & Rogoff (the Harvard professor and co-author of This time is different and Foundations of International Macro Economics), the Chinese construction sector represents 25% of total domestic demand, so a collapse would be much worse than the housing correction in US or Spain during the great financial crises. There is probably a political will to avoid such a collapse, but the question to live with in the coming months is whether the ability also exists after the clean out in the Chinese establishment and if a feasible way exists. For the time being, the most reliable data shows that China has probably reached a level of 40+ square meters of real estate living space per capita. At a par with developed nations. Most of this is located in tier 3 cities where real-estate prices are down 10% according to official Chinese figures and where the population has started to shrink (Rogoff and Yang, NBER working paper 30519, September 2022).
Figure 2: 18 months total return for fixed income ETFs in USD
Investing in bonds
2022 has been a difficult year for most types of investments, but generally speaking and in relative terms it has been most difficult for bonds. And nowhere has it been worse than in Chinese real-estate related junk bonds. As seen in Figure 2, even for the broadest sense of “related”, meaning Asian high yield, the experience has been devastating. Capital invested in a broad-based ETF in this sub-asset class has been halved, a return so poor that it makes the 20% drawdowns in USD denominated investment grade corporate bonds look good. Outside of Asia, the sell-off in bonds has been driven by a repricing of money and a general move up in the yield surface, the determining factor for losses has been bond duration. And the result has been that high yield bonds with the worst credit rating have had the best returns, with losses of “only” 10% year to date, for both USD high yield and for Euro high yield ETFs. (In Figure 2, we show the Euro ETF hedged to USD for the comparison). For more than 20 years the world has marvelled at the Japanese and later the Chinese FX reserves and these countries holdings of US Treasuries.
Figure 3: US money supply growth year over year
It is remarkable to see how things have played out as the Fed tightens, and the previously discredited USD rise and rise in value. Noting the increase in yields and looking at the USD M2 growth, it is tempting to consider whether, as in so many other cases, it was the rise of the cost of US dollars which made the overextended Chinese real estate sector break down, thus putting this important domestic growth engine of recent decades in trouble. If this is indeed the case, then China is less different than so many other developing nations and there is again a risk the country gets stuck in a middle-income trap. At the same time, it is evidence that Chinese real estate is more prone to bubble like behaviour than many would wish. As global central banks have now started talking about scaling down the pace of tightening and as yields have moved up, it is worth considering where value can be found in bonds. In this context, two unusual phenomena are worth observing. First of all, the nature of the sell-off and the shape of the curve means that, apart from the Asian High Yield bonds, those bonds which have sold off the most still offer the lowest yields. A US 10-year bond offers less than a 2-Year government bond and a US government bond index with no credit risk offers only a bit more than half the yield of a US or Euro high yield bond ETF basket. From a stand-alone point of view, we therefore maintain that the US and European high yield market is more attractive than most other bonds, both in relative and absolute terms. And as we have often mentioned, not only because of the short duration, but also because of an unusually high credit rating. This will surely not help indefinitely if a harsh recession sets in. But it will help contain defaults for any scenario compared to previous recessions. As for government bonds, it is now reasonable to expect that US 5-10-year part of the cure will again be delivering solid returns in a recession. Yields are now high enough that they can fall and that it is likely that they will fall if a recession is harsh, as this will be enough to ease pressure in the labour market, especially in the low skill, low pay, end of the market, where there currently seems to be both high wage pressure and something close to a global shortage of staff.
Assuming such a harsh recession is avoided, another thing which is different from normal market crises is that the pain from the bond correction has been so intense this time around that what we need to see happening for high grade bonds to become an attractive asset class again will also probably make the broader investment environment more attractive. The latest confirmation of this was the turnaround in equity markets after the CPI and the following news in the Wall Street Journal that the Fed would start considering smaller rates hikes from December. Such intentions were all but announced in the recent FOMC statement, even if the overall signal was made more hawkish by Powell’s comments and wavering on the subsequent press conference. For everything to play out according to this script, we need inflation to calm down in a convincing manner, which means that those most scared of inflation need to see it declining. Here the collapse in M2 growth is a good starting point and when it happens, we will be back to the times when government bonds offered value as a diversifying asset class in a portfolio context while offering protection in risk off situations. Exactly when this will happen remains unknown, but our best guess is within the next 3-6 months.
Mads N. S. Pedersen
Managing Partner and CIO