Soft Landing & China’s COVID Policies
October 24, 2022
Is a Soft Landing Possible?
A soft landing is defined as where the Fed achieves its policy goals of limiting inflation expectations by cooling the U.S. economy but without creating a recession. The Fed’s long-term track record is not encouraging. Looking back in history, when the Fed embarked on a rate hiking cycle, it often led to a recession down the line. Can this time be any different? The equity market clearly thinks not. The fact that the S&P 500 Index has lost almost 30% since its peak indicates that the market is already discounting a proper recession.
The U.S. Economic Surprise Index – which measures the extent to which the economic data is either beating or missing economists’ forecasts – has recently moved back into positive territory. A move above zero indicates that economists have been overly pessimistic and have been underestimating U.S. economic conditions. This year, the S&P 500 has generally moved in line with the Economic Surprise Index. U.S. stocks benefitted during periods when economic data consistently surprised to the upside, and equities fell when data disappointed consensus expectations.
However, this relationship has recently shifted. The S&P 500 has been selling off for the past two months even though the Surprise Index has been improving. This move from a positive correlation to a negative correlation suggests that we may now be in a “good news is bad news” environment. Positive data surprises imply that the economy is holding up better than expected.
As long as inflation remains unacceptably elevated, this economic resilience reduces the likelihood of an imminent softening of the Fed’s hawkish stance. However, what most investors seem to have forgotten is how fast inflation unexpectedly rose from 2.6% last year to over 8% now. This is because the price curve is not linear.
The right framework for thinking about inflation is that of the kinked Phillips curve. Not only did this inflation vs. unemployment framework predict the surge in inflation, but it helps to resolve several puzzles that have baffled analysts in recent months, such as why the U.S. unemployment rate has remained stable as job openings have plummeted. The Phillips curve framework makes several surprising market-relevant predictions. Most notably, it predicts that contrary to the consensus view, inflation may fall fairly painlessly over the coming months, which would give the Fed room to back off its hawkish stance before economic activity deteriorates significantly. In other words, a soft landing might actually be possible this time.
China Says No Room for COVID
On Thursday, we saw a protest in Beijing regarding Xi Jinping and his zero-COVID policies. Banners hung over highways and overpasses referencing the nation’s strict COVID policies. Signs read, “Say no to COVID test, yes to food.” and “No to lockdown, yes to freedom.” This protest comes as China still maintains its COVID-19 policy, which has seen little change since the initial outbreak in Wuhan. Xi further reinforced the policy on Sunday following the protests earlier in the week. He stated that there would be no easing of the zero-COVID policy in the immediate future. But the question has to be asked, given China’s struggling economy, is this the right decision?
Throughout the pandemic, multiple cities in China have been in on and off full or partial lockdowns. This includes major financial and manufacturing hubs such as Shanghai, Shenzhen, and Guangzhou. Continued restrictive policies have limited output and domestic demand throughout the year, causing growth to fall 1.3% in the first half of the year. The impact has been material, with September Manufacturing PMI coming in at only 48.1, meaning Q3 is likely to disappoint as well. Despite the civil unrest and falling GDP growth, Xi has, at least publicly, continued a hard stance on his zero-COVID policy.
Still, throughout this entire pandemic, one thing has remained a constant, Chinese equities are cheap. Currently, China is seeing a forward P/E of 10.28, which is at the same level as in 2008. Comparing this with the forward P/E of the Nasdaq at 24.17 and the S&P 500 sitting at 16.53, it starts to become clear just how cheap Chinese equities are. This becomes even more apparent when comparing previous performance compared to EM and the MSCI ACWI. Given the current valuations of Chinese equities, we still remain firm in our view that Chinese equities are attractive.
DISCLAIMERS & DEFINITIONS
The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to the accuracy, completeness, or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth or the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
The Citigroup US Economic Surprise Index (CESI) are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises. A positive reading of United States Economic Surprise Index suggests that economic releases have on balance [been] beating consensus. The indices are calculated daily in a rolling three-month window. The weights of economic indicators are derived from relative high-frequency spot FX impacts of 1 standard deviation data surprises. The indices also employ a time decay function to replicate the limited memory of markets.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value-weighted index with each stock’s weight in the index proportionate to its market value.
The Phillips curve is an economic model, named after William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy.
The Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.
The MSCI ACWI Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes.
The Nasdaq Composite Index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The index includes all Nasdaq listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures.