Market Update 18.08.23

Markets have had a lacklustre first three weeks of August. All major equity indices are firmly in the red month-to-date, including declines of -4.8%, -4.7% and -5.5% for the S&P 500, Nikkei 225 and Euro Stoxx 50, respectively. Given this comes on the back of a strong July and a strong first half, it is perhaps not unhealthy for stocks to consolidate gains somewhat – which remain solidly in double digits for the year so far. But either way, equities are not the only story in markets right now: bond markets are again setting the tone.

Last week’s US CPI print offered reassurance that the disinflationary trend was continuing, with a headline +3.2% YoY coming in a tad below expectations, and markets initially responded positively. However, a laboured US 30Y Treasury auction took the shine off later in the session. The US Treasury is engaged in a bumper refunding wave; 3Y and 10Y auctions went off smoothly at the start of the week but come Thursday the tougher auction at the long end suggested markets had limited absorption capacity for the bloated issuance (a risk we have flagged in previous newsletters). This set yields on an upward path and the following day’s PPI print showing annual wholesaler price inflation had risen slightly above forecast to +0.8% in July (up from +0.2% in June) confirmed a move higher in bond market volatility. Coupled with plenty of other macro data underscoring the continued vigour of the US economy, as well as recent oil price rises, this added to the ‘higher-for-longer’ narrative in investors’ prognoses. US 10Y yields consequently lifted to their highest weekly close in nine months (4.17%). The bond selloff has continued this week, whipped along by Wednesday’s release of the July Fed meeting minutes, which warned of ‘significant upside risks to inflation, which could require further tightening of monetary policy’. This has seen yields break through several barriers this week; most strikingly, at yesterday’s close the US 10Y had crossed the 2008 peak to reach 4.274%, a high-water mark not seen since 2007. The move has not been limited to the US: on this side of the Atlantic, UK gilts have seen the worst of it (the 10Y is up to a post-2008 high of 4.74%) but 10Y yields for German bunds, French OATs and Italian BTPs have all shifted up. It is principally this increase in DM yields that has been weighing on equities – with those growthier tech stocks again particularly exposed; tellingly the NASDAQ has felt the August fall the most, down -6.1% MTD, and the FANG+ group of tech mega-caps has sagged to a two-month low.

But higher-for-longer rates are not the only risk on investors’ minds. The Chinese economy’s travails have continued to generate headlines – and market moves. China’s initial rebound following the abrupt termination of Zero-COVID decelerated in Q2 and doubts about the world’s second-largest economy continue to mount. Last week came news that consumer prices had officially dropped into deflationary territory in July (CPI registered -0.3%) and exports fell -14.5% in dollar terms (troubling, yes, though we would reply to all those journalists – correctly – identifying this as the worst fall since 2020 that this was a big drop from a very-high highpoint this time last year and exports remain well above pre-pandemic levels). The bad news has kept coming, with the July YoY numbers for industrial production and retail sales this week both marking worse-than-expected declines. Dissipating global demand for Chinese output and domestic consumer blues are a big part of the story here but front-and-centre remains the troubled property sector – especially when it comes to financial market risk. Official data indicate that both new (-2.5%) and existing home prices (-0.5%) fell MoM in July. The country’s big property developers are of course in the direct line of fire. Country Garden, previously singled out by most analysts as the best-placed to weather the storm, defaulted last week, causing its shares to slide into penny-stock territory, then yesterday came the news that lurching behemoth Evergrande had filed for bankruptcy protection in New York.

But the second-order impacts may be at least as important, with large parts of China’s financial system geared towards the massive property sector – a point underscored by shadow-bank Zhongrong’s missing of payments on its investment products this week, as well as the continued fragility of the country’s Local Government Financing Vehicles. With challenges mounting on multiple fronts, investors want to know what the government is going to do about it. “Not enough” is markets’ resounding verdict so far. On Tuesday the People’s Bank of China unexpectedly cut a key lending rate to generate some monetary stimulus (though the problem here is that this further widens the spread between US and Chinese rates, adding more downward pressure on the renminbi, which the central bank is now moving to prop up). But on more substantive efforts there is little news so far, with no meaty follow-up to last month’s dovish Politburo meeting, whose output was more a list of aspirations than a battle plan. Chinese stocks have therefore reversed the gains that first followed the Politburo meeting, when investors were heartened by signs something might be in the works.

Meanwhile, China’s friend of convenience across the Amur River is facing more problems of its own making. On Monday the Russian rouble sank through the important 100-to-the-dollar threshold, leaving it down -49% against the dollar since its 2022 peak (and -51% versus the euro). The currency performed well last year, helped by central bank action and surging commodity prices. But this year the contradictions and constrictions in the economy are making themselves felt. The economy continues to grow – but principally driven by bigger government deficit spending, largely on the destructive capacity of the military and outlays such as ‘coffin money’ to families of soldiers killed in Ukraine. Hardly the stuff of productive, long-term economic growth. The currency is facing a cloud of downward pressures. Sanctions are choking capital inflows while capital flight is sizeable. The current account is under real pressure, squeezed on the one hand between a +20% increase in imports in H1 (now coming from China, Turkey and the UAE, rather than the West) that nobody wants roubles for, and on the other by tumbling export earnings as sanctions take their toll (including the G7 cap on Russian oil prices). Oil prices were on a six-week streak until last week, pumped up by OPEC+ production cuts and strong demand, but remarkably the normally tight correlation between the values of oil and the rouble frayed over the period, such was the fragility of Russia’s economic position. After the 100 RUB/USD line was crossed, the central bank stepped in to prop up the currency with an extraordinary +3.5% rate rise at an emergency meeting on Tuesday. This has stemmed the tide for now but additional capital controls are in the works.

So much for the economic state of two legs of the BRICS group, as the quintet of big emerging markets prepare to meet at their summit next week. The confluence of circumstances that made their economic prospects look plausibly comparable at the turn of the century (the end of apartheid, Communism and the Licence Raj, a commodity supercycle, etc) has not held over the last two decades – and their respective performances this year are particularly striking. After an uninspiring decade, Brazil is having a good time of it this year. Inflation has come down (allowing the central bank to cut rates), exports are doing well (a good harvest particularly helping the agribusiness sector), tax reforms are in the works, investor bullishness is on the up and the government has just announced $350bn of green industrial investment to flesh out President Lula’s aim of making the country a ‘green superpower’. India is also enjoying a robust rebound from the pandemic and the IMF expects +5.9% growth in 2023. Prime Minister Modi, too, has been pursuing an infrastructure drive and continues to push for multinationals to include the country in their ‘China-plus-one’ production plans to diversify supply chains – with some success (including plans for a new iPhone production facility in Karnataka). Portfolio investment inflows are also surging, helping India’s stock markets back to their perch as the world’s fifth-largest by market capitalisation. Summit hosts South Africa are sitting less pretty, weighed down by the governance dysfunction of the ANC and the – not unrelated – plague of electricity utility Eskom’s load shedding. What should we expect from next week’s summit, then? Not much. Lula’s call for a BRICS currency will be on the agenda – but we won’t hold our breath. The politically disparate group is no alliance – and much less the basis for a currency union. Since linking up in 2009, the group has collectively achieved nothing politically to make it more than the sum of its parts, leaving it sniffily dismissed by international relations scholars as mere ‘international policy by Goldman Sachs analysts’ (to be fair to said analysts, they never claimed it was anything more than a buzzy acronym to shift some sell-side macro research).

So we stand, most of the way through the thinly-traded summer lull when markets can be unusually flighty (apparently many market participants have sneaked away from their desks and off on holiday; alas, this newsletter is not being penned from a sun lounger). The renewed rise in yields is noteworthy and we buy the view that rates will remain tighter for the time being – while remaining cognisant of downside risks as the effects of prior tightening continue to evolve. Nonetheless, we do not see this bout of bond volatility as the start of a clear trend higher in rates; with policy rates about their peak, we have taken the opportunity to lightly increase duration from an underweight starting point. Much can change when markets knuckle back down to work in September, so caution remains warranted.