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Good morning. The US beat Iran at the World Cup and we’re not sure how to feel. If the regime’s team lost, we’re happy; if the loser was the team of the brave people of Iran, it’s bittersweet. Meanwhile, markets churn on. Send us your thoughts: [email protected] and [email protected].
China unrest & global markets
It would seem that the zero-Covid protests that spread across China in recent days have, for now, been suppressed. From the FT:
China’s health authorities on Tuesday blamed local governments for their handling of coronavirus outbreaks as Beijing distanced itself from the crisis after unprecedented protests against president Xi Jinping and his zero-Covid policy.
The National Health Commission reaffirmed Beijing’s commitment to the zero-Covid measures and pledged to boost vaccination rates among the elderly, a day after police and security forces appeared to have stamped out demonstrations across at least 18 cities.
China’s domestic markets have recovered, after being shaken by news of the protests. The story may not be over, though. The situation in the country is plainly tense and finely balanced. Another medico-political disruption could arise at any time. How should global investors think about this?
We were struck by a thoughtful Twitter thread from William Hurst, a political-science professor at Cambridge who studies China. To summarise crudely, Hurst thinks that the zero-Covid protests are a novel phenomenon and “potentially quite important”.
Previously, protests in China had taken certain clearly distinct forms — workers’ rights, rural citizens’ rights, student protests, urban governance protests and political dissent. The recent protests blur those lines and cross regional boundaries in an apparently co-ordinated way, “crossing a boundary”. The (relatively) moderate force used in the state response is also interesting; does it suggest some tacit elite support?
Hurst argues that three scenarios are possible: the protests fizzle out; are decisively repressed; or the state makes some concessions. He says the first is most likely (most protests fizzle, most everywhere), the second entails major costs and risks and the chances of the third are “extremely low”.
Hurst’s likeliest scenario is not exactly benign for investors. The risk of a fizzle and a sustained status quo is that, from the point of view of domestic demand, the status quo is not good. The chart below, from Capital Economics China economist Zichun Huang, illustrates nicely how zero-Covid has crushed growth in domestic demand, outside of online goods:
Add in a collapsing residential property market, and the resulting picture is bleak. And neither the problem of inadequate vaccination nor the property mess seem amenable to a quick solution, as we have argued before.
But global investors don’t have to worry much about this, unless they have investments in public Chinese companies that serve domestic demand. The broader worry is whether China’s export machine can keep humming. If it does not (as Don Rissmiller at Strategas emphasised to us) it could easily cause another global supply shock, with consequences for both inflation and growth. So — assuming, with Hurst, that the “concession” scenario ain’t happening — what global investors have to focus on is further repression or security measures that are severe enough to shut down what are, in effect, the world’s most important factories.
What is remarkable is how well those factories have functioned despite the zero-Covid policy and relatively ineffective vaccines. Below are the country’s manufacturing PMIs, which crashed with the initial outbreak, but have managed to remain around neutral since (in PMI surveys, over 50 is expansion, below 50 is contraction):
Here is the year-over-year change in the China export trade, which is slowing with global demand, but has so far avoided a decline:
China’s “closed loop” or rather “closed loop-ish” internal supply chains appear to be doing a good enough job, for the purposes of the global economy and global markets. Is there a risk that unrest, driven by zero-Covid policies, could cause a harsh enough official response to change that? Our instinct is that the unrest would have to be pretty spectacular, but as we are always at pains to say, we are not China experts. We are keen to hear from readers who are.
How strong is the economic momentum?
Our past two newsletters discussed the peppy performance of industrial/cyclical stocks but only glancingly hit on the bigger question: how is the business cycle going?
Yesterday we showed you this striking printout from the Atlanta Fed’s real-time GDPNow growth estimate:
Yet on Monday we showed you a rather gloomier chart of new manufacturing orders survey data. New orders are bellwethers for durable goods demand and have been softening across the board:
How does a bumper GDPNow reading fit with contracting new orders? Partly, the two fail to fit because GDPNow is a measure of quarter-on-quarter real output growth, and this quarter has brought a smattering of surprisingly punchy data in areas like new home sales and durable goods orders. Fit what GDPNow predicts for the fourth quarter into a longer-term chart of real output and it looks less impressive:
GDPNow also has a penchant for big swings, especially if all the good data comes at the start of a quarter. Other forward-looking data are turning over. The Conference Board’s index of leading indicators has fallen 3.2 per cent between April and October, which historically has signalled recession. Dreadful consumer confidence is a big reason why, but so is more tangible data like new orders. Here’s another indicator the Conference Board uses, new permits for private housing construction:
Several other leading indicators are holding up, though. Hours worked in manufacturing are standing pat; as long as there are goods to be made and sold, someone has to man the machine. Compare the steady decline throughout 2008 to today’s stability:
This is consistent with how strong consumption still is:
As we’ve rattled on about before, the economy just isn’t doing that badly right now. Several leading indicators are glaring menacingly, but with consumer spending still high, real output is but a hair below its pre-pandemic trend (while nominal output has overshot). The business cycle is turning, but has not yet fully turned. We are absolutely not in a recession.
You can make the case the cycle is turning using selected leading economic indicators, but the far stronger argument is just how high the federal funds rate is, and how fast it’s gotten there. Monetary policy works by throwing a wet blanket on demand, and though that process is slow, it will work. That is essentially what bond markets are betting on, sending yield curves deep into inverted territory despite a rather resilient economy. The bond market sees the writing on the wall. Do stocks? (Ethan Wu)
One good read
A nice piece from James Mackintosh about the important relationship between inequality and stock prices (see also here and here).
