Financial Update from Brewin Dolphin - 18 August 2023

August 2023

The Weekly Round-up

Friday 18 August 2023

In her latest weekly round-up, Janet Mui, Head of Market Analysis, discusses the sell-off in global bonds and troubles in China’s property sector.

Global bonds sell off

August is not only going to mark an awful month in terms of weather in the UK, but it has also not been kind to stocks. Global equities saw a third straight week of declines, amid mounting economic risks in China and concerns of higher-for-longer interest rates. There has been a relentless rise in global bond yields fuelled by resilient US economic data, hot UK inflation prints, hawkish Federal Reserve meeting minutes, the US debt downgrade, and increased supply of US treasuries.

This week, an aggregate measure of US treasury yields hit a 15-year high. The closely watched US ten-year treasury yield came close to its October 2022 peak, which was the highest since 2007. UK ten-year gilt yields breached levels last seen during the mini-budget to reach the highest since 2008. The markets seem to be coming to terms with the fact that interest rates will stay higher for longer and the era of cheap money is not coming back soon.

What took markets so long to realise that the Federal Reserve’s ‘pivot’ to easier monetary policy may not materialise? Inflation is indeed heading in the right direction, particularly in the US. But as energy prices have rebounded in recent weeks, it is apparent that supply shortages will be with us for a while and energy price volatility is likely to stay. The reacceleration in the headline US consumer price index (CPI) shows the last leg to reach the Fed’s 2% inflation target is not straightforward.

US economic data continues to surprise on the positive side. This is a good thing, as it lends more support to the case for a soft landing. The problem is that the data is considered ‘too hot’ to be consistent with a 2% inflation target. One notable strength is US consumers – retail sales in July expanded at double the pace economists were expecting. The housing market saw signs of life even as 30-year mortgage rates went above 7%, with new home sales improving and beatingexpectations. A lack of existing home inventory is driving home purchasers to seek out new-build houses. Even the US manufacturing sector, a relatively weaker area so far, posted strong growth in July.

The relative strength in economic data is resulting in the Federal Reserve staying cautious even as inflation slows, and there are emerging members of the committee that are erring towards a pause in hiking rates. That said, from the minutes of the July meeting, most members continued to see significant upside risks to inflation. The markets have interpreted this to mean that the Fed is not done raising interest rates yet and the debate will shift to how long these elevated levels of rates will stay. The longer rates stay high, the more potential problem it causes to the real economy and financial markets. Indeed, as inflation slows and nominal bond yields pick up, real bond yields are rising fast. This is an important headwind for technology stocks, with markets already sceptical of the high valuations driven in part by the artificial intelligence frenzy year-to-date.

UK inflation fight is proving tricky

Here in the UK, gilt yields also surged this week, with the key driver being the expectation of stubbornly high inflation after CPI and wage growth data. UK inflation in July came in higher than expected on both headline (slowed from 7.9% to 6.8%) and core (stayed at 6.9%) measures. Utility bills are the biggest drivers of lower headline inflation. Food price inflation also continued to slow, which is good news for many households. Goods inflation is heading in the right direction as imported goods inflation and producer price inflation have slowed meaningfully. That said, services inflation, which is more linked to domestic activity, has strengthened due to a still resilient labour market. Hotel inflation was a key driver, so for those considering a staycation, it is getting costlier.

In terms of the UK labour market, there are signs of weakness, but the strong wage growth dominates headlines. The unemployment rate has risen further from 4.0% to 4.2% and job vacancies continue to decline. Employment in the three months to June fell by 66,000 as well. However, so far, the cooling in the labour market has not translated into weaker wage growth. Headline average weekly earnings growth rose to 8.2% YoY, from an upwardly revised 7.2% in May. That probably had a lot to do with the one-off bonus and 5% pay increase for over a million NHS staff. Excluding bonuses, regular weekly earnings growth accelerated to 7.8% from 7.5%. So, there are still market forces driving wages higher due to the competition for the right worker.

The Bank of England is data dependent, and the string of data suggests inflation is sticky and that it will be difficult to bring it down to 2%. This strengthens the case for further rate increases, even though the lagged impact of higher interest rates has yet to play out. A 25-basis point rate increase in September is fully priced in by markets and there is an almost one in three chance of a 50-basis point hike. Interest rates areexpected to peak at close to 6% in March 2024.

China woes intensify

China is the primary source of pessimism in markets this week. It is not surprising that markets are worried when the biggest sector of the second-largest economy in the world is struggling. Country Garden was at one point the largest Chinese property developer by sales. It has failed to make interest payments on its dollar bond, highlighting the liquidity squeeze in the sector due to plummeting home sales amid weak buyer confidence. Investors are focused on contagion risk to China’s financial system, notably its opaque shadow banking sector, estimated to be worth $2.9trn.

How does a contagion happen and how worried should we be? The bad news is that we are already seeing that contagion unfold. First of all, other private property developers are most at risk of contagion. Confidence has been hit hard and buyers would rather buy from state-owned developers. Slumping sales mean a further squeeze on cashflow and inability to pay liabilities.

From the troubles at Zhongzhi, which has failed to honour payments to investors, we can see the linkage of losses in the real estate sector to shadow banking. Zhongzhi is a large established player in the shadow banking sector, which pools investors’ cash to invest in a range of asset classes. In order togenerate high returns for investment products, some of these opaque trust products have high exposure to real estate projects. There is little visibility over the true extent of failures within the shadow banking sector. Failure to pay back investors by established asset managers will trigger a crisis of confidence.

As investors pull money and as banks and private credit become more risk averse to the property sector, more players will fail. That will impact businesses, creditors, investors and workers in the property supply chain in China.

State-owned banks’ direct exposure to property developers is relatively small (4.4% of banking assets) but exposure to residential mortgages and construction loans is substantial. According to data from the FT, the aggregate exposure to the property sector for Chinese banks is 28.8% of banking assets. If banks were to take a hit from losses in their property loan books, it would curtail their ability to lend elsewhere.

It is not difficult to see how the ongoing downturn in the Chinese property sector could cause a downward spiral in the economy. This is all unfolding against a backdrop of disappointing Chinese economic data, which prompted economists to downgrade China’s growth forecasts.

China’s debt problem has been a case of kicking the can down the road for years. I still think China will do whatever it can to avoid systemic contagion and hopefully the worst-case scenario will be avoided. But the task is very difficult, and it is just another reason for international investors to shun China exposure, on top of a range of regulatory, structural, politicaland geopolitical concerns.