Financial update from Brewin Dolphin - 19 August 2022

August 2022

The Weekly Round-up

Friday 19 August 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses higher-than-expected UK inflation data, a decline in US new housing starts and the outlook for China.

United Kingdom

After the potential for a change in the inflation cycle last week, with US inflation finally lower than anticipated, there was no real evidence of that following in the UK. Inflation edged over 10% year-on-year in July. Whilst we know inflation is going higher in the UK, breaching double figures has happened earlier than expected and the market has duly increased its interest rate hike expectations. The peak for UK interest rates is now around 3.9%, more than 2% above the current level and taking the form of, say, three 0.5% hikes and three 0.25% hikes. If these hikes come to pass, they will put some pressure on mortgaged homeowners as and when they come to refinance their fixed rates. House prices fell modestly in August, according to Rightmove. The data are highly seasonal and August usually sees a decline, but this was the steepest fall since 2018.

With the prospect of higher mortgage bills, on top of higher fuel bills and the Bank of England warning about a recession, it is no wonder that UK consumers are down in the dumps. The GfK consumer confidence survey was at its lowest level since records began. Consumers claimed that the climate for major purchases is as bad now as it was during the global financial crisis or Covid recessions. But as it stands, we are not in a recession and even though consumers claim that they will prioritise saving over spending, the harder data such as today’s retail sales numbers suggest UK consumers are still shopping. Companies raised prices and, according to these official figures, consumers raised their spending accordingly, leaving retail sales above their trend growth rate of the last decade, even after adjusting for inflation.

What UK consumers are saying suggests only a limited need for rate increases, but what they are doing suggests the Bank of England needs to administer some tough medicine.

United States

In the US the same may be true, with the data suggesting that the economy may be creeping out of a temporary inventory cycle that depressed growth in the first half. But that alone will not be enough to tip the economy into a recession. It does seem to suggest that the chances of a soft landing could be higher than thought if the manufacturing sector is recovering, at a time when consumers are feeling the pinch and generally inventories are kept reasonably low. Even if a recession cannot be avoided, this is one of the reasons to believe it could be mild.

The factors that seem consistent with a recession right now are the very low level of unemployment, which limits the scope for jobs growth to support the economy over the medium term, and the sharp slowdown in housing market activity. Perhaps most notable on this front was

a further decline in the NAHB housebuilders sentiment index and a subsequent slowdown in new housing starts, which was more severe than expected. Although there remains a shortage of housing in the US, the challenges of rising interest rates and elevated house prices are discouraging demand, while material and labour expenses are discouraging builders from lowering prices. Away from the housing market, though, the US economic data this week did not imply that a recession was imminent.

China

China’s recovery from lockdowns continues to falter, mainly due to continued flare ups in Covid. The latest, in the tourist hotspot of Hainan, is acting as a fresh drag on growth. As we discussed last week, credit growth numbers were weak, partly reflecting reduced mortgage activity as loans are being boycotted on properties that have not been finished, which serves to discourage borrowers and lenders. China also remains concerned about inflation, even at the relatively low levels it is seeing. The People’s Bank of China (PBOC) met last week and, referencing inflation in a statement, said “We can’t lower our guards easily” whilst forecasting the consumer price index would rise to over 3% this year. The PBOC recognises the economy is weak, especially in certain pockets. For this reason, at its meeting this week, it cut the key medium-term interest rate, albeit by just ten basis points. Looking ahead, there will probably be more targeted stimulus, but broad monetary easing measures like lowering the reserve requirement ratio for banks or deep interest rate cuts seem unlikely given the PBOC’s comments on inflation.

At a time of all these domestic headwinds, and without the hope of big monetary stimulus, trade will diminish as a source of support for the Chinese economy.

China has been transitioning to becoming a more service-led economy, but it remains very exposed to manufacturing. This means that China is set to lose out from the shift away from goods towards services. Added to which, its trading partnership with the US only seems likely to improve if it suits the US politically. Right now, that seems less likely if inflation really has passed its peak.

Oil slip

As ever, the most meaningful driver of inflation is energy. What’s driving the weakness in oil is a decline in global oil consumption relative to production. Part of our justification this spring for believing that oil prices had peaked in March was that, historically, when global oil consumption drops below production for the first time in the cycle, the oil price tends to peak very shortly afterwards. So far that appears to be playing out.

Oil does not contribute directly to CPI, but oil products do, most notably gasoline. This has actually been surprisingly weak, suggesting that oil consumption is back to levels last experienced when the economy was locked down. It is possible that oil has become more price elastic, with the advent of hybrid working perhaps allowing employees to save on commuting costs by working from home more often. But it is certainly surprising that this would have such a big effect on oil consumption.

Property

A big part of what is weighing on the Chinese economy right now is the property market. Chinese property is expensive. Average gross residential rental yields are lower in China’s major cities than anywhere else in the world and this against a backdrop of Chinese population growth plunging to almost zero.

Nevertheless, it would probably be wrong to adopt too negative a long-term view. China will likely continue to urbanize, and that process will entail more home building. And even with its demographic issues, China is also likely to continue outgrowing the rest of the world, which should offer support to house prices.

While Chinese property is in a cyclical downturn, the Chinese authorities have announced a plan to get all these stalled real estate projects going again. The plan has the central bank issuing low interest loans to state- owned commercial banks, which will be expected to leverage this money with their own funds to lend out to developers. As ever, the authorities are trying to strike a tricky balance between doing enough to make sure that the market stabilises and homes get delivered, and not completely bailing out real estate developers.

Last month, the authorities announced a boost to infrastructure spending to provide further offsetting growth. Alongside the modest monetary easing and bigger falls in market interest rates, these conditions are usually positive ones for Chinese assets.

So, although there are challenges for China, it seems worthwhile taking a contrarian stance and maintaining a preference for the region. The crackdown on digital stocks will continue, but we’re probably past the worst in terms of the announcements. The authorities are taking steps to fix the real estate crisis, and lockdowns should become much less common following the Party Congress in the autumn. In the meantime, infrastructure spending is picking up and interest rates have plunged. Asia ex Japan stocks appear short-term oversold in relative terms. Finally, as important a reason as any to maintain exposure to Asia ex Japan stocks is their low correlation with the rest of the world. If the upturn in US and European stocks since mid-June turns out to be just a bear market rally, Asia ex Japan equities stand to hold up relatively well.