Bedrock’s Newsletter for Friday 28th October 2022

Friday 28th October 2022

Markets moved last week to the familiar tune of macro factors – above all, anticipation of what notes major central banks would strike at their upcoming meetings. While a fourth consecutive 75bp hike is fully priced in for next week’s meeting of the Fed’s Open Market Committee, pricing for December leans towards a gentler increment of 50bps, amidst growing expectations that major central banks will ease off the monetary choke (and firm indications this week from the Australian and Canadian central banks that they planned to do just that). Belief in this ‘Fed pivot’ last week helped motivate a rally across major equity indices: the S&P 500 (+4.7%), Nasdaq (+5.2%), and Euro Stoxx 50 (+2.8%) all enjoyed robust weekly gains; indeed, it was the S&P’s best in almost four months. Another tune was also coming into play, though, as we got into earnings season. Last week, strong reports from the likes of Goldman Sachs and Lockheed Martin provided another base for the upward momentum. The upbeat tone continued into this week before the mood music soured amidst a slew of disappointing reports from Big Tech names including Meta, Microsoft, Amazon, and Alphabet – whose stocks all took a mauling. Just shy of an eye-watering $1 trillion was wiped off their market values. Amazingly, having tumbled -74% since its share price peak just over a year ago, Meta is now underperforming the S&P 500 since its 2012 IPO (returning +226% and +252% since then, respectively, as of Thursday’s close). While company-specific developments were of course a big factor (profligate hiring at Google, madcap metaverse spending at Meta, etc), two messages stand out: the claim that online ad-based business models would be resilient in a downturn is looking decidedly weak; and the fact that mega-retailer Amazon is warning of weak revenues in Q4 (calendar home of Black Friday and Christmas shopping, no less) is another worrying indicator for the macroeconomic outlook.
 
We had hoped to break the streak of newsletters where we were obliged to discuss turbulence in the UK but Liz Truss’ resignation as Prime Minister (PM) last week thwarted that hope. Resigning after just 44 days, Truss claims the ignominious title of the UK’s shortest-serving ever PM. The chaos sparked by her fiscal plans, covered in our recent letters, terminated her brief stay in Number 10 – but not before she sacked her first finance minister, Kwasi Kwarteng. He was replaced by Jeremy Hunt, who wasted no time in reversing almost her entire economic programme. This – together with the Bank of England’s (BoE) emergency intervention – was enough to steady UK markets. While Truss’ departure presaged another prolongation of Britain’s chronic political instability, an abbreviated leadership race (cut short not least by some backroom dealing to avoid giving grassroot party members a say; they had chosen Truss in the summer) meant a successor was in place within a week. Next up in Britain’s first year of three PMs since 1868 is Rishi Sunak, who lost against Truss a few short weeks ago and was finance minister under Boris Johnson. Sunak entered Downing Street warning the UK faced a ‘profound economic crisis’. How does he plan to respond? We will know more with the (delayed) fiscal statement now scheduled for 17 November but Sunak and Hunt have already begun charting a path toward tax rises and yet more public service cuts, in an effort to balance the books. What this – or anything else Sunak has up his sleeve – will do for the UK’s more profound, systemic economic frailties remains to be seen. UK fundamentals look decidedly weak, with twin deficits, recession, and inflation (likely more intractable here than in other major economies) all severe near-term headwinds.
 
How will Sunak fare politically? Although recent experience has taught us that 44 days is now a long time in British politics, we are reasonably confident he will survive the remaining 64 days to see out the year and ensure 2022 does not become the first with 4 PMs since 1834. For now, Sunak’s chief appeal lies in his being neither Boris Johnson nor Liz Truss – and he is focused on projecting the feeling that the adults have finally entered the room. Investors are certainly not immune to this charm, rewarding what has been dubbed the ‘dullness dividend’ of lower borrowing costs (contrasted with the ‘moron premium’ levied on Truss’ plans), as gilt yields have fallen back to where they were before the ill-starred mini-Budget. He has also moved swiftly to reset relations with the UK’s European allies in order to correct the damage done by his predecessors’ diplomatic ineptitude. But he has already begun shedding political capital in defence of his reappointment of Truss’ interior minister, who resigned in disgrace just last week for breaching security rules and leaking sensitive documents (not widely considered an appealing behaviour in the minister responsible for MI5, the domestic intelligence agency) – and that is before the real pain of soaring energy, rent, and mortgage bills and more public service cuts really starts to bite in the coming months. Any honeymoon is likely to be short.
 
Just as Sunak was claiming the keys to Number 10, on the other side of the world a rather different power changeover was taking place at the top of the Chinese Communist Party (CCP) – though if we were feeling facetious, we might note certain similarities; both were stitch-ups by horse-trading party bigwigs, with no vote for the grassroots, let alone any democratic input from the wider population. But in Beijing there was no new face at the pinnacle of power, as Xi Jinping was duly anointed for a norm-smashing third term as CCP General Secretary at the quinquennial National Congress. If this was no surprise, the sheer – apparently unbridled – power Xi displayed came as a shock, including to financial markets. Xi stacked the new Politburo Standing Committee (PBSC), the supreme organ of Party power, entirely with his men, disregarding the practice of giving multiple factions balancing representation on the PBSC. The CCP’s constitution was amended to enshrine Xi as the Party’s ‘core’. The Congress cements a true turning point for China: the era of collective leadership is at an end; Xi himself declares his rule a third New Era in post-revolution China, equal to the ages of Mao and Deng Xiaoping. A bizarre incident where former paramount leader Hu Jintao was pulled from the Congress (apparently for medical reasons; Hu has been suffering ill-health) was a potent symbol of an era ending. Markets saw nothing to like. The Congress emitted no positive signals on the economy but rather confirmed the focus is on security and political control, not pro-business reforms. Chinese stocks sold off sharply on Monday. Worst hit were US-listings; the Nasdaq China Golden Dragon Index plunged -14.4%, while the Hong Kong Hang Seng Index fell -6.4% (its worst daily fall since 2008). Onshore A Shares are more sheltered from international capital flight; the CSI 300 fell -2.9%. Meanwhile, the renminbi fell to its lowest level against the dollar since 2007 (and the offshore CNH yuan hit its weakest ever). Both stocks and currency have since recovered some of these drops but the political overhang clearly remains.
 
While the Congress was truly momentous and markets were perhaps not wrong to react, we would caution that it should not entirely overshadow another crucial development: the imposition by the US of sweeping new export controls on high-end semiconductor technology. The sector is a strategic priority for Beijing – for its crucial value both in the modern economy and in modern warfare, amidst China’s ‘Civil-Military Fusion’ policy to use civilian technologies to hone its military edge. It was for this reason the Biden Administration acted. Already, the key global players in the sector have halted servicing Chinese clients as they assess how to proceed. We expect the restrictions to have a meaningful impact on a pivotal area of economic and technological development in China. Certainly the move marks an important turning point in the modern era of globalisation, if not necessarily a nail in its coffin. More broadly, the outlook for China’s economy looks worse than at any time since it joined the World Trade Organisation in 2001 (the step that rocketed it into its current position in the global economy). Even without the drag of zero-covid, it is clear the era of double-digit growth is over. The government’s 2022 goal of +5.5% year-on-year GDP growth seems unlikely to be met. Worsening demographics is the greatest challenge: 12% of the population is now over 65 years old; Japan’s per capita income was double China’s today when it hit this level of greying. There is a growing awareness that, longer term, China’s economy may never eclipse the US’. In the immediate term, China’s slowdown is bad news for the global economy. As North America and Europe are poised to slip into recession, this time – unlike 2008 – China will not come to the rescue. Disappointed by the recent Congress, investors will have to wait for December’s Central Economic Work Conference (a key annual event) for any indication Xi has a plan for a more positive economic course.  
 
For now, we, like others, are keeping a close eye on corporate earnings and the Fed next week. The central bank policy path remains too uncertain for us to rush to extend duration but we will be looking for the right signals to do so. Meanwhile, we see valuations in credit opening up meaningful opportunities, provided you are comfortable riding out some volatility.


 

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