China Holds Risk Markets in Check

GLOBAL MARKETS

US stocks are a tad lower in a choppy session as investors digest and position around an extremely weak Empire manufacturing survey; however, the beat on China’s Q4 GDP suggesting the Mainland economy has turned the corner and continues to hold global risk markets in check.

The odd disconnect between business sentiment and what appears to be happening in the US economy in real-time continues to baffle investors, with the Empire manufacturing survey falling 21.7 points to -32.9 – its lowest level since the depths of the pandemic in 2020.

So why are the activity indexes so weak when the activity does not appear to be as stagnating?

It is due to the surprising nature of what is coming down the” hard data pipe,” which is much better than expected. Last fall, there was broad consensus that China was in the wrong place, Europe was slipping into a recession, and the Fed was ultimately caught ‘wrong-footed” by very sticky inflation. But fast-forward to these early weeks of January, and China’s reopening has put the country on a path to much better growth; investors are far more optimistic about Europe’s recovery and the bane of all ills US inflation is even starting to recede. These improvements only became apparent over the past month. It may take business sentiment another survey or two to catch up.

Equity implied volatility has dropped sharply since the turn of the year, with implied volatility across expiries and indices resetting to levels near r their lowest in the last year. As the market narrative has shifted, the sharp drop-off in implied vol is a function of the market lessening the weight on catastrophic economic outcomes from fast and large rate hikes. There has been continued progress towards lower inflation, the Fed looks likely to downshift again, and the labour market has remained strong.

That said, under most market calls, where economists still see a 60 % chance of a US recession, it is easier to see scenarios where implied vol moves at least somewhat higher from here than much lower, especially as excess risk premium has been priced out. We expect a modest increase in equity implied volatility throughout 2023 as the unemployment rate rises, while a recession scenario would see a sharp increase in vol. So, we do not see investors out of the woods yet, even as the VIX trades sub-20.

While the debate about the pace of increases is leaning towards a further slowdown, as Chair Powell and other Fed officials have emphasized, the focus should shift from how fast to how far rates need to rise and how long those levels need to be maintained. So far, Fedspeak indicates that rates will likely rise above 5% over the coming meetings and be held at those levels for some time which should continue to keep US recession probabilities above 50 % due to an expected material rise in the unemployment rate courtesy of the Feds aggressive rate hikes.

BANK OF JAPAN

Most expect YCC to remain in place with potentially greater flexibility introduced.

If the BoJ decides to proceed with a second consecutive tweak to the current policy, even if still characterized as a technical adjustment, the market would likely press more aggressively against YCC and prepare for a nearer-term exit, so the street remains locked into bullish JPY trades.

ASIA FOREX

Although the beats on the Chinese activity data were generally perceived as positive, the data did not trigger any follow-through buying of the renminbi or Asian currencies. Rather than the start of the end, this interlude is likely a pre-Lunar New Year “profit-taking pause” ultimately, when Chinese consumers start spending their three years’ worth of Covid savings, it will provide a spectacular growth boost to the Yuan and other ASEAN currencies like the Malaysian Ringgit and the Thai Baht.

OIL MARKETS

China’s economic activity broadly beat low market expectations. And even though this strong growth came mainly from food, oil traders think the message is clear, and China’s economy has likely already passed a turning point in Q4 and will strengthen from Q1 onwards.

The return of China’s consumption engines is enormous for the oil market outlook; while the industrial engine is revving up, guzzling down oil products, consumers will soon catch up at the petrol pump. Crucially, the accumulation of household savings is massive and has risen fast over the past three years. Ultimately, when Chinese consumers start spending, it will boost oil prices.