Why the outlook for markets hinges on China

Markets seem fixated on whether the Fed will change policy and slow hikes in interest rates. Comments by Fed chair Jerome Powell overnight suggesting the pace of rate hikes could soon slow drove a rally on Wall Street.  

But an easing of Covid lockdown restrictions in China could have a significant bearing on the fates of commodities, inflation and interest rates over the next 12 months.

A recent surge in China-related stocks suggests investors believe that recent Covid lockdown protests in China will force the government’s hand to lift lockdown measures sooner rather than later.

We think these investors will be disappointed as Xi Jinping will lose domestic credibility if he does this.

Much more likely is that China cracks down on the protests, keeps the lockdown going until Covid cases decline, then gradually re-opens and stays open. This way, Xi can declare a success over Covid and ensure protests don’t get out of hand and threaten social stability – which is the Communist Party’s greatest fear.

If re-opening happens in the first quarter of next year, as we anticipate, then oil and industrial-related commodities are expected to soar. Energy and the likes of copper remain extremely tight markets given massive undersupply of these commodities. A reopening may also see another spike in global inflation, and interest rates could potentially rise as well.

How widespread are the protests?

Your author lived in Asia as an investment analyst for more than four years, including in China and Hong Kong, and one thing I learned is to be sceptical of opinions on China from those outside the country (including mine perhaps!). China is a huge, diverse place and commentators often generalize and simplify the reality of what is a complex country.
That’s especially the case when it comes to issues such as protests. What seems clear is that there have been several relatively small protests over Covid lockdowns across several cities in China over the past week. What is less clear is how widespread the anti-lockdown sentiment is and how much of the protests are also anti-Xi Jinping.

What’s bizarre is that China remains locked down even though cases remain exceptionally low. The latest daily new case number of 39,047 is tiny for a country with a population of 1.4 billion. Keep in mind that daily cases peaked in Australia above 150,000. China’s current new cases are the equivalent of 700 Australia-wide cases, when adjusted for population.
Note that from May to October of this year, China remained locked down despite daily new cases being below 2,000 for the entire period.

There’s no doubt that businesses are being impacted by the Covid protests. Apple supplier Foxconn has had severe disruptions at its iPhone factory in Zhengzhou. Those livestreaming the protests say workers were beaten by police. It appears lockdowns were only part of the worker grievances, though, as claims of overdue pay emerged too.

Government support measures

The backdrop for these ongoing lockdowns is daunting. The lockdowns are causing China immense economic pain and the government is trying to spur the economy through a variety of supportive measures. The People’s Bank of China has announced a 0.25% cut to the reserve requirement ratio to 7.8% and says it’ll inject around 500 billion yuan (A$104 billion) in long-term liquidity.

The government has also stepped-up support for the ailing real estate sector. This includes 250 billion yuan (A$52 billion) for bond financing of private property developers and the announcement of 16 measures to support the housing market, including supporting issuance of construction loans and encouraging banks to extend mortgage repayments for home buyers.

When will China reopen?

President Xi Jinping has taken personal responsibility for China’s Covid-zero policy. He lauded the country’s efforts in 2020-2021 when cases remained low and pointedly referenced overseas case numbers at that time to highlight the success of his policy.
With the latest lockdown protests, there are three probable scenarios which investors need to consider:

1. The lockdowns stay until Covid essentially disappears, or at least gets to very low numbers. That’s likely to mean a further prolonged period of lockdowns, which have already been in place for nearly three years. China may get more vigorous in extinguishing any protests.
2. Lockdowns ease immediately and the country puts up with any subsequent increase in Covid cases. The protests may be too much of a danger to social stability and that forces the move. China had started to gradually re-open over the past few months until this latest spike in cases.
3. Protests are quelled, and China remains locked down until Covid cases ease somewhat. They then re-open and stay open. This way, Xi can declare victory over Covid, protests die down and the economy gets up-and-going again.

Markets seem to be betting on scenario 2. It seems to us that the greater probability lies with scenario 3. The reason is that opening now after almost three years of Covid-zero rhetoric would dent Xi’s credibility. It’s a dangerous thing for a dictator to lose credibility.
Scenario 3 would appear to be a win-win for Xi and the Chinese people, who are no doubt craving freedom from being locked down for so long. First though, protests need to decline and Covid cases need to go down.

If we had to guess, we would pin re-opening around Chinese New Year. However, that’s purely a guess given it’s dependent on both Covid cases and protests.

What happens to markets under these scenarios?

Let’s look at the likely market reaction to each of the scenarios.
Under scenario 1, China’s economy would continue to slow, and it would dampen demand for goods and inflation globally. Commodity prices might fall. That would help worldwide inflation to ease, perhaps a lot. And that would be supportive of the US Federal Reserve slowing interest rates hikes.

The concern might become one of slowing economic growth rather than inflation. Continued lockdowns would hurt exporters such as Australia and European countries such as Germany.
While stocks might bounce initially, any hints of a slowdown would cap any upside. Bonds would likely be the largest beneficiary. Commodities would be in the doldrums for some time to come.

Under scenario 2, there would be a significant and near immediate spike in Chinese holidaymakers and spending on goods such as luxury goods would boom. Demand for energy and commodities would re-accelerate as the economy surges.
Your author remains positive on the likes of oil and copper as both are significantly undersupplied and any pickup in Chinese demand may send prices higher, potentially a lot higher.

Scenario 2 would be positive for commodities prices, emerging markets’ stocks and currencies. It would be bearish for interest rates and bonds, and for countries with indebted consumers.

While Australia would appreciate the higher commodity prices, higher inflation and higher interest rates would weight down the consumer and, of course, the housing sector.
Under scenario 3, it would be the same as scenario 2 except with a time delay. We are guessing the first quarter of 2023 might be the time, though there are many variables which will determine that.

China’s long-term problems

We’ve talked about scenarios for China over the next 12 months, but the long-term picture for the country remains problematic. There are three main issues:

A prolonged real estate slowdown, not unlike Japan in the 1990s.

For far too long, China stimulated real estate and infrastructure to pump up economic activity and GDP. The effectiveness of that stimulus has waned, slowing economic growth, and resulting in falling residential and commercial property prices. Homes in so-called 3rd and 4th tier cities have seen price declines of up to 20% since 2020. Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University, suggests these cities account for more than 60% of China’s GDP so any slowdown there will have broader implications. He also notes the real estate sector accounts for roughly 23% of China production and 26% of final economic demand.

Demographics also bode poorly for China’s long-term economic growth prospects.

The UN estimates that China’s working age population may decline by two-thirds by the end of this century. 

China’s long-time one-child policy is mostly to blame. The importance of a shrinking working age population is that it weighs on economic demand. After all, GDP (gross domestic product) equals the population growth rate plus GDP per capita. A paper by Rand Corporation found that a 10% increase in the fraction of the population aged +60 decreases the growth rate of GDP per capita by 5.5%. “Two-thirds of that reduction is due to slower growth in labor productivity of workers across the age distribution, while one-third arises from slower labor force growth”, according to the paper.

China’s 20th Party Congress in October clearly emphasized security and stability as priorities and deemphasized the economy.

The focus on security is understandable given the US has effectively declared a tech war through its restrictions on semiconductors, initially implemented against Huawei and extending them to include all Chinese corporations (a recent article in Firstlinks provides more detail on this). But it doesn’t bode well for the private sector. Internet companies have already gone through a regulatory assault aimed at purging “bad habits” associated with online gaming, live-streaming, music, and private tutoring. There’s no sign of government incursions into the private sector letting up any time soon.