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Federal Reserve and Chinese central bank – unusual bed fellows or fiscal allies?
In our last Investment Market Update we covered the recovery in markets following early August’s volatility and the beginning of a slowdown in US technology equities.
Since then, policymakers from both sides of the Pacific have provided stimulus measures to markets, with the US starting their interest rate cutting cycle with a bang, delivering two rate cuts in one meeting, followed by the announcement by Chinese authorities of new fiscal and monetary stimulus measures.
In this month’s update we will take a closer look at Chinese stimulus, it’s expected economic effectiveness and ongoing market impacts, along with the impact of these initial US rate cuts on markets.
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US Rate Cuts
The US Federal Reserve (Fed) chose to cut rates by 0.5% at their September 18th meeting. Interest rate rates are typically changed by 0.25% at a time, so this ‘double cut’ was a surprise to some investors. Fed Chairman Jerome Powell cited falling inflation, as well as emphasising initial signs of weakness in job markets that he would like to get ahead of with pre-emptive interest rate cuts.
Markets at this point were expecting a further weakening in jobs figures and anticipated two more ‘double cuts’ at the November and December Fed meetings. In equity markets investors crowded back into the ‘Magnificent 7’ technology stocks, with these 7 accounting for 55.2% of S&P 500 returns in September, owing to their high-quality business models and perceived resilience to potentially slowing economic conditions.
In early October, just as markets were reflecting upon the direction of economic travel, the very same labour market data investors were so vigilantly watching showed a pickup in job creation, pushing unemployment down and wage gains up. Markets turned, with only a 0.25% rate cut now expected in November versus 0.5% previously, and government bond yields moving upwards in unison. Within equity markets there was a renewed rally in cyclical industries like industrials and financials.
Where to from here? Markets have begun to increase their probabilities of market volatility following the presidential election on November 5th, with the Federal Reserve meeting the following day to choose interest rate policy (0.25% cut expected). All eyes will be on the results of the election and Fed policy.
Fed rate cuts have also been supportive of asset markets globally, in particular with increased dollar liquidity spilling into emerging markets, allowing Chinese authorities to bring forward stimulus measures without putting undue depreciation pressure on the Yuan.
Chinese Stimulus
That brings us to the other main story in markets: Chinese stimulus. As mentioned, China had been waiting for the US monetary policy easing to provide large stimulus measures, with the People’s Bank of China (PBOC) Governor Pan Gongsheng previously emphasising currency stability in messages over the summer. With that US roadblock out of the way, China has announced their first large round of fiscal and monetary supports, summarised as follows:
1. Monetary Policy
a. Cut in central bank base rates by 0.2%.
b. Cut in commercial bank reserve requirements, releasing $160bn in new credit.
2. Property Market Policy
a. Cut in mortgage rate by 0.5%.
b. Cut in down-payment requirement.
3. Stock Market Support
a. $80bn central bank borrowing facility for brokers, dealers and funds to fund stock purchases.
b. $50bn central bank borrowing facility for companies to fund share repurchases.
4. Household Consumption Support
a. Continued funding for household goods & automotive trade-in schemes (cash-for-clunkers).
b. Initial pilots of cash-handouts to the deeply impoverished.
So, what’s the assessment of all this? Given the total value of support is around 1.6% of GDP this stimulus is substantial, but not as significant as the huge 30% of GDP credit stimulus seen in the post-financial crisis 2008-9 period.
Points 1 and 2 are unlikely to move the needle, having been tried last year to little effect – the demand for credit, both by households for property and businesses for capacity expansion, is fairly subdued, so falling interest rates may have little impact on credit growth.
Point 3, on the other hand, is already having an impact. This has increased investor confidence in Chinese domiciled assets and those assets that are most correlated with rising wealth and economic activity in China; Chinese equities have skyrocketed, gaining 25% in two weeks, while commodities and emerging market equities have rallied. The “ripple effect” has seen the Asia-focused UK bank Standard Chartered rally by over 9% and European luxury goods group LVMH rise over 8%. It should be noted that these improvements in market liquidity and investor confidence lay relatively brittle foundations for this rally that will need stiffening with improvements in corporate and economic fundamentals.
Point 4, while a good start, is just too small to effectively redress the structural imbalance at the heart of China’s economy – of weak domestic consumer demand, owing to a low household share of national income, and the subsequent need for high rates of questionable Government funded property & infrastructure investment to prop-up otherwise weak demand in the economy. Further announcements are scheduled in the coming weeks of additional fiscal measures, expected to be targeted at households, which hopefully will start to enact rebalancing. Unfortunately, without a comprehensive set of such reforms, rallies in China’s equity market are unlikely to turn into long-term positive trends, as businesses continue to deal with the pressures of a deflationary economy.
Conclusion
In summary, asset markets have been supported by increasingly supportive policy in both China and the US, with China enacting wide ranging, but fairly shallow, stimulus and the US Fed starting their interest rate cutting cycle with a bang.
Markets have been buoyed by this increase in liquidity and investor confidence, however questions remain over the effectiveness of Chinese stimulus and the medium-term health of the American labour market. In the shorter term, politics is likely to be a driver of market volatility. Investors are therefore advised to allocate to diversified portfolios and maintain their nerve through short-term rough patches in the pursuit of long-term returns.
Please contact your advisor if you have any questions.
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The information in this article is correct as at 11/10/2024.
This market update is for general information only, does not constitute individual advice and should not be used to inform financial decisions. Investment returns are not guaranteed, and you may get back less than originally invested; past performance is not a guide to future returns.
