If you ever had any doubts that China is a controlled economy where growth can still be manufactured at will by the mandarins, today’s Caixin Manufacturing Purchasing Managers’ Index (PMI) reading should put those doubts to an end.
October’s Caixin PMI came in at 51.2, up from 50.1 in September and ahead of market estimates. That is a two-year high and the fastest rate of improvement since March 2011. A reading over 50 suggests economic expansion, while a number below 50 points to contraction.
The Chinese economy is effectively experiencing a mini boom of sorts:
- The pace of economic growth is stronger than the markets were expecting.
- Strength in the underlying data is quite broad based.
- Small enterprises are improving and so are new orders.
In other words, final demand is trickling down and, it seems to me, there is enough momentum to carry the day for this and perhaps even next quarter.
Emerging Markets Outlook
As China goes, so go the rest of emerging markets (EM) and commodity prices. Consequently, at least for the next few quarters, the outlook for EM equities and currencies is quite good. Furthermore, almost certainly―again for the next few quarters―the outlook for EM interest rates has dimmed quite a bit as Chinese and EM monetary policymakers try to deal with a reflationary environment rather than cut interest rates to stimulate growth.
In the same vein, to some extent even developed market interest rates will not be immune to the reflationary trade, in my opinion. If you look at the front end of the U.S. yield curve and the performance of the 10-year note, the current sell-off in the rates market is not a Federal Reserve-raising-rates phenomenon. In fact, the front end of the yield curve is still discounting a very modest rise in rates over the next few years.
Instead, the bulk of the sell-off is due to break-even inflation rates rising. If the EM data flow keeps improving, and that is my expectation, the reflation-driven sell-off in global rates may deepen some.
But, again, as I have argued previously, don’t confuse a policy-driven cyclical rebound with a change in the secular and longer-term outlook.
While the current rebound in Chinese growth is encouraging, the longer-term challenges in China in particular, but Asia in general, of high savings rate, capital misallocation, and increasing debt load are still very much intact. These secular issues will assert themselves once the growth outlook starts fading in the second half of 2017.
Global Equities: Asset Class of Choice
What is an investor to do with all of this? I reiterate my bottom line outlook:
- Global equities remain the asset class of choice and EM equities will most likely remain the star performer for the next few quarters.
- Global rates are in a temporary bind due to China’s stimulus-driven reflation.
- Credit and commodities will do reasonably well in the current environment, with senior loans being the credit asset class of choice.
- EM currencies, as opposed to EM rates, will probably do fine in the current environment as well.
- Finally, as a result of the temporary reflationary pressures, overall volatility levels should inch higher from their current very low levels.
Longer term, things have not changed that much and investors ought to be very cognizant of that when sizing up the risks. We are still talking about a late-cycle global economy that is being helped by temporary factors. A significant rally in EM will create its own risks much the way a significant selloff in global rates will create its own opportunities.
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