In our House View released on June 28, 2023, titled "Global Economic Outlook for the Second Half of 2023," we demonstrated an astute ability to forecast the course of the global economy throughout the summer. Today, we revisit our discerning analysis to delve into the underlying rationale behind an array of events unfolded during the third quarter, and offer our perspectives on the economic developments of the United States, China, and Japan as they pertain to the forth quarter.

Summary

• The surging oil prices together with strikes in the automotive industry have introduced uncertainty into the previously cooling inflation prospects in the United States, putting pressure again on the downward trend in inflation. We anticipate that the Fed will refrain from additional interest rate hikes in the fourth quarter but will send a hawkish signal during the following policy meetings to curb excessive optimism. U.S. Treasury yields have reached their highest point since the 2008 financial crisis, and the U.S. dollar has regained strength. The economy is expected to achieve a soft landing, and we believe there is still a 5% to 10% downward potential for the S&P 500 index.
• Despite the Chinese government's series of stimulus measures, including interest rate cuts, a reduction in securities transaction taxes, and the home-buying easing policy, these initiatives have not provided long-term support to the economy. Rebuilding confidence will take time and patience. The performance of the Hong Kong stock market has not yet reflected corporate profit growth, and while geopolitical tensions may ease, they are unlikely to disappear entirely. As a result, we have revised China's GDP growth rate for this year down to around 5%.
• In July, the Bank of Japan made subtle adjustments to its monetary policy, leading to a continuous rise in the yields of Japanese 10-year government bonds. Wage growth is no longer sufficient to counteract rising inflation, eroding domestic purchasing power. Japan urgently needs policy interventions to address the significant increases in energy and food prices. Possible measures include expanding the scope of yield curve control and ending the negative interest rate policy. In a rising interest rate environment, banks and the financial system are expected to benefit, and we predict the Japanese yen will strengthen to a range of 135 to 140 against the U.S. dollar.

United States - Ongoing Credit Tightening,  Elevated Oil Prices Exacerbate Downward Pressure on Inflation

Inflation has exhibited a persistent moderation trend since the second quarter of the current year. June's CPI posted a year-on-year growth of 3%, still somewhat elevated above the long-term 2% target. Nevertheless, this figure reflects a substantial decrease of nearly two-thirds from the zenith of 9.1% recorded in June 2022. Data from non-farm employment for both June and July conspicuously undershot external anticipations, returning to the conventional range of 100,000 to 200,000, compared to 281,000 in May. As we predicted in June, the sequence of interest rate hikes initiated by the Fed since early 2022 has indeed introduced a cooling effect on the American economy.

However, the move by Saudi Arabia and Russia in September to extend their oil production cuts until the end of the year has cast an ominous shadow on the inflation landscape, introducing a measure of instability and unpredictability into the future direction of Fed policies. Currently, the Brent crude oil benchmark has vaulted from approximately $70 per barrel at the end of June to an excess of $93 per barrel, momentarily grazing the $95 mark. This surge can be attributed to robust demand for air travel during the summer and fall seasons, coinciding with amplified oil consumption for electricity generation. The world is currently experiencing historically unparalleled daily oil demand, exceeding 100 million barrels, while the OPEC+ coalition continues to curtail production, leading to a reduction in OECD inventories. We posit that there exists an opportunity for the oil supply-demand gap to expand further in the latter half of the year, propelling Brent crude oil prices toward the coveted $100 per barrel threshold.

In tandem with this surge in oil prices, the U.S. August CPI registered a 3.7% year-on-year growth, up from 3.2% in July, marking the second consecutive month of resurgence. While the core CPI, which excludes energy and food components, exhibited a marginal decline, housing rents remained obstinately elevated. Compounding the already grim outlook for CPI is the ongoing strike by the United Auto Workers (UAW), representing a workforce of 146,000, against the big three automakers, commencing on September 15. The union rebuffed the automakers' proposal of a 21% wage increase (with the three principal demands encompassing a 40% wage hike, a four-day workweek, and enhanced paid leave and retirement benefits). With constrained room for government-mediated negotiations, labor costs for automakers are anticipated to swell by 26% by 2027, and such escalation is expected to adhere with a remarkable degree of persistence. In the short term, aside from the 3,200-unit daily vehicle production reduction resulting from the strike, translating into an impact of 5 to 10 basis points each week on quarterly GDP (akin to the 42-day strike by General Motors in 2019), the ongoing strike inflicts a substantial blow to the burgeoning electric vehicle initiatives of traditional U.S. automakers. Tesla, owing to its non-unionized status, is poised to consolidate its cost-competitive standing as the strike persists, and labor market tenacity is poised to endure. Foreseeably, the resistance to inflation's downward trajectory in the final quarter of the current year is anticipated to be more pronounced than initially envisioned.

The recurrent oscillations in inflation align with our antecedent prognostications. Our stance remains unswayed in asserting that the Fed has already concluded its final interest rate hike in July. Additional rate hikes are not anticipated at the policy meetings scheduled for September, November, and December. Consequently, the policy interest rate in the United States will continue to hover within the corridor of 5.25% to 5.5% by year-end. In light of elevated energy prices and wage escalations fueled by government infrastructure investments and a dearth of hourly workers, the Fed led by Powell will adopt a more hawkish stance than witnessed in July - which will make the high rate environments lingering longer than previously anticipated. This posture is strategically aimed at tempering the exuberance and opportunism pervading the financial markets. However, we contend that the dot plot, emblematic of interest rate projections articulated by regional Federal Reserve Bank presidents, constitutes a more genuine reflection of officials' innermost convictions.

The perpetuation of a high-interest rate milieu has the potential to forestall economic overheating. Curiously, further interest rate hikes may paradoxically expose the economy's vulnerabilities, initiating a sequence of undesirable and unintended consequences. Going into 4Q, the pain of higher borrowing costs and credit tightening condition will be even more prominently felt by consumers, home owners and corporates (particularly SMEs). As the Covid bonus will run out soon (before the end of the year) and Fed is orderly shrinking its balance sheet, people will start cutting back on spending as well as expectation for the future. This was discernible in the diminished Consumer Confidence Index in August.

In the realm of equities, the AI driven hype in the past few months has masked the slow-down in the underlying economy. As macroeconomic fragility becomes manifest, the S&P 500 and Nasdaq indices underwent a discernible retracement in August. .  Investors will come to realisation that while AI will continue to reshape the industry and our societies in the foreseeable future, the sky high multiples enjoyed by the industry will be challenged and scrutinised with some wagon riders to face the hard reality. While broad market crash is not in our play books, we anticipate that the U.S. stock market, notably large-cap technology stocks, will weather a correction ranging from 5% to 10% in the near term. In such a milieu, a fraction of capital may be redirected towards Asia in search of new opportunities. Simultaneously, semiconductor stocks, poised on the cusp of a tightening cycle, may yet experience a measure of upside potential in the fourth quarter.

U.S. Treasury yields have climbed throughout the whole summer, ascending to levels unseen since the aftermath of the financial crisis. An excess issuance of bonds and the attainment of a decade-high yield level have endowed investors with auspicious entry points. Although yields may conceivably ascend further in response to hawkish pronouncements from Fed officials, the extent of such ascent remains circumscribed. Our prediction suggests that, by the third quarter of the ensuing year, yields, on the whole, will commence a descent. Presently, the recommendation entails augmenting the duration of bond portfolio holdings to lock-in elevated yields and capitalizing on the tail end of the prevailing period of U.S. dollar strength through certificates of deposit.

On the geopolitical front, notwithstanding the resumption of high-level U.S.-China engagements in the third quarter, underpinned by economic exigencies, we harbor the conviction that U.S.-China relations will persist in a dynamic characterized by a "tango" rather than a "tandem" Improvement in relations is not seen either in the run-up to or aftermath of the 2024 presidential election. Both countries will wrestle with finesse to solidify allies in different parts of the world - while westerns might pull out resources from China, the Middle East and BRICS will fill the void.  

China – Anticipation for Further Stimulus Measures

Since Q2, the Chinese economy has experienced fluctuations, marked by a decline in external demand and sluggish domestic consumption. Manufacturing has continued to contract, and consumer confidence has reached lows not ever seen since the reopening. The Politburo meeting on July 24 briefly revitalized market sentiment, emphasizing the need to optimize housing policies, notably omitting the notion of "houses are for living, not for speculation." Subsequently, the PBOC, after August, implemented additional monetary easing measures by reducing RRR, MLF, and LPR. Moreover, a cut in the securities trading stamp tax bolstered enthusiasm in the financial markets, while first-tier cities implemented policies where property purchases were not linked to mortgage eligibility (primarily for those seeking to upgrade their homes), contributing to a slight resurgence in the real estate market.

These stimulus measures, however, cannot entirely mask some underlying economic issues. Real estate developers still grapple with substantial debts, and while Country Garden won eight bond extensions in early September, it serves as a deferred remedial measure, offering only temporary respite. Other property firms face similar predicaments. The weakness in the real estate market has begun to permeate the financial system, with state-owned enterprises such as Zhongzhi Enterprise Group and Sino-Ocean facing default risks due to their exposure to real estate assets.

Revival of economy is still the top priority of the government. Given the likelihood of persistently high-interest rates overseas for about a year, external demand is not expected to see significant improvement. With Consumers yet to recover from the COVID syndromes, market is reluctant to vote with confidence until they see concrete actions, not just being announced, but to be implemented with real impact.  Uncertainty towards the future, coupled with the Trust scandals in the 3rd Q along with debt-ridden LGFV, not to mention the lingering effects from the fall of the RE industry, we continue to see high percentage of income to be deposited into financial system. While consumer purchasing power is gradually recovering (with estimated high-speed rail ticket sales for the National Day Golden Week expected to be about double that of the Spring Festival), the revival of import and export businesses will not pick up at the same pace. In August, China's exports declined by 8.8% year-on-year, while imports fell by 7.3%, reflecting a narrowing trade surplus trend.

Despite the challenges, there have been some positive effects stemming from summer tourism and stimulus measures. For example, August Industrial Production and Retail Sales, both exceeding expectations, displayed encouraging figures. The Caixin Manufacturing PMI for the same month also returned to expansionary territory. However, investors remain cautious about the economy's ability to emerge from its slump. The real estate market remains the most significant drag, and rebuilding confidence will take time and patience.

We believe that Chinese government will not take drastic measures but to revive the economy in a systematic and organised matter. While the broad market is hoping that government would take more aggressive stands to combat the situation, our take is that China, during the implementation process, is leveraging this gradual and painful process to wind down non-performing/sub-par industry companies/practices to bring back a healthier fundamental change for years to come.  Consumer spending during the National Day Golden Week in October will be a crucial data point of interest for both the market and the government.

Regarding the stock market, the short-term stimulus measures introduced by the government have failed to convince investors of any significant changes in the macroeconomic fundamentals. Typically, stock prices rise briefly on the day of such policy announcements but quickly retract. It is anticipated that the market will continue to monitor whether the government will implement more robust policy support to further boost market sentiment. In the third quarter, the Hang Seng Index continued to decline, with a 21% drop from its peak on January 27, now residing in bear market territory.

A closer examination of major companies' financial reports reveals that firms like Alibaba, JD.com, Tencent, and Meituan have all outperformed Wall Street's expectations, with profits markedly higher than during the pandemic. Nevertheless, stock prices have not reflected this trend. Consequently, we believe that Hong Kong stocks have likely reached their nadir. Presently, valuations at around 10X, which are appealing, and we anticipate a slow recovery moving forward. With strong consumption data during the National Day Golden Week, coupled with mitigating and fading negative factors such as changes in Alibaba's management, and the delay in Alibaba and JD's business split plans, we expect the Hang Seng Index to rise above 19,000 by the first quarter of next year.

The recent surprises by Huawei Mate Pro 60 on 7nm chips supplied by SMIC truly sent a wake-up call to the western world - the harder they press, the faster China will react. Having said that tech giants will continue to cope with further sanction pressure from US and allies to curtail China’s technological advancements - which is something not going away any time soon (likely to intensify).

Overall, despite ongoing global economic uncertainties, China is on a path to recovery. We have revised our year-end GDP growth expectations from 5.3% to 5%, with driving forces behind growth coming from Government’s pull to fill the gap on consumer spending and exports.

Japan - An Evolution in the Central Bank's Monetary Policy

Contrary to our June forecasts, the Bank of Japan undertook a substantial recalibration of its monetary policy during its July 28 meeting. Although it maintained its policy balance rate at -0.1%, it introduced two pivotal declarations that indicated a fundamental shift:

• The previous 0.5% ceiling became a reference rate
• BOJ would purchases of 10-year JGB at a 1% yield on a daily basis

While on the surface, the Bank of Japan continued with its Yield Curve Control (YCC) policy (anchoring the 10-year rate at 0%, with an upper limit of 0.5%), this adjustment essentially breached the substantial 0.5% upper limit. In less than two months, from July 28 to September 19, the yield on 10-year JGBs escalated from 0.45% to 0.73%. This marked increase effectively constituted an implicit interest rate hike, lending further credence to our earlier perspective that the BOJ was progressively steering away from its protracted phase of ultra-loose monetary policies.

The pivotal question dominating the landscape in the fourth quarter pertains to the timing of the BOJ’s subsequent moves. Analyzing the rather ambiguous signals conveyed by Ueda in July, it becomes apparent that the BOJ remains inclined towards the perpetuation of lower policy rates, aiming to invigorate domestic demand and attain the elusive goal of stable 2% inflation, firmly anchored in domestic demand and wage growth, breaking free from over a decade of deflationary spirals.

However, the low-interest rate environment has attracted foreign arbitrageurs to attack on Japanese bonds. The yen, relative to the dollar, has depreciated by a further 13% this year (while the yuan has depreciated by approximately 5%), continually driving domestic inflation and eroding consumer purchasing power. Paradoxically, this is not conducive to the central bank's desired recovery in actual consumption. Thus, the existing weakness of the yen has coerced the BOJ to pivot towards a more hawkish stance, poised to counteract undesirable inflation stemming from external factors, notably the surge in import food prices. In a noteworthy development, during an interview on September 10th, Governor Ueda articulated that ending negative interest rates remains a viable option. This has fortified expectations that the BOJ may   phase out its negative interest rate policy and YCC by 2024.  

Japan, being a nation with low self-sufficiency, relies heavily on imported energy, natural resources, and other consumer goods. In July, the CPI grew by 3.3% year-on-year, marking 19 consecutive months above 2%, with food price increases accounting for 70% of this surge. Given recent spikes in energy prices, despite government subsidies, the fundamental issue remains unresolved. We anticipate that CPI will continue to rise and remain elevated in the fourth quarter.

Simultaneously, real consumption in Japan remains stagnant, if not below pre-pandemic levels. Unlike the demand-driven inflation experienced in the United States, fueled by expectations of economic growth, high job vacancies, and wage growth, Japan's inflation is cost-driven. For instance, hotel expenses are rising at a double-digit rate (a rapid resurgence in overseas tourism driven by yen depreciation). Considering an increasing elderly population heavily reliant on pension income and the prospect of higher taxes in Japan, demand-driven inflation is unlikely in the foreseeable future. In July, average wages in Japan increased by 1.3% year-on-year, marking the 19th consecutive month of growth, but the rate of nominal wage growth still lags behind CPI, resulting in a real wage decline of -2.5%. This further amplifies inflationary pressures.

We maintain the viewpoint that the Bank of Japan is grappling with the challenge of embracing a yen depreciation to the extent of 150 against the US dollar. Therefore, starting in the fourth quarter and extending into the first quarter of next year, we anticipate a gradual sequence of policy interventions, including the cessation of the 0.5% yield reference for Japanese bonds, the abandonment of the 0% target yield for 10-year JGBs, Widening the YCC upper limit, and the termination of the negative interest rate policy. These steps will serve to support the yen and control inflationary pressures, thereby enhancing purchasing power. In this scenario, banks (we prefer MUFG & SMFG) and the financial system will continue to benefit and lead other sectors within Topix, with the yen potentially appreciating to 135-140 against the dollar by year-end.