Recent PMI and trade data from China indicated a potential uplift in the outlook for the world second largest economy. A rising trend, possibly boosted by stimulus, would sit in sharp contrast to developed markets, currently engaged in a battle against both soaring inflation and looming recession. Today we will examine these diverging East-West trends and look at how they could play out across different asset classes. We also focus on recent adjustments to our tactical asset allocation.

Could you start by giving an idea of how financial markets closed out the first half and started the second?

It's been a very difficult first half of the year for both equity and bond markets. The MSCI All Country World Index, our proxy for global equity markets including emerging market equities, is down more than 20% to the 15th of July. The S&P 500 index and the Euro STOXX 50 are both off 19% or so in local currency terms and it's been painful in the bond space too.

Government bond yields have risen, and credit spreads have widened, leading to losses both in sovereign and corporate bond strategies. Investors in the US 10-year bond, for example, are down about 11% in dollar terms and investors in US high yield have lost more than 12.5% year to date. In that broad context, the outperformance of some Asian equity markets has been notable in the year to date. For example, Japan has held up better with the Nikkei 225 index off just 7%, measured in yen, year to date. And China is at -11% in local currency terms to the 15th of July, which is a meaningful outperformance, although still negative in absolute terms for the year so far. Notably in the last two months, Chinese equities have outperformed global equities by more than 12%.

That is interesting, and it's the outperformance from China that you mentioned that illustrates the theme we'll be discussing today. Could you give us some recent data points that might suggest an uplift in economic performance for China?

Since the major lockdowns ended in May, the PMIs have rebounded strongly. Especially the June non-manufacturing PMI surprised to the upside, with a print of 54.7 versus an estimate of 50.5. We also saw an encouraging uptick in economic activity. Nonetheless, the negative impact of those lockdowns in major cities was evident in a surprisingly poor GDP number. Q2 GDP grew only by 0.4% y/y versus the estimate of 1.2%, the slowest pace since the country was first hit by the Covid outbreak two years ago. On the positive side, China’s export numbers continued to be strong. In June, exports grew 17.9% y/y versus market expectation of 12.9%.

There remains the risk that lockdowns could be reimposed as the zero-Covid policy is still very much in place in China.

Exactly, despite some minor relaxation of Covid rules recently, dynamic zero-Covid is still in place. We saw a rise in cases recently, but most places have been able to contain outbreaks at a small scale without resorting to the drastic citywide lockdowns deployed in April. The new normal, which means frequent testing and the aggressive use of more targeted early lockdowns, has worked so far without being broadly disruptive for the economy. While policymakers will continue to try to limit the impact on manufacturing supply chains, the continuing cycle of Covid restriction rates on consumer spending and consumer confidence, the important question is when will the zero-Covid policy end? The best case is that there will be some positive news during the party Congress in October. However, my base case is that it won't happen before Q1-Q2 2023, when another important party meeting called ‘Two Sessions’, a key moment in the Chinese governmental calendar, takes place.

It does seem quite a while to wait, but on the positive side we have seen signs that the regulatory clampdown which so shocked the markets last year might be becoming less severe.

Indeed, we saw crackdowns on a broad range of industries last year from tech, betting, education and most significantly, the property sector. Recent indications show that the peak of regulatory crackdown is maybe behind us, or at least the market is more aware of it and has a better idea of which industries are more aligned with the long-term goals of the government. Just yesterday, after more homebuyers refused to pay mortgages for unfinished real estate projects, government reacted quickly and is discussing a grace period for homebuyers on their mortgage payment to restore confidence in the property market.

That all certainly builds a more encouraging backdrop for investment in China. By contrast, though, if we turn to the developed markets, we are surrounded by predictions not only of inflation expectations becoming embedded, but increasingly of imminent recession. The story seems very different.

Indeed, the latest inflation data in particular, have come in high and higher than expected. We had US CPI come out at 9.1% y/y for the headline figure for the month of June. And inflation in the eurozone hit a record high of 8.6% in the year to June as well. The situation in Europe is particularly challenging potentially. The very high inflation numbers come at a time when Europe faces a number of threats to growth, ranging from the prospect of energy rationing in the coming months, to political instability in Italy. The ECB is more cautious in raising interest rates than the Fed. They are looking for just a 25-basis point increase at their meeting this week. This would still leave the base rate in negative territory at -0.25%, with a view to potentially getting above zero at the September meeting.

The IMF, the International Monetary Fund, is due to cut their growth forecasts again, and largely because of the impact of inflation, and of course rising interest rates, on consumption. Again and again we are hearing predictions of stagflation.

But stagflation is the worst-case scenario for markets, really, a case where low growth fails to translate into low inflation. This is particularly worrisome for financial markets because low growth is bad for stocks and high inflation is bad for fixed income investments. So there are very few places to hide in that scenario.

At the moment, the intention of policymakers, most notably the Fed, and the expectation of investors is that, by cooling down demand, supply and demand will become better aligned, moderating the price increases we are seeing at the moment.

Despite growth potentially rebounding in China, inflationary pressures there seemed far more mild.

Yes, China reported, a June CPI number of 2.5% from 2.1% the month before, driven by increases in both pork and oil prices, a rebound in service prices and a low base for comparison. While year over year, CPI could break above 3% in the second half of this year, given the upward trend of pork prices and a lower base from last year, the market expects the core inflation rate, ex-food and energy, to stay below 2% through the rest of the year. That said, while China CPI inflation could trend up over the rest of the year, the market doesn't expect any of the strong inflation pressures we currently see in US or Europe.

Yes, and it's only natural then that the rhetoric from the People's Bank of China (PBOC) is very different to what we've been hearing from the other major central banks.

Indeed, although PBOC turned a bit more neutral on potential RRR interest rate cuts in the near term, they are far away from the monetary tightening mode of most of the other central banks. Given the full year growth target of 5.5% now looks harder to achieve, PBOC will further support the economy if needed at the moment. Policymakers appear to be focused more on boosting aggregate credit growth to support the real economy, complemented by more fiscal policy support.

Thank you for that. And if we look now at the US Federal Reserve, they surprised markets with an unflagged 75 basis points interest rate hike in June and the Fed is very keen to stress a commitment to restraining inflation. What is the next move for the Fed now?

Well, the Fed next meets on the 26th and 27th of July, a 75 basis point increase had been widely expected, after the move in June. Two things have happened in recent days that have pushed that expectation even higher potentially. The high US CPI inflation figure, which came in at 9.1% for headline last week, a 40 year high, and the aggressive 100 basis point hike that came from the Bank of Canada last week.

With this backdrop then, it's interesting to see such a lack of alarm in the bond markets.

Indeed, the US 10 year has been stable in the past week or so. The yield is at just under 3% right now at 2.97%, stable from a week ago, and down from 3.27% one month ago. That's because markets are a forward-looking mechanism and a relatively aggressive path of Fed hiking had already been priced in. With recession worries then starting to impact investor expectations, the US 10 year has come down from a month ago and the 2-to-10-year curve has become more inverted, in the last week, meaning the 10 year bond offers a lower yield than the 2 year equivalent. And the differential is greater now than it was a week ago. This is a feature that tends to be associated with lower growth expectations further out.

And it's that lower growth which will be the next hurdle for equity markets, particularly in the second quarter reporting season, which we are entering now. We'll be given guidance on full year figures. We've already seen downgrades, notably from Apple, and this naturally calls current valuations into question, certainly in the US and Europe. Is this quite such a live issue in China?

It is indeed. The Q2 reporting season, which starts in the coming weeks, should give the markets some important information on how companies are dealing with the uncertainties around Covid. The consensus EPS growth forecast for MSCI China is 7.6% for 2022 and 13.6% in 2023. Besides that, in China the earnings downgrade cycle is way ahead of some of the other developed markets. Which could give some more room for positive surprises. Regarding valuations, the 12 months forward PE for China is at 10.7, which is around 0.6% standard deviation below the 10-year average and at a significant discount to developed markets, especially the US.

It is interesting that discount still persists. And in the light of this, could you please talk us through the recent changes we have made to our tactical asset allocation?

Yes, we have turned more cautious on equities and high yield bonds. And conversely, we have increased the duration profile of our government bond strategies.

Taking those in turn, we are moderately underweight in equities. Persistent inflation, tighter monetary policy, and ongoing risks to growth, such as the energy and food crisis on the back of Russia/Ukraine mean the probability of a recession, or ‘hard landing’, has been increasing.

As a result, we have moved to a moderate underweight position in equities. Within that we maintain a preference for US and Asia Pacific equities, relative to European or eurozone equities, and are now at a full underweight in Europe equities. We see the war in Ukraine weighing significantly on growth in the area via a large drag on consumer spending from high energy prices, weaker trade, and of course the tighter financial conditions.

We've had a moderate overweight to Chinese equities in place which has worked well. As we've just discussed, we still see upside for that relative to developed markets and maintain the view and have recently expanded it to the Asia Pacific region a bit more broadly.

We are neutral on government bonds. Having recently moved to neutral duration in most fixed income asset classes, we have recently completed the move by upgrading euro government bonds to neutral as well. We think a lot of the rise in yields is priced in already and as the possibility of a recession grows, government bonds may protect us better through their traditional safe haven status going forward.

Finally, on high yield, which is a risky asset class, given the weaker outlook for risky asset classes, we are reducing high yield back to neutral. While the yield on the asset class is now at very attractive levels, the risk of credit spreads widening further from here has grown, as the economic backdrop looks set to possibly weaken further.