On Feb 1, the US Federal Reserve raised the fed funds rate by 25 basis points (bps) to a range of 4.50% to 4.75%. The decision of the Federal Open Market Committee (FOMC) was unanimous.
FOMC chairman Jerome Powell acknowledged that inflation was moving in the right direction and that price pressures had likely peaked. However, he maintained the need to stay the course and does not expect a rate cut in 2023 in the assessment of the economy.
The strong labour market remains the key concern for Powell, with demand for labour still higher than supply while rising wages mean these conditions are not consistent with the FOMC’s target inflation rate of 2%. Labour market measures, such as the non-farm payrolls, recorded over 517,000 in January while unemployment was at its lowest in 53 years at 3.4%.
The FOMC chairman’s assessment of the US economy continues to run against the market’s expectation of a rate cut in the second half of the year. Core inflation, having peaked at 5.4%, fell to 4.4% recently. This led investors to react positively to the 25bps hike. After the FOMC meeting, the S&P 500 rallied 1%, while the 10-year Treasury yield fell 0.10%.
The market may be unrealistic and running ahead of fundamentals. Financial conditions as indicated by the Chicago Fed’s National Financial Conditions Index remain loose in the face of the higher fed funds rate. The easier liquidity environment has the potential to keep inflation higher for longer.
Falling commodity prices have also helped with the inflationary environment. The WTI oil price has fallen from a high of US$123 per barrel in 2022 to US$80 levels, which has helped to ease price pressures. However, things may change with China’s reopening. What will its exit from lockdown bring?
After China exited its Covid-19 lockdowns in the fourth quarter of 2022, the infection rate has climbed to about 80%. That is the most rapid spread of the coronavirus compared to other Asian nations. While this puts stress on the healthcare system in the short term, China is expected to achieve herd immunity faster than any other country in Asia.
High frequency data already show people movement climbing sharply, much faster than South Korea and Hong Kong. The return to normalcy also contributed to a much better than expected GDP growth in the fourth quarter of 2022. As a result, we have upgraded China’s 2023 GDP growth from 4.5% to 5.2%. The underlying strength of the recovery is seen in the provincial government growth targets for 2023. Over two-thirds of the provincial governments in China have set the GDP growth target in a range of 5% to 6% for the year.
We also expect incremental policy support in addition to those that were announced earlier during the Central Economic Work Conference (CEWC). Next month, China will conduct annual meetings of the Chinese People’s Political Consultative Conference (CPPCC) and the National People’s Congress (NPC) — collectively known as the “Two Sessions”. In the past, the “Two Sessions” announced forecasts of the country’s growth and other important indicators like the Total Social Financing (TSF) that supports consumption.
Other indicators such as a survey on corporate profitability signals higher profits from Chinese corporates. The confidence shown by Chinese corporates in improved profitability will lift consumer and business sentiment.
China’s reopening will have the twin effects of easing supply chains and pushing up demand for raw materials. The first will help to lower inflation and the second will drive up raw material prices. The inflation risk from China’s reopening is not fully reflected in the price of commodities such as copper. Either the reopening will be gradual and not push prices higher or the market has not fully adjusted for the impact of China’s reopening.
The road to 2% inflation
Current market sentiment on falling inflation and the Fed’s interest rate cut remain too optimistic considering the strong labour market in the US. And China’s reopening impact on commodity prices remains unclear. Our forecast is still for the fed funds rate to rise to a range of 5% to 5.25% with two more 25bps hikes. And we do not expect any rate cuts in 2023.
Hence, a diversified and balanced approach is still warranted in US assets. And the improving fundamentals and sentiments from China’s reopening will benefit Chinese assets. Having performed positively since the start of the year, it is likely there will be profit-taking activities along the way. There will also be higher volatility as investors assess the recovery in the Chinese economy. Geopolitical tensions will intermittently flare up with incidents like the shooting down of unidentified balloons over US soil. On balance, the still reasonable valuation and tailwind from the reopening means the upswing in Chinese equities has a solid footing.
Michael Lai is executive director of wealth advisory (wealth management) at OCBC Bank (M) Bhd