China’s recovery is stronger than the Party expected.
Consumption, construction (housing sales at a 20-month high) and industry:
All sectors are participating in the economic upturn.
The industrial rebound is on a scale not seen for 10 years (the NBS manufacturing PMI is at its highest since April 2012). So much so that the authorities could reduce the stimulus initially envisaged.
China accounts for a large part of the surge in the Global PMI index reported by Deutsche Bank, S&P and Haver Analytics: it is back above 50 for the first time since last August.
The rebound in Chinese and global PMIs indicates that a recession is not imminent. This is good news for the growth of European companies, especially those that are sensitive to the Chinese cycle. Filling export order books is offsetting the slowdown in domestic manufacturing activity. Consumer discretionary companies are also benefiting from the good performance of the European consumer and the Chinese appetite for Western goods.
This windfall effect has combined with resilient domestic growth to support European cyclicals.
Since the beginning of the year, their rebound has been brutal.
Carmakers, banks, retailers and industrials are up 20% and have led the rebound in equity indices.
Is this performance sustainable?
The strength of activity is, however, a further challenge for central banks.
90% of US industrial respondents admit that producer prices are still rising. Logistics costs or material prices are not the only problem: in the fourth quarter, unit labour costs rose twice as fast as expected: +3.2% annualised.
Inflation in France, Spain and Germany continues to spill over. In February, prices rose by 9.9% in the euro zone. A bad surprise for the ECB, which seems to have the Council to keep the pressure on financial conditions. The effect of the tightening is infusing the economy and price dynamics very slowly. Perhaps more difficult than expected. Christine Lagarde confirms that the rise in rates must continue (+50 bp in March) and that all necessary measures must be taken to calm inflation. The same is true in the US where Raphael Bostic of the Atlanta Fed seems to be opposed to a rate cut before the second half of 2024.
All the language is being used to anchor inflation expectations around 2%.
So far, central banks have been firing blanks. The rise in interest rates has taken place against a background of low bond yields on the part of companies that have refinanced in 2020 over several years. The increase in the cost of refinancing for companies is therefore virtual for the moment. The tightening of financial conditions has thus had only a moderate impact on economic growth.
With central bankers’ rhetoric tightening and inflation remaining recalcitrant, economic agents will probably have to learn to live with higher rates for longer. With German two-year rates rising above 3%, the highest since the beginning of the great recession, the page of the post-2008 crisis low interest rate regime seems to have been turned. The markets foresee an ECB deposit rate above 3.5% with swaps raising terminal expectations to 4% by the end of the year. Across the Atlantic, the peak in FED rates (5.5% according to swaps with a September 2023 maturity) is pushing the US 10-year yield above 4%, towards last November’s levels, despite an exceptional start to the year in terms of buyer flows (the best since 2004, according to Bank of America).
This rebound in yields has penalised defensive stocks (whose earnings growth is struggling to keep up with nominal growth) and stocks with low free cash flow yields. With cash and sovereign yields close to the dividend yield (3.5% on the Stoxx600 Europe), investors may have preferred to create a Barbell portfolio by favouring bonds (less volatile) and cash for the defensive part of their strategy and the beta of cyclical stocks for the dynamic part of the allocation.
Nevertheless, after two exceptional first months, the revaluation of cyclical stocks may have anticipated the underlying economic upturn a little too much.
Indeed, the level of outperformance relative to the rest of the market has sometimes doubled compared to its 10-year average. Consumer discretionary, industrial and materials and construction companies are trading 80%, 40% and 22% higher than the Stoxx Europe 600 (PER Forward) respectively. The market value of their equity (price to book) is thus at a more than ten-year high.
By incorporating a more favourable economic scenario into their valuations, they are now less immune to the risk of a potential economic slowdown caused by persistently higher interest rates.
Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in March 3rd, 2023.
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