China –Time to open up
Speculation about the fate of China’s Covid Zero policy has recently attracted attention. After President Xi Jinping defended the strategy at the Communist Party congress address, investors were left wondering what comes next as the lockdowns and blanket testing continued.
However, Since Xi’s speech at the Party congress, there have been some solid indications that Chinese officials have at least started a dialog about how to ease the most restrictive aspects of Covid Zero: Officials are debating how they may go about further reducing mandatory hotel quarantine for incoming travellers and the aviation regulator has also encouraged state-owned carriers to add more flights.
On the vaccine front, German Chancellor Olaf Scholz gave the first indication that China may be willing to roll out more effective, foreign Covid shots: China agreed to approve the BNTX/Pfizer vaccine for foreign residents, the first approval of an mRNA vaccine in the country.
However, it still remains unclear whether China is getting ready to end its zero Covid policy with no concrete signs of China easing its internal Covid playbook of lockdowns, curbs on domestic travel and frequent mass testing.
Overall, whilst further concrete steps in vaccinations, hospital capacities, easing of border regimes (to name a few) need to be seen, we think the end of Covid Zero might be slowly approaching. To this effect, we believe there is the potential for China to outperform the US and the RoW if positive developments continue. Following the initial headlines, the HSCEI Index closed last week up 13%, and CNH appreciate c.3.5% versus the dollar over the same period.
US Inflation – Signs of upcoming peak
Last week, the October headline CPI rose 7.7% YoY down from the 8.2% September reading and below expectations of 7.9%. Core inflation also beat expectations coming at 6.3% YoY, down from 6.6% in September. October inflation has been the lowest YoY print since January 2022.
The composition of the print increases hopes for potentially more downside. Core goods disinflation is extending to household items, and commodities remain on a back foot. Services remain stickier, but do not show signs of increase. Used cars and industry-dependent items continue to come down strongly. Shelter and housing inflation remain elevated, but they tend to move with a lag to market conditions, and coincidental indicators are already coming lower.
Overall, the October report delivered the first downside surprise versus expectations since July, and we think it will likely pave the way for a Fed downshift to a 50bp hike in December. Whilst one good CPI print proves nothing, we think last week’s print could be a game changer. This, together with weakness in household employment in the last jobs report, confirms our view that we might be approaching peak Fed hawkishness, consistent with our bullets last week. Currently, the market is pricing a terminal rate of 4.9% in May-23.
UK Budget – Back on track in fiscal
The Chancellor will announce a substantial multi-year fiscal consolidation in the Autumn Statement on Thursday 17. As a reminder, Mr. Hunt likely will set out to find savings equal to around £50B by 2025/26. To save £50B, real government spending in 2025/26 will need to be about 1.2% lower than in 2022/23.
Chancellors always build-in some headroom into their plans, so that they do not need to respond automatically to slight deteriorations in the outlook for the economy or borrowing costs. So, we believe press reports that Mr. Hunt will seek annual savings of about £50B sound plausible. Moreover, we think the gilt market will be satisfied only by a consolidation plan that raises meaningful sums in year one, given the strong tendency for Chancellors to scrap or delay tightening measures just before they take effect.
As for the distribution between spending cuts and tax rises, recent reports suggest that the Chancellor now is favouring a 60:40 split, rather than a strictly balanced approach. This makes sense, given that it will be easiest of all to reduce the plans for public sector investment. Investment cuts could plausibly save £11B, while £5B can be saved by ditching a planned rise in overseas aid. Mr. Hunt likely also will resort to raising benefits in April in line with wages rather than prices, saving a further £5B.
Looking at taxes, we think windfall taxes aren’t long-term money-raisers; a VAT hike could have harmful second-round effects on inflation. Corporation tax probably won’t be touched by Mr. Hunt, given that the main rate already is due to rise to 25% in April, from 19%. So, income tax rises will have to play a major role in filling the fiscal hole.
In terms of implications for monetary policy, we think that potential delivery of fiscal tightening in the November budget, further soft growth data, and a slowdown in the global pace of tightening – from the Fed and the ECB – will allow the BoE to apply the brakes in December, and in 1Q23, as well.
US Midterms – Tighter than expected
Last week, talk of a red wave crashed into a decidedly less triumphant Election Day for Republicans. Republicans still look likely to win the House majority in the midterm elections, albeit by a smaller margin than anticipated. The Senate was a closer call, with the Democrats coming out on top over the weekend following the win of Sen. Cortez Mastos in Nevada, securing at least a 50-50 split even before the Georgia runoff on the 6th of December. The outcome of the House majority to become clear quickly. House elections in states that close polls early and report results quickly are likely to provide early clues on election night regarding House control.
Overall, the results in both chambers are closer than expected. Many of the key House races have not yet been called, but preliminary results suggest Republicans will win a narrow majority in the House. With the Democrats likely clinching the Senate and with the race for House control remains tight, the end result nevertheless appears to be a divided government.
We believe market reaction to a Republican win should be muted. A surprise Democratic win in the House and Senate would likely weigh on equities, as market participants might expect additional corporate tax increases. Interest rates might also rise in that scenario, as market participants might expect additional spending legislation, which would lead to tighter monetary policy all other things equal.
Algebris Investments’ Global Credit Team
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