Many pundits consider the present supply scarcity and the overall constraints as a hindrance for growth potential in the economy and return on assets. The reality, however, is that we have the highest propensity to innovate and change when we are under the most pressure. We believe that the higher marginal cost of capital, the constraints on available energy, and the inability of central banks and political systems to allow markets to have true price discovery will lead to a complete break with the old models, but a positive one for moving forward. The negative break came in 2022 when both bonds and equity fell. In 2023 we have new fundamentals.
The peak in policy rates is close – not here yet but closer. The consumer continues to spend money as they draw down the stimulus money from the pandemic and savings, and sometime in 2023 they will move into credit financing. We have full employment. Financial conditions are easier than when the Fed starting hiking in 75 bps increments in June of last year. And importantly, China has pivoted away from its zero-Covid policies and some of its crackdown on the private sector.
We consider President XI’s reversal on zero-Covid policies, tech companies and not least housing critical for the rest of 2023. Last year China imported less energy, had low demand in commodities and ran the economy at maximum 70 percent of capacity. Now China leadership realises that the last decade of slowly decreasing private initiatives has left the economy weak and exposed. This will mean renewed, massive support for fiscal spending, much of it in infrastructure, support for housing credit, expansion of state-owned banks’ balance sheets and a reopening of the economy.
This may be the single biggest event in 2023 having happened before this publication goes to print. Pull out a chart and observe what China’s scaled-up expansion did to the global economy in 2003 (post-WTO entry), 2009 (post-GFC crisis) and 2016 (currency devaluation). We expect the magnitude of China’s credit impulse to match 2007-2009 as the three-year lockdown will mean China will be fiscally expanding longer and deeper than normal.
Q1 is likely to be dominated by the fight between a soft landing and recession. For now, the soft landing probability is rising fast, and the recession probability is falling. We see this and trade this as long risk assets in Q1, but at all times we remind ourselves that nothing has changed fundamentally. We are long energy, long deglobalisation as the economy is running on very easy financial conditions. This means by H2-2023 inflation will resurface, growth will surprise to the upside globally, but mainly in Europe and the US, and the Fed will be forced to begin hiking again after only a short pause (not set for a long series of cuts starting later this year). This will echo the path of Fed Chair Volker in 1979 to 1982.
The models are broken, but before we change, we will likely see the market pricing a new round of extend and pretend in Q1.