China: From Drip to Rising Tide

At the beginning of December, we were worried about the impact the European Central Bank’s (ECB’s) and the U.S. Federal Reserve’s (Fed’s) continued tightening would have on the financial markets. Typically, central bank tightening is unfavorable for financial assets, and markets decelerated going into December.

Then, suddenly the Fed signaled it would stop raising rates and reverse on quantitative tightening. This led to a rally in U.S. equities and other asset classes, but I view it as a glass half empty for the following reasons.

Europe Reacts to ECB Tightening

As soon as the ECB initiated a little bit of quantitative tightening, in the second week of December, the financial markets started performing poorly. For demographic and other reasons, Europe’s sustainable growth rate may only be zero, which indicates that it is not a significant contributor to global growth. However, it is very important in the global trade and financial systems.

European Markets Seized Up Following ECB Tightening
Eurozone Manufacturing PMI

Source: Bloomberg.

The tightening by the ECB had a major impact, and I think the Fed’s decision to ease was made reluctantly. The Fed was also concerned about global economic growth rates, especially in Europe and in China. The financial markets have been going up since January, but I think investors should note that the Fed acted out of concern. Likewise, investors should watch these risks carefully.

The ECB is also now changing course and moving to ease. At its March 7 policy meeting, the ECB pushed back its timing for increasing interest rates and is expected to stay on hold through the end of 2019. It also announced a program to stimulate bank lending, with another round of targeted longer-term refinancing operations (TLTRO) launching in September. TLTRO loans from the ECB provides banks in the euro zone with cheap rates.

China’s Drip Stimulus Kicking in on Schedule

At the end of last year, we said, “Don’t fight the PBOC,” which was an oversimplification of the fiscal, tax-oriented, and monetary steps being taken in China. We call it a “drip stimulus” because, rather than a big infrastructure stimulus program similar to what was implemented after the financial crisis, this was meant to be a more moderated program.

Our expectation in December was that this stimulus would kick in around Q1 and Q2 of 2019, and it looks like we are on schedule for that. I think this is good news for Chinese equity investors in 2019, and I think it is just the beginning.

Drip Stimulus Taking Effect in China?
China Composite PMI¹

Source: Bloomberg.

Portfolio Implications

We always argue for diversification, though international diversification has admittedly been a tough story to tell for the last 10 years. The U.S. was going in one direction while the rest of the world was moving sideways. However, diversified investors have been rewarded over the last three to six months.

The fourth quarter of 2018 was difficult for U.S. stocks, but emerging markets debt was flat and gold was up. And despite the trade headlines, emerging markets equities outperformed U.S. equities.² So, while the U.S. economy may still be considered the strongest in the world, being balanced and continuing in a normalized interest rate environment, investors should stay diversified, especially in light of a likely cyclical upswing in China.