The final days of September saw a series of stimulus measures be announced by Chinese authorities, catching the financial world by surprise and triggering a sharp rally in the –undervalued – local stock market. The fact that Beijing has decided to rely on private capital deployment rather than public money may, however, limit the near-term economic (and market) impact of this stimulus package. Meanwhile, understandably, all eyes are now also focused on the Middle East, where the conflict between Israel and Palestinian Hamas has taken on a much broader turn. A scenario in which Iranian oil facilities come under attack and/or the Strait of Hormuz is closed, resulting in high oil prices, cannot be ruled out.
Any severe oil-induced inflationary pressures, at a time when Western central banks are looking to cut interest rates further to support economic growth (and relieve indebted governments), would obviously be a rather unwelcome development.
The coordinated fiscal and monetary measures announced in the days leading up to China’s National Day were portrayed as the country’s most aggressive stimulus programme in years. The local equity market certainly responded fast and enthusiastically, with a 27% gain on the Shanghai Shenzhen CSI 300 Index in the space of just a few days. A rally which we believe had more to do with the surprise factor (closing of “short” positions), and with valuation considerations (Chinese equities were very cheap), than with quantifiable near-term economic benefits.
As for surprise: last March, we mentioned in this letter how intriguing we found the very sharp increase in Chinese iron ore and coal imports (from Brazil and Australia respectively). Emphasising that imports of basic commodities are always the starting point for faster economic expansion, we wrote that our take on China was somewhat rosier than the broad consensus. With hindsight, we now think that the Chinese authorities were already planning these stimulus measures, and took advantage of attractively low iron ore prices to prepare for them.
In terms of valuation, Chinese equities had clearly reached extreme levels of pessimism. Their forward P/E stood at only 11.5x just before Beijing begun to unveil the various measures, almost 20% below the 10-year average of 13.7x. Following the rally, the forward P/E has expanded to 14.5x, implying that the market is already pricing in a (somewhat) positive impact of the stimulus package on the economy and corporate profits.
Which brings us to the key question: how and to what extent will this stimulus package deploy its effects? Looking at the real estate market, which is clearly China’s largest current problem area, the measures proposed are indirect by nature. Rather than injecting public money, authorities want to mobilise private capital by, for instance, lifting limits on the number of properties an individual can buy, lowering mortgage rates or reducing bank reserve requirements. This approach makes sense, given the huge stock of savings held by Chinese households. How much of these savings will actually be used to buy properties during the coming months is, however, difficult to predict.
According to the 2024 McKinsey China Consumer Report, confidence currently appears to be particularly low within the key Millennial generation (aged 26-41). In our view, a better social security safety net – in particular a more generous pension system – would provide a strong incentive for greater private spending/investment in China. Note in this respect that social security enhancement was precisely one of the main topics at the Chinese Communist Party’s “third plenum” last July, a meeting held every 5 years or so that aims to map out long-term policy trends. It will be no easy task given China’s very difficult demographic situation (with a population set to almost halve by 2100 due to the prior one-child policy). Which in turns means that investors will have to be patient and keep their short-term return expectations modest. Still, we choose to maintain our (small) portfolio exposure to Chinese equities, recognising that they remain “cheap” compared to US and European peers, and also taking into account expected GDP growth rates in each of these three geographic blocks.
Turning to the Middle East, Israel’s recent invasion of Southern Lebanon (to fight Shiite Hezbollah) and Iran’s subsequent missile attack on Israel have clearly changed the overall picture – and the associated risks. A counterattack by Israel on Iran is now in the cards, possibly backed by the US. The only restriction publicly stated by President Biden is that Iranian nuclear facilities be spared. In other words, targeting Iranian military installations or oil production facilities (a major source of revenue for Iran) remain options. It might even be viewed as an opportunity to topple the Iranian regime. Besides, with the date of the US presidential election now fast approaching, the incumbent may want to avoid higher oil prices and additional geopolitical turbulences in order to keep up the chances of a Democratic victory. But what of after the election?
Should Israel attack Iran’s oil installations, the only possible response we can expect from Iran (or rather the one that would cause the most damage) is a closure of the Strait of Hormuz – the sole gateway to the Persian Gulf. This would cripple the flow of oil from Iraq and Kuwait, amongst others. As for Saudi Arabia, one of the few OPEC producers with significant spare capacity, it would only be able to ship oil out of its west coast (the Red Sea), strongly restraining exports. Moreover, access to the Red Sea is currently severely hampered by the Yemeni Houthis (allies of Iran). Needless to say, the impact on the price of oil in such a scenario would be substantial, rekindling inflation concerns.
For Western central banks, currently intent on cutting rates further to sustain economic growth and, more importantly, alleviate the interest burden weighing on debt-ridden governments, an inflationary burst would be very unwelcome. Obviously, equity markets, too, would be disrupted. In this respect, energy investments, alongside exposure to precious metals, should today be viewed as potential portfolio hedges against an adverse geopolitical scenario.
A word, finally, on Europe. Assuming the ECB can indeed continue its monetary easing, with the next rate cuts possibly occurring even sooner than anticipated, holding long-term government bonds remains a sensible strategy in our view.
While lower rates do support equity valuations, corporate profits are coming under pressure. Not only does Europe have no “Magnificent 7”, but austerity measures are looming in France and several other European countries. Some sectors (especially manufacturing and retail) are experiencing severe pressures, the automobile industry being a prime example with heavy current losses. Unlike the US, which has erected hefty trade barriers and is now also invoking national security issues to completely block the sale of Chinese electric vehicles in the US, even if manufactured there, European authorities are effectively allowing their carmakers bear the brunt of cheap Chinese competition. The recently imposed (limited) import tariffs may not calm the ”yellow” storm. At the same time, the European Commission is imposing strict emission targets (and fines) that will force European carmakers to scale back sales of combustion-engine models, hurting both earnings and employment in the sector.
All told, the interest rate outlook remains favourable for financial markets – helping offset disappointing profits. Should the situation in the Middle East get out of hand, however, this rate support could disappear. A resurgence of inflation due to (much) higher oil prices would prompt central banks to halt, or even reverse, the currently policy of gradual rate cuts.
In such an adverse scenario, as already mentioned, energy stocks and precious metals would probably be the most efficient portfolio hedges. But let us hope for the best.
