East/ West divide: contrasting fortunes makes it mark on financial markets

The economic news out of China was bleak for November. Both services and manufacturing PMIs for the country fell for the second month in November, reducing hope for a China economic rebound as we move towards the new year. While China struggles, Germany and other European countries are bouncing back. Retail sales in Germany were significantly stronger than expected, rising by 1.1% MoM in October, giving hope that Germany’s largest economy is finally rising from its economic slumber. There was also hope that the ECB may cut interest rates soon, as inflation fell across the currency bloc. France saw consumer prices fall 0.3% in November, and Spain, a leading economic indicator for the Eurozone when it comes to inflation, saw annual price growth fall to 3.2% YoY in November. The overall inflation figure for the Eurozone for November was 2.4%, which is within touching distance of the ECB’s 2% inflation target. The diverging economic fortunes between Europe and China is startling, and comes at a time when investment managers are looking at their asset allocations for 2024.  

Second guessing the ECB

The ECB is currently expected to cut rates by the most of any major central bank next year, according to the latest readings of 1-year forward rates. There is nearly 80 basis points of cuts priced in already, which could limit how much more is priced in. However, the timing of cuts could shift dramatically on the back of falling inflation. The ECB, like the UK, are expected to cut rates from the middle of 2024, however, with such a weak economic outlook for both nations, there is a possibility that the cuts could come sooner. The ECB is now dealing with disinflation on a monthly basis and also signs of a consumer in difficulty. Consumer spending in France fell by 0.9% last month, while the unemployment rate in Germany for November and Italy for October both ticked higher to 5.9% and 7.8% respectively. Consumer confidence is also extremely low, and the M3 money supply in the currency bloc is at its lowest level since before 2008. The weak credit impulse in the Eurozone, and the shift in the economic dynamics, suggests that the ECB can’t ignore these numbers for much longer. Next month’s ECB meeting will be worth watching closely, will this be the first time that Lagarde and co. give a hint that rates could be heading lower earlier than expected? We assign a fairly high probability to this happening. For the euro, this could stunt any upside, particularly since US economic data is outpacing that of the currency bloc. For European stocks, this could be good news, especially for defensive sectors. The luxury sector is harder to predict, it has had a weak 6-months, and continues to roil from the weak growth coming from China. LVMH’s stock is down 1% today on the back of the China PMIs.

The problem with China’s economy

With falling inflation in the currency bloc, the question now is why is China’s economy weakening as we move to the end of the year? The service sector PMI was 50.2, the lowest level since last December, when China was in the middle of another wave of Covid. The slowdown in demand and the service sector, which is meant to be a beacon of light for the Chinese economy is another sign of economic weakness. The PBOC and the government do not act like economic growth is a priority, they have taken little decisive action to support the beleaguered property sector, and deflating China’s property bubble is proving to be a very painful process. Profit at China’s industrial companies was weaker than expected in October and export growth is negative, with no sign of picking up. External demand for Chinese goods is expected to remain weak as the global economy slows, and geopolitical relations with China come under pressure. The question is whether or not the Chinese government will now start to add fiscal stimulus to support the consumer and the service sector. If yes, then risk will likely rally and we could see the dollar fall, if they fail to add support into the end of the year, this could prove problematic, not only for the Chinese and local stock markets and the yuan, but also for risk sentiment more generally, since China is a major component of the global economy.

So far, while China has cut interest rates and tried to encourage people to buy property, the measures have not helped to boost consumer sentiment. Geopolitical relations have deteriorated, which casts a shadow over the long-term growth potential for China, particularly on the export side. The future outlook for Chinese growth will depend on the services sector, and right now, that seems to be heading south.

The market impact and an FX run down

The market impact of Thursday’s economic data fest has been relatively limited, and stocks are trading in a fairly benign manner. European stocks are higher, and the main Chinese index is down a touch. US stock index futures are pointing to a higher open later today. Overall, we think that the prospect of lower interest rates in the western world could buoy stock market sentiment in the short term. In the FX space there is more of a risk averse flow into safe haven currencies and the dollar, Swissie and the yen are all higher today. USD/JPY is our currency pair to watch this week, it has fallen 1.3% so far this week, and is currently trading around 147.50, we continue to think that 145.00 is on the cards for this pair in December, and we look for further yen strength vs. the USD, especially as the Fed’s messaging gets more dovish. GBP is under pressure across the board today, and GBP/USD is now below $1.2650. It’s hard to rally when the central bank governor comes out and says that the UK’s growth trajectory is the worst, he has ever seen it! This doesn’t take away the fact that GBP/USD has rallied more than 3.9% this month, although $1.30 is proving to be elusive at this stage. Next month’s central bank meetings and inflation data will be critical for FX, and we wait with bated breath!