Week Ahead: China woes, UK data and the rise in Treasury yields

There are three key themes that are dominating financial markets right now: what will happen in China, and will it impact the global economy? Will the UK’s inflation problem recede? And, finally, what will central banks do next? The answers to these questions will dominate price action as we move into the summer lull in mid-August. For now, the retreat in the recent oil price rally and expectations that the Federal Reserve will cut interest rates in the second half of this year, have left financial markets in buoyant mood at the start of a new week, after two straight weeks of losses for the Nasdaq 100. The tech heavy index was helped by a 7% surge in the price of Nvidia, which has seen its stock price triple this year, suggesting that there is still plenty of appetite for the tech giants as we move towards the end of the summer.

China’s real estate problem rears its head once more

We have mentioned in prior notes that China is deflating one of the biggest debt bubbles in history and when that happens it causes economic pain. Thus, anyone looking for China to be a quick fix to the economic problems faced by the global economy this year have been sorely mistaken. Growth has disappointed, the economy is in deflation and another property developer looks like it is on the brink of collapse. The latter point is worth noting, Country Garden was one of China’s largest home builders and it failed to pay its coupon on an international bond last week. If that happened anywhere other than China, it would have caused severe ructions in financial markets, however, when things happen in China the world seems to look on in interest, but without concern. Perhaps that is because China is considered a closed economy, that is only for Beijing to deal with. Beijing has in some way manufactured this crisis, it brought in a series of measures to bring rising house prices under control in 2020, and it has also tried to limit homebuilders access to credit. This has worked: Country Garden is expected to announce a 61% slide in sales in the first half of this year, and a loss of $7.6BN. This suggests that China’s real estate sector is suffering another acute crisis after Evergrande last year.

China’s next domino to fall

However, this second phase of the property crisis could be more malign, as problems also pop up in the shadow banking system. Investment products managed by Zhongrong International Trust have not made payments to three high profile clients, which suggests that trouble in the real estate sector is spreading to the shadow banking system, which make investments on behalf of their clients. Trust funds are worth approx. $2.9 trillion as of March and have approx. 15% of their assets in real estate. Although the total amount invested in real estate is thought to have halved in recent months, it could still be worth more than $150BN. Thus, there could be further downside to come in the form of more missed payments from the shadow banking system if the property sector in China takes another nosedive.

Overall, it is also worth looking closely at the sectors that Beijing tends to target. Both real estate and the shadow banking system have been under Beijing scrutiny in recent years, and, it seems, for good reason. The latest shock in the property market could also further dent Chinese growth this year, with some analysts estimating that it could knock 0.7% from GDP in 2023. The main casualty from the China news was global commodity prices, the price of crude oil futures fell 0.8% on Monday, halting the near 7% rally in crude over the past month. The price of copper, a key material used for housebuilding, rose late on Monday, however, the recovery barely reversed the 3.22% decline in copper futures prices over the past week. Commodity prices are not trading as a unit right now, and we expect copper and other industrial metals to continue to struggle in the coming weeks, while the price of crude may well attempt to reach $90 per barrel, as the market looks towards tighter supply as we move towards winter for the Northern hemisphere.

UK wage and CPI data to focus minds

Elsewhere, the UK will be in focus this week. On Tuesday, all eyes will be on the labour market data and the wage data. The market is expecting average wage growth to rise by 7.4% on a rolling 3-month annualised basis. If this is proven to be a correct assumption, then the market will likely focus on how wage growth is higher than price growth. However, we have mentioned in previous notes, average wage growth is mostly a useless figure since it is an average. Thus, if there has been a large downgrade in wages for the lowest earners, it won’t show up in the data, although it could be a sign of economic woes to come. Thus, while wage growth could move the market on Tuesday, it really shouldn’t, and any move in sterling or UK bond yields could be faded.

UK inflation finally expected to drop

The focus will be on UK CPI data that is released on Wednesday. July price data is expected to fall sharply, as this is when the reduction in the energy price cap will filter through to the data. The headline rate is expected to fall 0.5% MoM, the annual headline rate is expected to decline to 6.8% from 7.9% in June. As always, central banks will look at core inflation when they come to set policy, and here the news is not expected to be as rosy. Analysts are expecting core inflation to fall to 6.8% from 6.9%, which could highlight the sticky inflation problem faced by the Bank of England and this could limit their ability to pause rate hikes or cut interest rates anytime soon. It is worth noting that both input and output producer prices are also expected to fall deeper into deflation territory for July, although there could be some upward pressure down the line due to the rise in oil prices. Nonetheless, this suggests that price pressure is abating at the top of the inflation pipeline.

Treasury yields and the dollar

A quick word on Treasury yields. The 10-year US Treasury yield is dominating markets right now, as it is comfortably above 4% at 4.2% on Monday, its highest level since 2007. The surge in yields, which have risen by nearly 40 basis points in the past month, comes as investors reassess the Fed’s future rate path, and expectations for a soft economic landing. US retail sales data this week, along with the minutes from the latest FOMC meeting will all impact the near-term direction for yields. Strong retail sales data for the US on Tuesday could trigger further gains in Treasury yields. If the rise continues, then we expect further upside for the dollar, which is trading with some upward momentum at the same time as yields are rising. At this moment, the upward trend in the dollar is not a cause for concern, as it appears orderly. However, a break above 105.00 in the dollar index, the highest level of the last 6-months, could lead some people to worry about the impact of a surging dollar on corporate earnings, especially for those with international exposure, as we move towards the end of Q3.