The week ahead: the China reopening trade is back, but Europe doesn’t benefit

At the start of the week there are signs that China has taken further steps to ease Covid testing restrictions, which is seen as positive for risk assets, particularly on exchanges that rely on China – South Korea, the Hang Seng etc. Key Chinese companies that rallied at the start of the week include technology, consumer and travel related firms, which are highly correlated to the development of zero covid restrictions.

China turns back to tech

There were some big moves in the Chinese tech heavy weights on Monday, such as Tencent, up; over 5%, Alibaba, up 4.7% and Xiaomi up 7%. This is an interesting development. We have said for some time that the ‘reopening’ trade in China is based on more than just Covid. Zero covid was a means for the ruling politburo to control the population, in the same way that the tech crack down last year was also a means to control the population and reinforce its power. Thus, a perfect trinity for risk seekers is starting to emerge in China: 1, easing of Covid policy, 2, supportive actions to support the embattled real estate sector and 3, the end to the crackdowns on tech firms. Thus, even though there have been no official comments on the tech sector from Beijing, the fact that the government is willing to ease covid restrictions, is seen as a broad-based shift in Xi Jinping’s stance to one that is more sympathetic and pro capitalist and pro the economy. We shall have to see if this is sustained, however, we imagine that these moves by Beijing are in response to a weakening economic backdrop for China.

Headwinds for China’s economy

Chinese trade data is released later this week and it is expected to be dire. The market is expecting a 7% YoY drop in the dollar value of China’s imports, which is a substantially sharper decline than October’s data. Exports data is also released, and the outlook for this important sector is also expected to have darkened considerably last month.  Recent PMIs from China have pointed to a sharp decline in export orders last month as concerns grew about recession in Europe and the US next year. China is facing a double whammy when it comes to its economic outlook: weak demand at home due to the Covid lockdowns and weak external demand, which is another headwind for Chinese exporters. Of course, overshadowing the Chinese economic outlook is the zero covid policy. The news that China is easing restrictions could help future trade data, however, weak external demand could be a problem for some time. Thus, just because China’s economically disruptive zero covid policy could be coming to an end, there are still problems ahead.

Europe’s PMIs suggest GDP contraction

Interestingly, European indices closed in the red at the start of this week, and at the time of writing US stocks are also weaker. This comes on the back of some contractionary economic news for Europe. France, Germany, and Italy all reported contractionary services and composite PMI figures for November. Spain’s service sector bucked the trend and reported an uptick back into expansionary territory above 50. The Eurozone composite PMI nudged slightly higher to 47.8 in November, up from a 21-month low of 47.3 the month prior. However, a fifth consecutive decline in output signalled by the PMI report, suggests that the Eurozone is rapidly falling into recession. It is interesting that Spain’s service sector ticked higher, if we continue to see an improvement in PMI reports for the Eurozone, then it is a sign that the recession will be shallow, with S&P Global predicting a mild 0.2% decline in output for the sector.

Europe’s energy mix and the Russian oil embargo

The Eurostoxx 600 index declined by 0.5% on Monday, with losses for food and beverage stocks. This comes after European stocks also closed on Friday, post the better-than-expected US labour market report for November. After November’s stunning rally across risk assets, there is a growing consensus that more bad news could surface in 2023. Even if the recession is mild, there could be some further downside for European stocks. One issue is the oil price. There was some positive news today that Europe has managed to wean itself off Russian gas, and gas demand was 24% below the average of the last 5 years last month, according to ICIS. This has helped to boost gas storage facilities, which are currently 95% full. However, this means that Europe is getting its energy from elsewhere, and new sources of energy are expensive. Europe has turned to LNG imports, in November the EU and the UK imported some 11.14 MN tonnes of LNG, a record monthly high, which is expected to be exceeded in December. If there is a cold winter, then energy supplies could still be an issue. Overall, demand will need to be lower than the levels they were before the Russian invasion of Ukraine, otherwise shortages could persist for years.

Stronger US data: when good news is bad news for financial markets

Thus, one of the reasons why European stocks have fallen at the start of the week is on the back of the higher oil price. However, the oil price gain was not sustained, and dropped some 1.2% at the time of writing, and Brent crude is now back below $85 per barrel. The turnaround happened after the news that ISM service sector activity improved in November, rising to 56.5 from 54.4, which suggests a Fed pivot may not be on the menu anytime soon, even if they do decrease the size of rate hikes from December. This has weighed on the price of oil, which is closely linked to the prospects of the US economy, and with the Fed hiking cycle in full swing, good economic news is actually bad news for commodities as it makes it more likely that the Fed will have to hike rates for longer.

US economic outlook brightens with festive cheer

US consumers seem to be embracing the holiday season, even as the cost-of-living bites. Supply constraints have eased for the wholesale trade, retail trade, accommodation, and food service industries. Overall, activity remains resilient for now, although it makes the case for tighter financial conditions from the Fed, and thus a recession more likely. There were a couple of weak spots in the index, new orders were slightly lower, and inventories contracted for the sixth straight month, as businesses scaled back expectations for future sales. Prices also remain high, which is another concern for the Fed. It is worth noting that recession risk for the US economy is approx. 60%, however, that compares favourably with the 90% chance of a recession in the UK. The ISM news boosted the dollar, and weighed heavily on GBP/USD, which was down nearly 0.8% and is currently below $1.22. If US data keeps surprising on the upside, then we could be past peak dollar sell off for 2022.

Overall, there are signs that the Fed pivot narrative is starting to fray as we move into the Christmas season when liquidity is notoriously low. This can exaggerate moves. We believe that the market will remain nervous, and range bound, with a slight risk off tone before the Fed meeting on 14th December.  After we get confirmation about what the Fed is thinking about future rate hikes, then we expect financial markets to be extremely quiet as traders pack up shop for the rest of the year.