Straits Financial Chief Economist Comments - August 2024

Short term liquidity risk diminishes, but remain defensive before US election

Summary:

• Bank of Japan’s (BoJ) rate hikes and debt purchase cuts triggered yen carry-trade unwinding, leading to a recent global stock market crash. However, we believe that short-term liquidity risks have been mostly released, and the oversold market is expected to rebound. Yen speculative short position was quickly covered since 9th July after making a historic peak, and the latest data shows that its position has fallen back below the level at the beginning of this year.

• Fed's balance sheet shows that from early June to the end of July, the liquidity provided by the Fed decreased by a total of $280 billion. Although this magnitude was not significant, it amplified the market liquidity risk. The Fed and Treasury department still have sufficient tools on their books to provide liquidity. Last week, the Fed has started to increase liquidity by reducing ONRRP, so we do not expect liquidity risk to further increase.

• Investors need to remain vigilant about various uncertainties before the US election. Biden's dropout from the election race means that the possibility of the US implementing a new round of fiscal or monetary stimulus in the short term is relatively low.

• Before the end of the November US election, investors still need to remain vigilant about various uncertainties that may be unexpected. The recent series of "black swan" events related to the US election indicate the intensification of political and social polarization in the United States, and the probability of similar uncertain events occurring before the election remains high. Biden's withdrawal from the election means that the probability of a new round of fiscal or monetary stimulus in the short term in the United States is relatively low.

• In 1H24, the cumulative Chinese government funds outlays were only RMB3.56 trillion, even lower than the same period last year. The slowdown in fiscal expenditure is clearly not conducive to improving overall demand against the backdrop of a downturn in real estate and slow consumption growth. The recent Politburo meeting highlighted the need to increase efforts to stabilize growth and promote consumption, so the growth rate of fiscal expenditure in the second half of the year is expected to improve.

• Previously, we had maintained a cautious view over the overseas stock market, but recently, the rapid decline in the overseas stock market has erased most of the previous gains in the stock market. We believe that there may be a short-term recovery rebound, but the overall magnitude may be limited. The marginal improvement in fiscal outlays in the second half of the year may provide more certainty for sentiment recovery in Chinese domestic stock market. However, the rebound space still depends on the magnitude of subsequent fiscal spending.

• The overall price rebound space of the product is limited, and there is a possibility of further decline that cannot be ruled out.

Previous Views:

The global market risk has shifted from a 'grey rhino' to a 'black swan'. This means that the volatility of the market will intensify, and risk assets other than treasury bond, such as stocks and commodities, may have downside risks. Although the US economy has not been in recession, the overall growth rate has slowed down and there is downward pressure due to previous excessive stock market gains. The uncertainty of this US election has intensified the risk of capital markets. Overseas expectations for China's economic improvement and policy stimulus continue to fall short, and there is a significant risk of decline in commodities, especially base metals. Treasury bond still remains as our relatively optimistic choice of asset allocation.

Views in August:

I.  Short term liquidity risk is mostly over.

Recently, the global stock market has fallen sharply, mainly due to the announcement by the Bank of Japan to hike its benchmark interest rate and reduced their treasury debt holdings of 400 billion yen each quarter. It resulted in a rapid appreciation of the yen and caused the yen carry-trade unwinding, which threw the global stock markets into a sharp sell-off. However, from the actual measures of the BoJ, the impact on its QT is huge. As of the end of July, the Bank of Japan held a total of 592 trillion yen of Japanese treasury debts. Even if it was reduced by 400 billion yuan per quarter, the total number of QT was only 0.4% of BoJ’s total holdings. In fact, BoJ held more treasury debts since last year (Figure 1). Therefore, we believe that the true factor that triggered recent sell-off is that the yen carry-trade was too crowded before, and BoJ’s QT was only a sentimental trigger of deleveraging.

CFTC showed that the yen speculative short position began to unwind quickly after reaching 223,600 historical apexes on 9th July, and the unwinding accelerated. The latest data shows that the level of yen speculative short position holding has been reduced to levels lower than the beginning of the year (Figure 2). Therefore, we believe that the yen carry-trade unwinding may have come to an end. Although the overall yen may not be devalued again, the overall rising yen promoted by short-cover and the rapid decline in stocks may have ended.

In addition, due to the acceleration of debt issuance by US treasury department as well as a deceleration of its fiscal expenditure, the liquidity of US domestic financial markets  went down in July. For example, the total amount of "Money in circulation + Bank reserve" on the Fed's balance sheet has decreased from USD5.81 trillion in early June to USD5.53 trillion at the end of July. Although this is not a large decline, in the context of global liquidity seize due to the yen carry-trade unwinding, the stock market tumbled further.

Last week, it has shown that the Fed's support for market liquidity has increased significantly. For example, from May to the end of July, the number of ONRRP held by the Fed has basically maintained more than USD400 billion. Since the beginning of this week, the total ONRRP has fallen to USD286 billion, indicating that the Fed released more liquidity into the market. In addition, the scale of TGA on treasury department has also fallen to a certain extent, showing that the treasury department also increased their spending. Therefore, we believe that short term liquidity risk is mostly over.

II.  Uncertainty and risk in overseas markets remain.

During our webinar in July, we proposed that market risks in the second half of the year will change from "grey rhinos" to "black swans". The over-crowded yen carry-trade was an example of a "grey rhino" risk, as it has existed for a long time but does not attract enough market attention, until it suddenly broke into a "black swan"event, which caused a huge shock in the market. We believe that although the short -term impact of the yen carry-trade unwinding has passed, there may be more "grey rhino" risks to become possible "black swan" incidents in the future.

Before the US election settles down in November, investors will have to be vigilant about various uncertainties. From the tumble of Biden's approval rate to Trump's failed assassination, as well as candidate change within the Democratic party, this US election is unlike anything we have seen before. After Harris replaced Biden, her approval rate continues to rise, and it has already surpassed Trump again. For the financial markets, this means that there are huge uncertainties in the future on both US internal affairs and foreign policies,  and the political polarization and policy divergence of the two parties in the US are going to get wider. Therefore,  this medium-term political uncertainty risk is still likely to remain before the US election settles down in November, and it will also have a significant impact on the global capital markets.

Biden’s dropout from the election means that short-term US stock market and economy performances will have much less impact on the race between Trump and Harris. The focus of the race is more likely to be placed on immigration policies, social security issues, social equality issues, and trade policies with China. This means that the US White House and Treasury department will now have less incentive to stimulate the economy or the stock market. Of course, this does not mean that the Democratic Party wants to allow the stock market to plummet or risk the country to face an economic recession. As long as the economy is still in the projected scenario of soft landing, we believe that it is not very likely that the Fed will cut rates tooquickly or the Treasury department will boost its spendings aggressively before the election.

Due to a recent slowdown in the growth of US consumption, the inflation pressure in the US has also been significantly reduced. The MoM core CPI in the past two months have been 0.16% and 0.06% only, which have significantly bellowed the 0.2% Fed targets (Figure 5). With the decrease in inflation pressure, the Fed will start to cut benchmark interest rates during the upcoming September meeting, which has basically been fully priced in by the market now. However, an expected rate cut will have limited boosting effects on the economy and stock markets. The first factor is due to the fact that  this has been expected and have been fully priced in by the market now. Secondly, if economic data or market liquidity further deteriorates significantly, the Fed cuts 2 to 3 more times will not be able to hedge all the risk. Based on the current economic data, if the Fed cuts interest rates much quicker than expected, it will not only be interpreted by the market as “panic”, but may also be accused by the Republicans as a move to help the Democrats to win the election. Therefore, we believe that the Fed will avoid cutting rates unless there is solid data to show a recession risk or financial market crisis.

III. China's fiscal outlays were below expectation in 1H24, but it may get better during 2H24.

In the first half of this year, the total outlays of Chinese government funds were only RMB3.56 trillion. This number only accounted for about 30% of the total projected outlays in 2024, which are RMB1.202 trillion as shown in the Chinese State Council’s report published at the beginning of the year. It was less than the RMB4.36 trillion outlays in the first half of 2023.

Although local government’s fiscal situation is overstretched due to the decline in land sales revenue, central government still has plenty of room to increase its outlays. At the Politburo Economic Working Conference held at the end of July, top leaders in China gave more attention to the promotion of consumption growth in order to reach this year's GDP growth target of 5%. Therefore, we expect and have reason to believe that the growth rate of government fiscal expenditure in the second half of the year is expected to accelerate. After deducting the negative impact of the decline in land sales revenue on local fiscal outlays, the government's fund expenditure for the whole of this year is still expected to reach last year's level with central government accelerating its own expenditure. Usually, the proportion of fund expenditure in the first and second half is 40% and 60% respectively. This year, it is expected to become 30% and 70%, which means that the fiscal outlays in the second half of the year will accelerate. Otherwise, ensuring a 5% GDP growth this year will be a difficult task to accomplish. With a series of meetings recently held by the State Council and the National Development and Reform Commission to stabilize the growth of consumption, we look forward to seeing the implementation of more policies and funds to promote consumption in the next 1-2 months. We hope that the domestic economy and capital market may also experience a certain degree of improvement and recovery.

In the short term, the relatively unfavorable factors for the domestic economy in the second half of the year may be a slowdown in export growth. The previous "export rush" before the tariff increase, coupled with the recent appreciation of the RMB and the weakening of demand in Europe and the US, may all be the factors causing the slowdown in exports in the second half of the year. With the slowdown of exports, the pressure of domestic policies to stabilize growth and maintain employment rate will become more crucial, indicating that domestic fiscal expenditure may need to increase more aggressively to offset the slowdown in external demand growth.

IV. Market strategy

Previously, we had maintained a neutral and cautious outlook towards the overseas stock market. However, the rapid decline in the overseas stock market has erased most of the previous gains in the stock market from the beginning of this year. We believe that the liquidity risk in overseas markets has been largely released, and there may be a short-term recovery rebound, but the overall magnitude may be limited. It is recommended that investors maintain a relatively cautious outlook towards the overseas stock markets before the US election.

A-Shares and Hong Kong stocks have recently fallen along with overseas stock markets, but the decline is relatively limited. Due to the current pessimistic domestic market situation, the marginal improvement in fiscal spending in the second half of the year may bring some opportunities for a market sentiment recovery towards the domestic stock market.

Previously, we were relatively bearish on commodities, especially base metals, but in the past two months, base metal prices have fallen sharply. Our current view on commodities is that there may be a slight rebound after the release of short-term liquidity risks. The possibility of an overall price rebound for commodities is limited and it is expected to have a further decline.