Trending in the Right Direction…

Global Liquidity growth is almost back to positive in December,  but signs of economic deflation and weakening demand

Global Liquidity Growth in December (the latest available month) of (0.3%) was far below the trend growth of 7% but bottomed in November. The large increase month-over-month is related to the stimulus provided by China, which offsets the declines in liquidity from the rest of the world. U.S. Liquidity has continued to decline close to 4% per annum.

China’s recent reopening by abandoning zero-COVID and policy support of the property sector via easing the “three-red-lines” policy through more liquidity has enhanced market sentiment across all markets (equities, bonds, and commodities).

The reopening of China and related policy easing may provide an additional deflationary impulse from supply chains, partially offset by potentially higher commodity price inflation later in 2023. Also weakening of demand in end clients (U.S., Europe) via higher interest rates and inflation may not support cyclical uplift in the global manufacturing cycle as we have seen in past cycles (2011, 2016). We have covered the China reopening and its potential implications in more detail in the second part of this document.  This catalyst supported risk assets during January 2023, with the MSCI All Country World Index (ACWI) up 7.5% during the month.

Global Liquidity has been below trend since November 2021 and the trend-following portfolios have been allocated to the Safety portfolio since January 2022 generally as a result of lower-than-trend Global Liquidity growth. Month-over-month liquidity growth momentum has increased as China has increased liquidity and long-duration assets have reacted positively (equities, REITs, and Bonds). Long Duration Equity/Bonds Returns tend to be positively correlated with Global Liquidity growth. With weak general liquidity/funding conditions, allocation to the Safety portfolio is prudent.

This month’s allocation within the safety portfolio (Gold, Chinese Bonds, US Investment-grade bonds)  reflects the market’s anticipation of the continuation of deflationary conditions into 2023 and further global liquidity growth momentum coming back to trend, which may kick off the next cyclical upswing. For January 2023, the Trend-following strategy and investment in the Wave Runner/Safety Portfolio have generated 5.9%. We are starting to see positive momentum in many of the factors in our global risk indicator that may switch at some point to “risk-on” in early 2023 such as improving the Copper-to-Gold ratio, and risk-on sentiment (Discretionary vs Staples). However, we have yet to see Housing Starts bottom yet.

As we cover in the previous posts, historically, bear markets lasting > 1 year and subsequent recessions have resulted in significant drawdowns (~45% for S&P 500 on average) and last 18 months on average as first earnings multiples are repriced, then earnings expectations repriced. The current bear market has been about 13 months, so we may be only halfway through the bottom and start of a new bull market. Generally, a bottom is formed when global liquidity turns positive and yield curve slope starts to steepen and has positive momentum, and Coppock curves are at their lows. We are starting to see indications of a bottoming process. The S&P 500 2023 Consensus EPS is expected to come down in the near term. 

Cyclical growth from China may be lower than in previous cycles as credit growth appears to be ~50% of the previous cycles (2011, 2014, 2016, 2020). Policymakers are not constrained by too-high inflation, and the economy is operating below potential. However, policymakers are also exercising self-restraint against the excesses of “flooding” the system with liquidity and overleveraging. Policymakers must walk a fine line between supporting housing rather than importing commodities, building, and increasing the housing supply for the sake of simply growing GDP. Speculation has made Chinese homes the most expensive in the world on a price-to-income basis.

The property sector is the largest single sector in China’s economy and its ups and downs usually have a meaningful impact on headline GDP growth. About 70% of homes sold since 2018 have been bought by people who already own at least one property. Higher household “excess” deposits appear due to lower housing sales and potentially residing in the upper end of the wealth distribution and consumer confidence is low in China. Much attention has been paid to U$2T domestic deposits available for deployment, however, current sentiment may not be supportive of ‘excessive consumption’ to offset the rest of the world slow down.

Achieving a 3-5% trend GDP growth will require more focus on driving private consumption in China. Household consumption is less than 40% of China’s GDP as of 2020, versus a global average in other countries of roughly 60%. Beijing’s new common prosperity policies focus on redistributing income from the wealthy to the poor and the middle class is expected to support this objective.

Restoring confidence remains crucial for the consumption outlook. Consumer confidence has appeared quite dampened in 2022, and we expect some improvement in 2023. Households’ confidence is closely linked to property prices, food price inflation, and stock market performance – we expect almost all drivers to argue for stronger consumers into 2023, but may not be able to offset weakened demand from the rest of the world. We will continue to track how this story plays out.

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