Freepik

US Markets

Equity markets faced a challenging week, influenced mainly by the ongoing sell-off in the Treasury market. The S&P 500 declined by 2.4%, with notable weakness in consumer discretionary, banks, and technology sectors. Critically, the index is hovering near its 200-day moving average as it moves lower.

The bond market remains a significant source of stock market angst, with 10-year Treasury yields briefly crossing the 5% mark for the first time since 2007. Despite multiple statements from various Fed speakers, including Chair Powell, suggesting a likely pause in rate hikes on November 1, the market's attention remains on several factors propelling yields higher. These include persistent inflation, robust economic data, a substantial federal deficit, ongoing quantitative tightening, and selling pressure from entities like China. Hence, the latest leg higher in yields has been driven by factors beyond improving growth expectations, making the carnage in the bond markets far more challenging for businesses to absorb.

The turmoil in the bond market is starting to affect valuations across various asset classes, signalling the potential end of the post-global financial crisis era of ultra-low interest rates. U.S. equities have, by and large, remained resilient despite the shock to interest rates, a robust economy and steady earnings expectations. Nevertheless, swift surges in yields push back against any perceived positives, culminating in a significant sell-off last week.

Furthermore, from an earnings yield standpoint, the yield on 10-year Treasuries is approaching the yield on the S&P 500 (approximately 5.5% based on forward-year estimates). Historically, the gap between these yields averaged about 4 percentage points since the global financial crisis. More significantly, during the cycle preceding the 2008 financial crisis, the spread averaged 2 percentage points. The ongoing adjustment in equity valuations indicates the market's exploration of the "new normal."

While it’s still the case that large companies with strong balance sheets have some buffer against the impact of rising interest rates. However, Jerome Powell's candid remarks on October 19 suggest that no company or household is entirely immune to rate increases. Unless there's an economic catastrophe, it's unlikely that rates will return to pre-pandemic levels. This shift may make the "short" in "short-term neutral" appear less applicable.

Still, the critical takeaway is higher bond yields increase the risks of a more severe economic slowdown as they impact various aspects of the economy. And effectively sow the seed of their own demise. But while these prospects should eventually limit the extent of the selloff in the bond market, yields may stay elevated or rise further for some time before stabilizing and turning lower..

The Commerce Department's report on gross domestic product (GDP) for the third quarter, released Thursday, might indicate that housing contributed to economic growth; it's essential to recognize that the housing market's current conditions are far from positive and are ultimately detrimental to the overall economy.

Quantifiably, the housing market is going to get worse. Existing home sales data are reported at the time of closing, and there is usually a delay of one to three months between when a contract of sale is signed and the closing date. As a result, the existing home sales data for September do not fully capture the impact of the nearly 1 percentage point increase in mortgage rates since the beginning of August.

The upcoming weeks will bring a wealth of economic information to the market. In addition to over 300 S&P 500 companies reporting their results in the next two weeks, significant economic data releases will be released at the end and the month's start. Additionally, the Federal Reserve is scheduled to hold its FOMC meeting on November 3, where it will provide insights into its monetary policy decisions and economic outlook.

China Markets

The recent data releases have helped alleviate concerns regarding the Chinese economy, particularly fears of a hard landing. China's key economic indicators, including real GDP (4.9% year-on-year growth in Q3), retail sales (5.5% year-on-year growth in September), and the survey-based unemployment rate (5.0% in September), exceeded expectations. The ongoing economic recovery, supported by modest stimulus measures, is expected to extend into the current quarter. Consequently, Beijing is on track to comfortably achieve its full-year real GDP growth target of "about 5%," an improvement from 2022's pandemic-affected growth rate of 3.0% and the average of 4.5% from 2020 to 2022.

While China's headline GDP growth appears robust and in line with its potential, the alarm bells in most headlines stem from underlying issues. The excesses of the past, particularly China's high reliance on debt, have begun to manifest. According to Bank of International Settlements estimates, China's private non-financial sector debt reached 227% of GDP in Q1 2023, surpassing the debt-to-GDP ratios in the United States (151%) and Japan (185%). This situation has led to concerns about struggling property developers, local governments (LGs), and their local government financing vehicles (LGFVs) – the primary off-budget entities used by LGs to fund infrastructure projects. While there are no official figures for total LG debt (including LGFVs), most estimates suggest it's approximately half of GDP.

China's property market outlook remains challenging despite recent measures to boost home sales, such as lower mortgage rates and relaxed down payment requirements. The housing sector's slump, with home sales down 21.1% year-on-year in September, has negative implications for local governments (LGs). LGs rely heavily on land sales tied to home sales for revenue, which weakens their capacity to support local government financing vehicles (LGFVs). As a result, there's increasing speculation that China's banks might need to restructure or extend new loans to troubled LGFVs to prevent defaults. While China's larger state-owned banks are better positioned for this, smaller regional banks with weaker balance sheets could face challenges.

Another significant development is the growing divide between China's more developed coastal regions and less developed inner provinces and between higher-tier and lower-tier cities. The country's manufacturing sector, particularly in the interior, is under increased pressure from the trade war with Western countries.

These factors contribute to the cautious outlook among analysts for China's economy. While some forecasts may have been revised slightly upward, most China watchers remain cautious. According to a recent Bloomberg poll, China's real GDP is expected to grow by 4.5% in 2024, down from 5.0% in 2023 and in line with similar projections. The IMF is even more cautious, downgrading its 2024 projection to 4.2% and expecting further slowing to 4.0%. If the IMF's projections materialize, the debt service capacity of China's corporate sector and LGFVs will face more significant tests.

China's economy is showing signs of recovery, but there's widespread skepticism about the sustainability of this momentum, not to mention the quality of the data. Many traders remain cautious about the economic outland and its dependence on the global economic situation, particularly in exports and the domestic fiscal policy response. While Beijing aims to maintain fiscal space, ongoing economic challenges may push the government toward more robust action to support the economy.

More By This Author:

VIX Back Above 20
Asia Open: Policy Is Not Too Tight And The IDF Green-Lighted For An Offensive
War Drums And The Fed To Compete For Headlines