«The Rate Hikes Could Have Done a Lot of Damage Which We Just Can’t See Yet»
Christopher Wood, Global Head of Equity Strategy at Jefferies in Hong Kong, sees the risk of a downturn in the US economy and a lack of economic competence in China. He likes individual tech stocks, India, Japan and gold.
When Christopher Wood speaks, investors around the world listen closely. The Global Head of Equity Strategy at Jefferies in Hong Kong and author of the legendary «Greed & Fear Report» keeps a close eye on the big picture of the global economy and financial markets.
In an in-depth conversation with The Market NZZ, which has been lightly edited for clarity, Wood shares his views on the p0licy shift by the Federal Reserve, consensus expectations of a perfect soft landing, the roots of the economic misery in China as well as where he sees the best investment opportunities.
«China is experiencing its longest deflationary streak since 1998»: Christopher Wood.
Financial markets hold high hopes that the Fed pivot is finally here. Are they right?
Let’s start with the observation that markets certainly think the Fed Put is back. Not only are rate cuts priced in, but markets also expect an end of the quantitative tightening policy of the Fed. However, there is a disconnect between the equity market, which is discounting a soft landing, and money markets, which are pricing in six rate cuts this year. The level of rate cuts projected is not really consistent with a soft landing and would only make sense in the context of a harder downturn. The bizarre thing about the December FOMC meeting was that easing expectations had increased significantly already before the meeting, and many investors, me included, had expected Fed chairman Powell to push back against those expectations. But in fact he did the opposite, he encouraged them. This gave a boost to equity markets.
What did you make of Powell’s statements after this week’s FOMC meeting? He did caution that the first rate cut probably should not be expected in March.
Yes, Powell retreated marginally from his doveish Pivot in December by playing down expectations of a rate cut in March. That said, money markets are still expecting 143 basis points of rate cuts this year.
But why the doveish turn by the Fed? Granted, inflation is coming down, but most macro data is still very robust.
I don’t know, but in absence of any other reason the most plausible explanation is the presidential election. It is probably a fact that most central bankers in the world, not only at the Fed, would prefer Trump not being president. That’s my operating assumption. Most people in markets were always assuming that the Fed would turn on a dime if there was any sign of softening, and that conviction was further strengthened by the December pivot. All in all, the robustness of the US economy in the face of this strong tightening cycle has been rather unique. There are a number of reasons for that: One, the corporate sector did a very good job locking in low bond yields, hence we saw no big disruption in corporate bond spreads. The Big Tech companies have huge cash piles, which means that net they were even beneficiaries of higher interest rates. Second, households had excess savings from the pandemic, and most of them are on fixed mortgages, hence higher interest rates didn’t hurt them much, either. Third, fiscal policy was extremely stimulative.
Where are the vulnerabilities?
One has to watch the small and medium-sized enterprises, because they account for 75% of private sector employment in the US. They can’t issue bonds, hence they have to borrow from banks. SMEs began 2023 in very good condition, with historically high profit margins. They also had trouble finding people after the pandemic, so there was a phenomenon of labor hoarding in America, which helps explain the robustness of the labor market. But now the cost of borrowing for SMEs has been growing, the latest NFIB survey showed interest rates for SMEs are at 9,8%. That higher cost of borrowing should at some point start to show up in the labor data. Another area of vulnerability: private equity and private debt, because leveraged buyout deals are usually linked to Libor.
Within financial markets, there is a broad consensus that we’ll have a perfect soft landing. But you wouldn’t quite rule out a hard downturn for the US economy yet?
The soft landing is definitely the consensus case in the equity market. But we know that monetary policy works with long lags, and there is still the issue that the rate hikes could have done a lot of damage which we just can’t see yet. We are witnessing a dramatic collapse in broad M2 money growth, albeit from a very high base, because we had a historic rise in M2 in 2020 and 2021. We have only now gone back to trend on the M2 to nominal GDP ratio. So you could make the case that the effect of monetary policy tightening hasn’t really kicked in fully yet, because M2/GDP has only now come back to trend. But now the direction of travel should break that trendline on the downside which increases the risk of a downturn (see chart). That scenario is not discounted in the equity market. If we really have a soft landing and no US recession, then obviously the US stock market should broaden out and all these small caps which did not perform well last year should start to outperform. We haven’t seen that yet.
A large part of last year’s performance of the S&P 500 was driven by a handful of large cap technology stocks, the Magnificent Seven. Is that worrying to you?
It is in a way. But at the same time, one should not underestimate the importance of the AI theme, which was triggered in January 2023 when Microsoft extended its partnership with OpenAI. This theme is hugely important. Tech is the biggest sector in the US stock market, and AI gave the sector a new story. Technology stocks always need a new story, and quite frankly I think that story can look through a US downturn. These big tech companies are not US cyclical plays.
So you would still invest in that story?
Yes, absolutely. But of course, the Amazon story had legs back in 2000 too, and that didn’t prevent Amazon from going through a brutal derating in the years after the dotcom bubble burst. We could have the same thing happen again theoretically. It’s not easy to identify whether a company like Google will be a winner or a loser with AI. But people in my view have rightly bought Nvidia, because that’s the picks and shovels of AI. Everybody who wants to build AI capability has to buy Nvidia chips.
In terms of global macro, the big negative surprise last year was China. Markets kept hoping for a big bang stimulus, which never came.
I was only expecting incremental easing in China, based on the stance of President Xi. That remains the base case for now. China has so far continued to avoid big bazooka stimulus, but clearly the pressure to do something more dramatic is growing. The technical issue in China, and for the stock market performance in particular, is that nominal GDP growth has been weaker than real GDP growth. China is experiencing its longest deflationary streak since 1998. Nominal growth right now is running at 4% or below, whereas in the five years prior to the pandemic it was running at an annualized 8.9%. And of course corporate earnings growth is in nominal terms. The thing with China is that it’s run by one guy. President Xi. He’s not an economist. And from what I hear, when people tell him that the government needs to do more, he doesn’t see the problem. After all, they have met their formal real GDP growth target of around 5% last year. We should not assume that he understands the difference between nominal and real growth. Also, is he bothered about the Chinese stock market? Probably not.
So you would continue to expect no convincing policy support from Beijing?
We do see growing evidence of action. I think in the current first quarter, the base effect for the Chinese economy will be harder, because a year ago they just reopened after the end of their zero Covid policy. So we could get a much weaker real GDP growth number this quarter, which may create the required pressure on the government to do more.
What should they do?
The biggest issue to me is that we don’t have any clear evidence of who’s running economic policy. The two senior technocrats who ran economic policy during the first ten years of Xi’s presidency, Liu He and Guo Shuqing, both retired last year. They were well established when Xi became president, and they had his confidence. Since they are gone, there is basically a vacuum, and we are getting confusing policy signals. On the biggest economic issue, the property market downturn, we get no coherent policy.
In what way?
They have two choices: Either put much more money in to support the property market, or let all these highly leveraged private property developers go bust. One or the other. Until now, they have only put up a policy support of one trillion RMB, which is way too little given the hole that was left by the collapse in pre-sales revenues for the private developers. They would need to put up at least 3 or 4 trillion RMB if they really want to plug that hole. Policymakers oscillate between one approach and the next, which means that more and more developers get sucked into the problem. China always had very capable technocratic management. But right now, we keep seeing conflicting signals.
Many investors see China as uninvestable, even though valuations are at rock bottom. What’s your take?
If you are lucky enough to have had no money in China, I think it would make sense to start putting some money into China now. It’s not all bad in China. Consumption is picking up, so is domestic travel. The attacks on the entrepreneurs from the government have basically stopped.
Because of China’s weakness, emerging markets in general suffered from a negative perception. But underneath the broad indices, performance in markets like India or Brazil was stellar. Do you expect them to continue their strong run?
Yes. Structurally, India remains the best story for the next ten years. You know me, I would have said the same twenty years ago. Last year, in aggregate, India performed even better than the US, because India unlike America is not a narrow market. The Indian market was not led by a few large caps but by the mid caps. But I have to admit mid caps in India are very expensive right now. Their charts look a bit scary. Short term, one could ask whether you should sell India and buy China. That could be a good short term trade this spring. If I had to bet on a policy response in China, it’s more likely when we get the real GDP numbers for Q1. But with a long term view, and not having to worry about any benchmark, my emerging Asia exposure would be 45% in India and 15% in China. India, macro wise, shows early signs of a new private sector capex cycle. The last one ended in 2010. So I’d rotate my Indian equity portfolio away from consumption themes, more toward real estate, capex and energy related stocks.
How about Japan?
In a world where the US has a soft landing, Japan is fantastically positioned. Because then the Bank of Japan can incrementally normalize monetary policy and end negative rates. That would be very good for Japanese financials, without causing a dramatic move higher in the Yen. Just a gradual appreciation. The yen is so cheap, moving to 130 to the dollar would not be such a big deal for the Japanese economy. But the main risk for Japanese equities is a hard landing in America. In the scenario of a US downturn, the Japanese market would be vulnerable to a correction. Fundamentally, the key question in Japan is whether deflation has ended. Corporates think it has, because they have started giving their employees wage hikes. If the spring wage round is similar to last year, then that should give the BoJ the confidence to normalize policy. And if at some point institutional investors in Japan come to the conclusion that deflation has indeed ended, they should do what they haven’t done since 1990, and that is reallocating out of fixed income back into Japanese equities.
Does that mean that until now, the Japanese equity rally is still mainly driven by foreign flows?
Yes, foreign ownership is continuing to increase. A lot of money that was invested in China has moved into Japan. Everybody has discovered the corporate governance reform agenda. The Tokyo Stock Exchange has created a formal timetable where if corporates don’t meet certain governance criteria, they risk being delisted in 2025/26. This name and shame dynamic is a motivating factor in Japan. And if Japanese institutions ever do reallocate to their home market, it would be a tsunami for Japanese equities. All this is good, it’s just the US downturn risk that worries me.
What’s your take on gold?
Logically, gold should not have done well last year, because real dollar yields were rising. So from that perspective, gold was very resilient. The most plausible explanation to me is that we saw record central bank buying of gold. This trend kicked off with the freezing of Russia’s foreign exchange reserves after the start of the war in Ukraine. Central banks outside the G7 world saw this move, which was historically pretty unprecedented, and reacted accordingly. So far, on the other hand, I see no evidence of ETF flows into gold. It’s mainly driven by central banks. For gold to convincingly break out from here, we need to see ETF flows picking up. If we get a real Fed pivot, gold should do well, and that should also give gold miners a boost.
Christopher Wood
