China’s reopening gives service industry a boost

It’s been more than three months since China loosened its zero-COVID protocols and reopened its economy. Many were skeptical about the benefit to China’s economy, with concerns that this could unleash an enormous wave of COVID infections. However, I was an early China bull. I was encouraged by the high percentage of fully vaccinated in China’s population — far higher than other countries that had successfully reopened. What’s more, I thought the reopening could be a powerful juggernaut for the economy.

Why? I saw how demand increased quickly after Western developed countries reopened following the pandemic. And given that China’s zero-COVID policy lasted far longer than these countries’ stringent conditions, I assumed there would be a much higher level of pent-up demand, which could provide a large boost the services sector. Today, we’re starting to see the evidence.

China’s reopening gives services a boost

We’re seeing signs that the reopening is having a substantial positive impact on the Chinese economy, especially the services sector. For example, the Caixin/S&P Global Services Purchasing Managers' Index (PMI) rose from 52.9 in January to 55.0 in February.¹ And the official NBS Non-Manufacturing PMI for China rose from 54.4 in January to 56.3 in February, its highest level since March 2021.² My key takeaway: the “revenge living” I had anticipated has begun. (It’s also worth noting that manufacturing activity has improved as well.)

Not surprisingly, China bulls have multiplied since the reopening announcement last fall. But that sentiment has been called into question by the National People’s Congress, which started last weekend with the delivery of the Government Work Report (GWR) by Premier Li Keqiang. Investors are disappointed by the “around 5%” target set for gross domestic product (GDP) growth this year by Chinese policymakers, as many had hoped for a target of 5.5% or even 6%.

Some are assuming the worst — that China set a low target because regulation is going to increase significantly this year. Others believe the message being sent is that China will not provide significant stimulus to its economy. However, I don’t believe either is the case. Policymakers have said they would support the platform economy and have also pledged to protect the rights of private businesses and entrepreneurs. In addition, policymakers pledged more effective and significant accommodative fiscal policy. And so I have a simpler perspective on the growth target: After a challenging 2022, policymakers may just be more comfortable setting the bar low so that it’s easier to handily beat it.

A big week for the U.S. Federal Reserve

This is a big week for the U.S. Federal Reserve (Fed). It started several days ago with the release of its Monetary Policy Report, which is a precursor to Fed Chair Jay Powell’s semi-annual Humphrey-Hawkins testimony to Congress on March 7. And the U.S. February jobs report will be released on March 10. This comes on the heels of some rather hawkish rhetoric from various Fed officials.

• Last week, Atlanta Fed President Raphael Bostic shared, “There is a case to be made that we need to go higher. Jobs have come in stronger than we expected. Inflation is remaining stubborn at elevated levels. Consumer spending is strong. Labour markets remain quite tight.”³
• San Francisco Fed President Mary Daly said on Saturday, “It’s clear there is more work to do. In order to put this episode of high inflation behind us, further policy tightening, maintained for a longer period of time, will likely be necessary.”⁴
• And Fed Governor Chris Waller said, “…if those data reports continue to come in too hot, the policy target range will have to be raised this year even more to ensure that we do not lose the momentum that was in place before the data for January were released.”⁵

I view these comments as part of the Fed’s campaign to talk down markets and stop them from getting ahead of themselves by prematurely loosening financial conditions. I’m not spooked by these quotes – in fact, I’d be spooked if they weren’t trying to talk down markets, as this should be part of the tools in their toolbox.

Fed report shows inflation is too high

Let’s spend a little time on the Monetary Policy Report, which reiterated what we’ve heard time and again from the Fed: inflation is too high and the economy will need to slow. However, that should come as no surprise as the report is always largely backward-looking. I’m more interested in the “special topics” that give me a sense of what is on the Fed’s mind.

For example, the Fed tackled labour market conditions, looking at what caused low labour force participation and anticipating that conditions are likely to remain challenging going forward. The report also covered developments in the Fed’s balance sheet and the impact on markets. The Fed noted that market liquidity is low in areas such as the Treasury market. The Fed recognized that it may need to alter its Quantitative Tightening strategy to manage market functioning and liquidity (this is likely to be a meaty topic during Powell’s Congressional testimony as well). Interestingly, the report also noted that high interest rates have caused the Fed’s interest expenses to increase significantly, which in turn has resulted in negative net income.

My biggest takeaway from the Monetary Policy Report has to do with its coverage of inflation expectations, which it deems to be well-anchored. It detailed examples of longer-term consumer and market-based inflation expectations remaining “broadly consistent with the FOMC’s (Federal Open Market Committee) longer-run 2% inflation objective,” and even mentioned that shorter-term inflation expectations are lower than where they were in mid-2022.⁶

What will Powell tell Congress?

With regard to Powell’s Humphrey-Hawkins testimony, there is of course significant speculation about what he will say regarding how comfortable the Fed is with the current inflation picture and what its plans are for monetary policy. I think Powell will largely echo the hawkish rhetoric from Daly and Bostic, underscoring the problems caused by inflation and pledging to remain tough — especially maintaining the terminal rate for some time. However, I think Powell will also stress that the Fed will ultimately be data dependent.

So what could that mean? We need to read between the lines — statements like that don’t mean the Fed has to hike rates to 6% or higher. I continue to believe the Fed is likely to give us two more 25 basis point hikes and then enact a “conditional pause” while continuing to talk tough. I believe the Fed will lean on tame inflation expectations as a reason to pause sooner rather than later. Recall that the Fed is a big believer in the importance of inflation expectations in determining future inflation, so I believe its positive assessment of current expectations will likely cause it to err on the side of fewer rate hikes. I do believe there will be no rate cuts this year — unless the U.S. economy deteriorates far more than I expect — but that is appropriate given the current strength of the U.S. economy.

Watching the U.S. jobs report

Finally, the U.S. jobs report will be released on Friday. I suspect job growth will be rather plentiful, but I’m hopeful it will be similar to January’s report, in which job increases exceeded expectations more than wage growth did. Of course, key data points to focus on will be labour force participation and especially average hourly earnings, given the impact on inflation.

Looking at the bigger picture

This should be an interesting, eventful week. But I don’t want to get too myopic. Investors are in a marathon, not a sprint, so we need to take a step back and look at the bigger picture. That means we should expect volatility in the next several months given monetary policy uncertainty — and a looming debt ceiling crisis in the U.S. It also means we need to take another step back and look at the even bigger picture — being well diversified across and within major asset classes for years to come, ignoring the background noise, and focusing on our long-term goals.