What’s driving the world’s two largest economies?

In October 2023, we observed a significant sell-off in US Treasuries, with the 10-year yield climbing even though inflation was cooling. The US 10-year yield generally goes up when inflation rises because it needs to compensate investors with a real return. In September, the Fed left interest rates unchanged but came out quite hawkish, perhaps also signaling another interest rate increase, which many investors did not expect at that point. This is a reflection of how volatile things have been, because now the market is pricing rates to move in the opposite direction. At the time, the US 10-year yield rose quite dramatically as a result, and we think it was also about the supply of US bonds where the US has a budget deficit of around 6% and there's a realisation in the market that this is becoming more of a problem.

This dynamic caused the US 10-year yield to touch 5% and although yields have since pulled back from those levels, they are still at multiples of where they were a few years ago. This came as a surprise to investors as there hasn’t yet been a scenario where something big has broken. However, this is effectively what happened during the Global Financial Crisis (GFC) because the mechanism of interest rates and long bond yields rising causes strain on the US economy. On the other hand, there is generally a delay when interest rates increase as this does not immediately change people's spending habits.

An interesting observation is that in the US there was a higher proportion of borrowers with adjustable-rate mortgages during the GFC. Since then, US consumers have taken a smarter approach where more than 90%  have refinanced their long-term mortgages, fixing them at much lower rates closer to 2%. Therefore, the mechanism of higher interest rates grinding the gears of the economy will take longer than one would expect, but there are different parts of the market like regional banks, credit card impairments, auto loans and commercial property which are showing signs of stress.

More recently, the Fed has been signalling that they will begin to reduce interest rates this year. Their stance is very data dependent and the encouraging inflation data saw them signalling a shift in their forecast for interest rates towards the end of last year. This can be seen in their latest “dot plot” – which is where the yields moved back down. However, the market is now pricing in even more interest rate cuts than the Fed is forecasting, so yields may have to adjust back up if the market turns out to be wrong. Additionally, investors need to be careful about believing what the Fed says because they are trying to manage expectations in addition to managing interest rates. There are still risks that inflation will not go back down to the 2% target, which means the market may need to reassess its expectations for the pace and extent of rate cuts this year. Therefore, we are cautious as there is still a lot of uncertainty before anyone can claim the fight against inflation is well and truly won.

Turning to China, many will remember that at the beginning of 2023, the market was very optimistic about the economy but now the general sentiment is that China is “broken”, with investors wondering whether they should avoid investing there. While growth has certainly been slower than expected, it is still growing at a faster pace than most economies, so it is our view that referring to it as “broken” is not accurate.

Considering the composition of the overall Chinese economy, more than 40% of it is property and fixed capital formation related. Although investors believed that sentiment would improve and that the property market would pick up, this has not been the case. In simple terms, a massive 40% of the overall economy is not doing well and is probably going backwards, but the other 60% can still grow relatively fast – in fact we believe that China’s growth will be led by the consumer and services in this cycle.

Mathematically, there can still be good retail sales and consumer spending – particularly with companies in the internet sector – and they can still have good growth. When looking at companies in China, their operating margins can be quite strong. A major issue with a lot of Chinese companies is that even if they have fantastic revenue growth, the pressure on wages often means their bottom line doesn't grow as fast. Fortunately, with the overall unemployment rate in China at around 6%, it is not an impending disaster.

There are still big enough cohorts of people who are wealthy and who prioritise saving, but they are also significant spenders and their habits are shifting. The Nedgroup Investments Stable Fund is invested in companies that are set to benefit from these trends and we’ve been careful to only pay attractive prices to maximise the chances of a good outcome for our clients.