The unexpected surge in stock market indices this year has taken many investors by surprise. Despite research firms predicting a possible recession and a defensive positioning in managed funds entering 2023, the dynamics of asset prices can reveal a great deal about the present situation and future expectations, although short-term fluctuations are driven by various factors.
At the start of the year, much excitement surrounded the reopening of China’s economy after stricter lockdowns than the rest of the world. Given its status as the second-largest global economy, a synchronized recovery with the rest of the world could provide substantial momentum. However, recent trends in the Chinese High Yield market have shown a sharp decline, which is noteworthy due to the divergences it’s creating among asset classes.
These divergences, while commonplace, gain significance as they grow and persist. Observations throughout the year indicate that the S&P 500’s performance was primarily driven by a few major companies, leaving many average stocks without a significant rebound. The period from June to July witnessed broader market participation in the rally, signaling optimism for market highs.
A prudent approach involves examining how other assets confirm changing trends and assessing the sustainability of these shifts. China’s growing credit issues might soon impact the world economy, potentially dampening inflationary environments. As the narrative of the Federal Reserve halting rate hikes persists, the intricate nature of inflation/deflation dynamics becomes evident. While inflation seems persistent in the US, China’s challenges are tilting more toward deflation, which could complicate maintaining a global inflationary scenario.
This trend becomes apparent in the sovereign bond market, with China’s 10-year yields influencing those of the US. However, this relationship has shifted in recent months, with Chinese yields declining while US yields approach cycle highs. This divergence, if prolonged, could lead to a significant mean reversion, whether through falling US yields, rising Chinese yields, or a combination of both. Such interrelated asset price movements will have implications for other risk assets.
Amid headlines about slowing inflation, a cautious Federal Reserve, a resilient US job market, and the rise of Artificial Intelligence, it’s crucial for investors to shift their focus to China. The potential negative effects of China’s challenges spreading globally demand attention, as the world remains largely unprepared for such an eventuality.