China Danger Strikes Fear Into Global Investors Stumbling on Fed

(Bloomberg) — The toxic combination of a slowing economy in China and what may be the most aggressive withdrawal of the Federal Reserve stimulus since 1994 is hammering the world’s financial markets.

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While everything from the Bank of England’s recession warning to poor US productivity data contributed to the selloff this week, a shift in tone out of Beijing further undermined confidence. Top Chinese officials committed to Covid Zero in the strongest terms at a meeting on Thursday, while leaving out earlier pledges to minimize the economic cost of the strategy.

“The economy was barely mentioned at the meeting,” wrote Nomura Holdings Inc. economists led by Ting Lu.

Investors are growing increasingly nervous. The CSI 300 Index of stocks fell 2.5% on Friday, taking losses this year to 21%. The use of borrowed money to invest in China’s stock market has failed for at least 17 days, the longest streak since early 2016 — when concerned about China’s economy was spooking global markets. The yuan on Friday weakened past 6.7 per dollar offshore for the first time in 18 months, reigniting a depreciation cycle that historically has gone hand in hand with global equity declines, Bank of America Corp. strategists say.

At a meeting this week led by President Xi Jinping, the Politburo’s seven-member Standing Committee said China will “exhaust all means and efforts” to eradicate Covid-19. Criticism of Xi’s Covid-Zero strategy would not be tolerated, was the stern message. Vows to support the economy were absent from the memo, raising questions about the 5.5% economic growth target.

Investors had been seeking clarity from authorities over top-level pledges first made in March to boost growth. The promises — reiterated many times since, including by Xi himself last week — had signaled to money managers that economic growth remained at the top of Beijing’s agenda, and had spurred briefs but powerful rallies in Chinese stocks.

There’s also a risk the weakening currency will accelerate foreign outflows. Yuan depreciation tends to signal risk-off sentiment globally: previous cycles during the first Covid wave in 2020, a deleveraging drive in 2019, the trade war in 2018 and the chaotic devaluation in 2015 coincided with declines in global stocks outside the US on average, said Bank of America’s equity strategy team led by Ajay Singh Kapur. They predict the yuan will weaken to 6.8 per dollar this year.

“We remain cautious on China equities based on our view that policy makers’ prioritization of common prosperity, nation rejuvenation goals, and now zero-Covid, could come in the way of profit maximization and equity market performance,” the strategists wrote in a note Friday.

It’s not just Covid Zero. Reports that the Biden administration may sanction a Chinese maker of surveillance systems has added to investor fears over harsher financial penalties from a newly united West. News that China’s public sector is starting to replace foreign-made computers points to further decoupling of the world’s two largest economies. Contemporary Amperex Technology Co. — one of the mainland’s most valuable listed companies — sank 8.2% after the worst-ever drop in quarterly earnings.

Global markets have seen losses accumulate week by week as Fed rate hikes, inflation fears and the war in Ukraine spur waves of selling. The S&P 500 Index is down almost 13% this year, while Treasuries followed their worst quarter on record with further selloffs. Credit markets have also posted the biggest losses since the global financial crisis. The Fed raised interest rates by 50 basis points on Wednesday, something it hadn’t done since 2000. A 75 basis-point increase would be the largest since 1994.

The bear case against China is growing. So much money flowed out of Chinese financial assets that the offshore yuan had its worst month ever versus the dollar in April. Allocations to China among emerging-market funds recently fell to the lowest in 32 months, EPFR Global said in a report this week. Hedging risk is challenging after China discontinued its version of VIX volatility futures in 2018, meaning selling is the only option for some funds.

The rising pessimism stands in contrast to the start of the year, when China was hailed by almost every Wall Street strategist as one of the top investment destinations as they expected regulatory crackdowns and a deleveraging campaign to come to an end.

“We suggest staying defensive as there is no catalyst in the near term for a sustainable sentiment reversal in Chinese markets,” said Gilbert Wong, a quantitative strategist at Morgan Stanley in Hong Kong — one of the only teams that warned against buying Chinese assets this year. “The spillover of volatility from the US to China is something we are monitoring.”

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