Stories matter. For those who doubt the power of narratives in financial markets, a cursory glance at the recent works of Robert Shiller, a Nobel economics laureate at Yale University, reveals the extent to which markets are driven by popular narratives as opposed to hard data.
When it comes to the recovery from the Covid-19 pandemic, there have been several big themes that investors have latched onto to explain and justify movements in asset prices.
The dominant theme last year, along with unprecedented amounts of monetary and fiscal stimulus, was the swift and vigorous recovery of China’s economy. This was underpinned by Beijing’s successful containment of the virus, which allowed China to emerge from lockdown much earlier than Europe and the United States.
The appeal of a leading economy that was “first in, first out” of the shutdown, and whose continued liberalisation of its capital markets provided foreign investors with greater access to its higher-yielding assets, fuelled a fierce rally in Chinese equities and bonds.
The CSI 300 index of Shanghai- and Shenzen-listed stocks surged almost 30 per cent last year, compared with a rise of 16 per cent for the benchmark S&P 500 index and a decline of 6 per cent for the Euro Stoxx 50 gauge of euro zone shares. Overseas investors’ holdings of onshore stocks and bonds rose 62 per cent and 47 per cent respectively, according to Bloomberg data.
One of the reasons investors were bullish about China was that Beijing was stimulus-shy compared with the “go big” approach in the United States. That it was America that was doing most of the heavy lifting to stabilise markets and support the global economy, allowing China to focus on maintaining financial stability, was initially seen as a justification for favouring Chinese assets, particularly the yuan and government bonds.
Yet, since the beginning of this year, a new narrative has taken hold in markets. This was driven in part by the West’s remarkable progress in deploying vaccines, especially in Europe, which only a few months ago faced huge problems with its vaccine roll-out.
To be sure, expectations were a key factor. Not only had China’s outperformance reached its limits, all the good news had been priced in. The vaccine breakthrough early last November was the trigger for a major reassessment of the outlook for the global economy. The prospect of life returning to normal allowed markets to look beyond lockdowns and surging infection rates, injecting new momentum into asset prices in the US and Europe.
Even so, the progress in vaccination campaigns in the West has been much faster than anticipated. In the US, 52 per cent of the population has received at least one dose of vaccine, approaching levels in Britain, which had raced ahead earlier this year. More surprisingly, the European Union is catching up with the US, with 42 per cent of the bloc’s population having received at least one dose.
In Bank of America’s latest fund manager survey, the euro zone overtook emerging markets as the region where equity investors had the largest overweight position. Euro zone stocks are up 14.5 per cent this year, outpacing the S&P 500 and powering ahead of the CSI 300, which has barely risen.
Yet, it is not just the vaccine-driven reopening of the US and European economies that accounts for the change in the narrative around the recovery. Equity investors have been overawed by the scale of US President Joe Biden’s administration’s fiscal stimulus measures and come round to the view that the biggest risk is doing too little to support the recovery.
There are still fears about a sharper and more sustained rise in inflation that have unsettled bond markets. However, the determination of central banks, particularly the US Federal Reserve, to keep policy ultra-loose is suppressing volatility, with the yield on the benchmark 10-year US Treasury yield falling back to about 1.5 per cent.
China, on the other hand, is struggling to stabilise its markets, partly because policymakers are more sensitive about excesses in the financial system. It is also because maintaining stability has become more difficult as China opens up its capital account.
In the past several months, Beijing has been more vocal in its warnings about asset bubbles. It has intervened to temper rallies in a range of assets, especially commodities, which China is finding difficult to manage given the country’s diminishing pricing power.
The renewed focus on deleveraging has taken the shine off China’s swift recovery, sowing uncertainty about vulnerable parts of the financial sector. That the pace of China’s rebound has slowed adds to the appeal of European and US assets.
While China is still growing at a rapid clip and at least trying to rein in the excesses of recent years, sentiment has shifted decisively towards Western economies. The US and Europe will face acute challenges when central banks start raising interest rates, but for now they control the post-pandemic narrative in markets.
Nicholas Spiro is a partner at Lauressa Advisory