Investors’ Outlook: Eyes on the end zone

Sony’s Walkman as a coveted technology gadget. Nintendo’s early gaming consoles that made children’s hearts beat faster. Along with Toyota’s and Honda’s cars making their way onto the world’s streets, these Japanese success stories were the embodiment of a phoenix rising from the ashes after the country’s industry was almost completely destroyed during World War II. But the economic miracle didn’t last, resulting in the “Lost Decade” and China subsequently taking its place as the world’s second-largest economy. Comparing the Japan of yesteryear with today’s China raises the question whether China could soon face a similar fate.

Japan experienced an economic boom after World War II up to the early 1990s. In 1988, Japan’s theoretical land value exceeded all of that in the US (which is almost 25 times the size of Japan) by a factor of four to five, and real estate prices climbed to dizzying heights. A year later, eight of the world’s 10 largest companies by market capitalization were domiciled in Japan, and the Nikkei 225 stock index soared from one high to the next.

Bank of Japan (BoJ) policymakers were concerned about the overheated economy, though mostly stayed on the sidelines, especially in the aftermath of the 1987 Black Monday shock. But one week after Yasushi Mieno took office as Governor of the BoJ at the end of 1989, he raised interest rates, saying the move would contribute to sustainable growth driven by domestic demand while simultaneously maintaining price stability. More hikes followed over months. Then, the Japanese asset bubble burst, triggering a balance sheet recession and ushering in the “Lost Decade”. The Nikkei 225 lost almost two- thirds of its value by 1992, while real estate prices plummeted around 70 percent by 2001.

China as the “Japan 2.0”?

There are similarities worth considering, such as the high level of debt. In the 1990s, Japanese household debt amounted to almost 70 percent of GDP. China’s debt has swelled to 62 percent in the third quarter of 2023 (the latest available data) from around 11 percent in the early 2000s (see chart 1).

The state of China’s real estate market evokes memories of what transpired in Japan. Property developers’ heavily leveraged business model has come under pressure after years of soaring Chinese house prices, and a Hong Kong court in January ordered the liquidation of troubled real estate developer Evergrande. A further escalation of the crisis could have a drastic impact, as the real estate market accounts for almost 30 percent of China’s GDP.

China’s GDP growth is expected to slow to 4.6 percent this year and to 3.5 percent in 2028, from around 5 percent in 2023, according to the International Monetary Fund. This is also reflected in lower price pressure, with signs mounting that China faces even more deflation. Lower prices may be positive at first glance, but harbor the risk that consumers postpone purchases in anticipation of even lower prices and thus of a deflationary spiral, as has been seen in Japan for decades.

Both countries are grappling with unfavorable demographic trends, such as a shrinking working population. Japan’s fertility rate (number of births per woman) peaked in 1967 at 2.2 and has fallen continuously since then, dropping to 1.5 in the early 1990s and remaining at 1.3 since 2020. China’s latest available fertility rate (2021) is even lower, at 1.2.

Deteriorating US-Chinese relations over the last few years (trade war, “near-shoring” or “friend-shoring”, etc.) is also reminiscent of Japan, which faced increasing US criticism for unfair trading practices.

What speaks against a Japanification of China?

For one, the Chinese economy appears to be struggling primarily with a hot real estate market, but not with a hot stock market. The Nikkei 225 was trading at 70× price to earnings (P/E) at the height of the Japanese bubble, while the Shanghai Composite is currently trading at around 12× (see chart 2).

The Japanese yen appreciated 20 percent in just a few months after the 1985 Plaza Accord. That’s not the case for the Chinese yuan, which, unlike the free-floating yen, is pegged.

Despite its growing influence in the world, China is still an emerging market. Developments like years of increasing urbanization speak against a Japanification of China as it’s often associated with higher economic growth. And finally, Chinese decision-makers do have one advantage: they can draw lessons from Japan’s economic history.

Food for thought

While there are several parallels between China today and Japan in the 1980s and 1990s, it’s not a one-to-one comparison. Should China face the same situation as Japan, it would reverberate throughout the global economy, given China’s much higher contribution to the world’s GDP and its importance for commodity markets. China will probably have to bolster the economy with a supportive fiscal policy rather than via monetary policy (see chart 3).

As the year unfolds, Fed officials face a situation that would typically be welcome: Inflation has decreased more rapidly than anticipated. However, this situation also presents a conundrum.

The issue is that with inflation consistently approaching the Fed’s 2 percent goal, real rates—those adjusted for inflation—have increased, potentially over-tightening the grip on economic activity (see chart 1). Given the Fed’s best estimate of a “neutral” nominal policy rate that neither stimulates nor slows growth, or inflation at 2.5 percent (0.5 percent in real terms), anything above that is essentially still weighing on the economy. This suggests the Fed could comfortably cut rates without changing its “higher for longer” mantra. Monetary policy would remain restrictive. The challenge lies in determining the timing and magnitude of rate cuts that are likely to begin in the second quarter. According to the Fed’s latest summary of economic projections, the central bank intends to reduce its policy rate this year by at least 75 basis points.

Tight lending standards

The Fed’s Senior Loan Officer Opinion Survey shows that while banks tightened their lending standards through the fourth quarter of 2023, the proportion has decreased from previous quarters.

A significant net share of banks reported fewer inquiries from potential borrowers regarding the availability and terms of new credit lines or increases in existing lines (see chart 2). This suggests US businesses remain very cautious and reluctant to put money to work right now. There appears to be “decreased customer investment in plant or equipment and decreased financing needs for inventories, accounts receivable, and mergers or acquisitions,” according to the report. Less borrowing often reflects declining investments by businesses and a drop in hiring activity, which in turn weighs on economic growth. In the past, tighter lending standards have led to a widening spread between yields for riskier corporate bonds and government bonds.

After the “almost everything rally” that characterized November and December, equity investors have become more selective since the beginning of January. On the one hand, the combination of solid data on economic growth and strong employment figures further fueled hopes of a soft landing. On the other hand, mixed inflation data for December and January, along with a strong economy, led central banks to push back on impending rate cuts.

This was particularly the case for the Fed, which clearly adopted a less dovish tone at its meeting in late January. Still, at the time of writing, markets are powering ahead, with the MSCI ACWI Net Total Return Index up more than 3 percent year-to-date, reaching a record high and topping the December 2021 peak.

The US market remains a substantial driver behind global indexes, which reflects what transpired in 2023, when US technology-linked mega-caps led the way. In the US, encouraging earnings, particularly in the large-cap technology segment, and supportive macroeconomic data pushed the S&P 500 Index above the 5,000 mark for the first time and to its 14th all-time high since the beginning of 2024 (see chart 1).

February saw the biggest single-day market cap addition in history, with Meta topping the leaderboard after posting fourth-quarter earnings and an almost USD 200 billion jump in market cap (see chart 2). A glance at Europe shows a similar picture, with the Stoxx Europe 600 Index in positive territory as well, driven by technology, communication services, consumer discretionary (particularly luxury goods), and financials. At the tail end, emerging markets are still in consolidation. Chinese stocks reflect a struggling economy, as evidenced by disappointing retail sales and a further deterioration in real estate activity.

There has been plenty of geopolitical support for oil recently—attacks on Russian oil infrastructure, failed efforts to achieve a ceasefire in Gaza, or uncertainties in the Red Sea. Despite the tense situation, oil prices have been trading between USD 75 and USD 85 for months.

There are mixed signals from the demand side. The International Energy Agency reduced its forecast for global oil demand, now expected to only grow by 1.2 million barrels per day (mbpd) in 2024 due to the weakening Chinese economy. This is less than a previous forecast for 1.24 mbpd. The Organization of the Petroleum Exporting Countries (OPEC) is much more optimistic with its call for 2.25 mbpd. Meanwhile, travel-hungry consumers support jet fuel demand, while solid US economic data buoys hopes for a soft landing (see chart 1).

On the supply side, US oil production, which reached a record high of over 13.3 million barrels per day (mbpd) at the end of 2023, according to the Energy Information Administration, which was lower than expected in January (12.6 mbpd).

Extreme weather caused wells and pipelines to freeze. Along with a series of planned shutdowns, this led to a slump in refinery production to its lowest level since the end of 2022. At almost the same time, the Energy Information Administration said US oil inventories rose by 12 million barrels in the first week of February, significantly more than the expected 2.6 million barrels. While the increase was probably partly due to lower refinery activity, some interpreted it as a sign of weakening demand.

OPEC cuts

OPEC and its allies will continue with their announced production cuts until the end of the first quarter. Saudi Arabia indicated the curbs may continue beyond that. However, in view of the accumulated excess capacity and the fact that Saudi Arabia will have to shoulder most of the cuts alone, market participants appear to have doubts as to whether words will really be followed by deeds (see chart 2). The U-turn on Saudi Aramco’s planned capacity expansion was also seen as bearish by some. The Kingdom instructed the state-owned energy company to aim for a maximum capacity of 12 mbpd by 2027, one million less than previously announced. Geopolitical escalation or a significant reacceleration of the Chinese economy remain a tail risk that could push prices significantly higher. In the absence of unexpected shocks, oil should continue to trade in a range of USD 75 to USD 85.

The Swiss franc depreciated slightly against the euro and weakened more significantly against the US dollar in January, which is when SNB President Thomas Jordan said the central bank is increasingly worried about the franc’s strength and its negative impact on Swiss businesses. This acknowledgement may be seen as a first step towards actively managing the franc lower.

A strong currency is no help amid worries about an economic downturn and deflationary conditions. While it’s unlikely that the SNB will start selling Swiss francs outright, merely halting purchases amid lower yields in Switzerland could contribute to a weakening of the franc over the course of this year.

Swiss inflation data took an unexpected turn in January, possibly paving the way for the SNB to consider rate reductions sooner than anticipated. Headline consumer prices increased 1.3 percent from a year earlier, significantly below the 1.7 percent economists had forecast. The core inflation rate, which excludes the impact of volatile items such as energy and food, decelerated to 1.2 percent from 1.5 percent (see chart 1). This decline came as a particular surprise, as some prices within the Swiss economy are controlled. Moreover, electricity costs and the value-added tax increased at the start of the year. Economists were initially eyeing September for the SNB to commence rate cuts, but the lower-than-expected inflation has prompted some to bring that timeline forward. The market-implied probability for a 25-basis point cut in March has doubled to more than 60 percent from around 30 percent. The SNB, unique among its global counterparts, convenes quarterly, making its schedule less flexible.

US dollar’s return to strength

The euro’s decline partially reflects a correction from the overly rapid sell-off of the US dollar in November and December, with January witnessing a retracement of some of those movements (see chart 2). It’s challenging to be optimistic about the euro-dollar exchange rate, given the stark contrast between strong US economic indicators and lackluster news from the Eurozone. The question remains whether the favorable economic narrative in the US will persist, which would influence yields and the outlook for the dollar in 2024.

Frank Häusler, Chief Investment Strategist

Stefan Eppenberger, Head Multi Asset Strategy

Christopher Koslowski, Senior Fixed Income & FX Strategist

Mario Montagnani, Senior Investment Strategist

Michaela Huber, Cross-Asset Strategist