China’s Covid pivot augurs for a brighter spring ahead

China's transition away from the harshest Covid containment measures has important implications for global inflation, monetary policy, and global growth

This year has been a disappointing year for China growth and markets. After two years of relative success in keeping Covid at bay, the emergence of the much more transmissible Omicron variant significantly challenged China’s zero-Covid policy.  

The two-month strict lockdown in Shanghai during April-May led to severe disruptions in both industrial and services activity, resulting in a 10.4 per cent quarter-on-quarter annualised contraction in real GDP growth in the second quarter of this year. Despite the government’s efforts to frontload and expand fiscal spending, with Covid cases rising again in multiple major cities in the current quarter, real GDP growth is on track for a meager 3.0% year-on-year increase in 2022, significantly lower than the “around 5.5%” growth target set at the beginning of the year. During the first 10 months of 2022, Chinese equity prices fell almost 30% and the Renminbi depreciated 15% against the US dollar.

Recent news on China’s Covid policy has been more encouraging. Over the past two weeks, unprecedented protests have erupted in many cities across the country. Although the authorities were swift to react to prevent the protests from running out of hand, it seems that the sense of urgency to prepare for a relaxation of zero-Covid has since increased. In fact, over the past few days, there have been signs of a shift in the official narrative, with the government putting more focus on vaccinating the elderly. Moreover, the protests have also put pressure on local governments to experiment with more relaxation of Covid rules. A good example is Guangzhou, where even though daily case numbers remain high, the city has started to lift restrictions and allow close contacts to quarantine at home. Beijing has also followed suit with home quarantine.

Investors remain especially focused on China’s Covid policies, as the tightening and loosening of travel and quarantine policies has implications on the outlook for global inflation, monetary policy and global growth. Importantly, many market participants now expect China’s path towards a full reopening to have shortened and should be a thing of the past come spring of 2023. Increased vaccination, the availability of medical treatment, and public messaging about the lessening of Covid dangers will be important milestones for a full reopening of China, but we should expect sporadic returns to restrictions in the meantime as China tries to smooth out its Covid caseload.

This dynamic is important to understand in view of its implications for the outlook of the global economy and key markets. For example, the economic growth story for Asia should be weak in the near term, but should begin to improve and outperform the rest of the world from the second quarter of 2023 through the balance of the year.

In the US, the reopening of the Chinese economy should help ease inflation as the supply of core goods picks up with supply chains running more smoothly. This, in turn, supports the notion that the Federal Reserve will be able to slow and eventually pause its rate hikes in 2023, even if headline inflation sees a rebound via higher gas prices from higher China demand for oil.

This overall dynamic will be most visible to investors in the foreign exchange markets. China’s currency should relatively benefit, particularly if reopening leads investors back to its equity markets. The US dollar, however, should peak, as the Fed approaches pausing its interest rate hikes and, accordingly, ceasing the increase in the interest rate advantage for holding US dollar assets versus the rest of the world.

Disclaimer: This article is brought to you by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd, which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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