China’s Zero COVID Policy fuels inflation

26 April 2022

By Gilles Seurat, Fixed Income and Cross Asset Portfolio Manager, La Française AM

China’s year-on-year GDP growth rose from +4% in Q4 2021 to +4.8% in Q1 2022 (Source: Bloomberg). But the outlook is significantly bleaker for the end of 2022 given namely the rise in the number of COVID cases which has jumped from just a few cases to close to 25 000 cases per day over the past two months. In response to this rise, the Chinese administration continues to pursue its Zero COVID Policy and has implemented new lockdowns. For illustration purposes, Nomura estimates that ca. 356.5 million Chinese, which represents 25.3% of the population and 38.4% of Chinese GDP, are in lockdown. Consequently, mobility indicators are down 50% on average, with a much bigger drop in Shanghai, where lockdown measures are the most severe. (Source: Baidu, YoY as at 17/04/2022)

The severity of the situation is causing unprecedented congestion. Due to strict anti-COVID measures, a significant proportion of port workers and truck drivers are absent, causing congestion and backlog. In Shanghai, more than 300 ships are waiting to unload compared to a mere 50 in February. The situation has escalated and is even worse now than in 2020 and 2021!

What are the implications for the global economy? Firstly, oil consumption is dropping in China as private car travel has been restricted. Air travel is collapsing too with only one out of four domestic flights scheduled. All of these factors naturally weigh on oil demand which is expected to decline by 9% in April 2022 (the equivalent of 1.2 million barrels per day) compared to April 2021 (source: Bloomberg).

The long-term effect of this drop on crude oil prices will largely depend on the Chinese administration’s ability to contain the spread of COVID over the coming months and the duration of lockdown.

However, in the short to mid term, congestion at China’s ports should have a more dramatic impact on inflation. Indeed, world demand for consumer goods currently exceeds supply, and Chinese supply chain disruption will only exaggerate this imbalance, hence leading to additional inflation. Shortages have run rampant, from semiconductors in 2020 to paper, glass, automobile parts and so on today.

Successive lockdowns have shifted the balance of consumption between goods and services. In the US for example, goods consumption is 15% higher than before the pandemic (Source: Bloomberg), and across the globe, demand for household appliances and IT hardware (made in China) has surged. Furthermore, the US labor market is still recovering following its collapse in 2020 and 1.6 million workers are still missing. US Business Roundtable CEO Survey reveals six-month hiring plans at all-time highs. Therefore, aggregate income should continue to rise and further support US demand.

Theoretically, the supply and demand imbalance can only be resolved by higher prices.  A good example is the German automobile industry, which has both increased delivery delays to sometimes more than a year and hiked prices. 

The surge in inflation has several consequences on financial markets and portfolio allocations. Central banks across the globe have initiated tightening policies and should continue to take measures given pressure to act against what has been labeled the worst of evils, inflation. This means that the front-end portion of the fixed income curve should remain under pressure. Markets should continue to price rate hikes for the months to come. Hence, we believe that yields on short to mid-term maturity bonds have a higher probability to rise than to fall. The same is less true for long-term maturity bonds as demand from some investors has started to pick up. Long-term disinflationary drivers such as slower population growth mean that long-term maturity bond yields are more likely to be capped. We therefore anticipate flatter yield curves in Europe and the lockdowns in China are adding fuel to this strategy.

This commentary is intended for non-professional investors within the meaning of MiFID II. It is provided for informational and educational purposes only and is not intended to serve as a forecast, research product or investment advice and should not be construed as such. It may not constitute investment advice or an offer, invitation or recommendation to invest in particular investments or to adopt any investment strategy. The opinions expressed by La Française Group are based on current market conditions and are subject to change without notice. These opinions may differ from those of other investment professionals. Published by La Française AM Finance Services, head office located at 128 boulevard Raspail, 75006 Paris, France, a company regulated by the Autorité de Contrôle Prudentiel as an investment services provider, no. 18673 X, a subsidiary of La Française. La Française Asset Management was approved by the AMF under no. GP97076 on 1 July 1997.

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