China: 'Pessimism is enormous' on country's economic slowdown, strategist says

President Biden described China's economic state as a "time bomb ready to explode" during this week, as the country witnesses a decline in growth coupled with deflation.

"The Chinese economy holds the position of being the second-largest globally, with the additional challenge of dealing with demographic issues. The country needs to ensure it becomes wealthy before its population ages, and this aging process is happening at an accelerated pace," states Martin Schulz, the Head of International Equity Group at Federated Hermes. During an interview with Yahoo Finance Live, Schulz explains the pressure faced by Chinese officials, who now have the responsibility to rejuvenate the economy.

Schulz talks about the way investors who have investments in China and Chinese stocks should perceive the future of China's economy. At the same time, he is taking into consideration emerging markets such as Brazil, the challenges related to energy prices in terms of geopolitical matters, as well as the potential risks of a recession in the United States.

SEANA SMITH: President Biden has directed his attention towards China this week, cautioning that its economy is a potential threat waiting to explode. The President highlighted recent obstacles, such as sluggish expansion, as proof of the Chinese economy's precarious state.

To delve deeper into how this impacts investors, we invite Martin Schulz, the Head of International Equity Group at Federated Hermes, to share his insights. Martin, it's a pleasure to have you join us.

It is widely known that China's economic revival has faced considerable challenges. However, what implications does this hold for individuals looking to invest? Should investors completely dismiss any potential investment prospects in China at this stage?

MARTIN SCHULZ: Hi Seana, I want to express my gratitude for inviting us. At Federated Hermes, we have been frequently traveling to China in recent months. And you are absolutely right, the journey has been extremely challenging. In fact, I believe the main lesson we learned from our recent trips is that the level of pessimism is remarkably high. This can be observed among various groups, including consumers, on-ground investors, and private investors.

Clearly, the market has experienced a difficult downturn. From an economic standpoint, we are facing challenges in the real estate industry. Moreover, there is a recurring issue of lacking trust amongst consumers and investors, which has further added to the hardships we are currently facing.

However, we believe that approximately two to three weeks ago, the government began to truly acknowledge the longstanding concerns of us investors. It seems they are now actively working towards implementing policy changes. This is extremely significant because, ultimately, the property markets in China have heavily relied on government regulations, which have contributed to a robust economic landscape.

And as for us, I believe that this opposing perspective of considering China to be surpassing expectations is likely something we have yet to catch up on.

AKIKO FUJITA: Yes, Martin, considering what you just mentioned, I would like to know how important you believe some of these changes are anticipated to be. There is currently a great deal of attention on the housing market due to its previous trajectory. To what degree can any of these measures contribute to revitalizing the economy? And how substantial do you predict they will be?

MARTIN SCHULZ: In the previous years, these industries were quite extensive. However, in the last decade, the government has attempted to reduce their influence. Akiko, your question is indeed insightful because it is evident that China's growth rate has significantly decreased compared to the past. Despite being the second largest economy globally, China is facing challenges in terms of its aging population. They must achieve prosperity before dealing with the consequences of an aging society, which is happening rapidly.

The government still possesses some control over economic factors but not as much as before. However, they have started to make slight adjustments in monetary policies, similar to emerging market banks like Brazil and others. They have the ability to reduce interest rates if needed. In terms of the real estate market, they have modified certain regulations. For instance, during the COVID pandemic, individuals were required to make an 80% cash down payment to secure a mortgage. That requirement has now been reduced to 30% to 40%. This demonstrates their ability to further lower these barriers.

However, once again, they are confronted with these challenges stemming from the population trends, yet it is important to acknowledge that China is both an advancing economy and a country experiencing ongoing urbanization. Numerous individuals are still migrating to urban areas, which consequently fuels job opportunities and the establishment of new households. As a result, this dynamic will persistently propel the country's economy in a positive direction.

SEANA SMITH: Martin, in your opinion as an investor, how long do you believe it will take to find worthwhile investment prospects in that area? What appears most appealing to you? How do you perceive the duration of this recovery process and its characteristics?

MARTIN SCHULZ: You see, Seana, it has been quite exasperating. Our plans to venture to China last summer were based on the hope that the COVID limitations would be lifted sooner. Additionally, we expected the burdensome regulations to disappear more rapidly. Thankfully, progress is now being made in that regard. However, during this period, it seems that we have unfortunately lost some trust or investors have become less confident, to put it accurately.

In our opinion, we find China to be extremely intriguing for the upcoming two to three years, especially when considering its current technical state. China has been stuck in a rut for quite a while now. Therefore, we anticipate the next 6 to 12 months to be a crucial period for focusing on internet commerce and consumer-oriented businesses. Specifically, we have a positive outlook on companies like Alibaba and Tencent, as we believe they will demonstrate significant earning potential in the future. Moreover, due to their currently low valuations and diminished expectations, we anticipate that these companies will outperform in the long run.

AKIKO FUJITA: Martin, aside from China, you've discussed various prospects in developing economies, specifically focusing on central bank strategies. It's worth mentioning that you're the second or third guest this week to mention Brazil as a promising option in terms of their monetary policies. However, I'm curious to know your thoughts on other central banks and the potential investments you see in this regard.

MARTIN SCHULZ: Definitely. When it comes to emerging markets, you're absolutely correct. Brazil is one of the locations that we have favored for a long time. Our top-down approach to determining country allocation enables us to prioritize markets that are undervalued and pose minimal risk. Brazil fits perfectly into this category.

And since they've been very proactive in implementing conventional strategies to manage their economy. So they have been ahead of the curve, ahead of the Federal Reserve, ahead of the European Central Bank. Thus, they have functioned effectively as a central bank and, disregarding political factors, a market that we anticipate will continue to thrive. Moreover, businesses with the capacity to take advantage of the decreasing interest rates will be the ones to achieve the greatest success.

On the contrary, there is a particular central bank in Japan that has been actively managing the yield control and curve control scenario. Therefore, we believe that Japan, although not categorized as an emerging market, will provide favorable returns for investors in the coming months and years.

SEANA SMITH: Hey Martin, can we discuss the current situation surrounding oil? We'll focus on both crude oil in the US and its impact globally. The International Energy Agency (IEA) recently released a statement stating that OPEC plus supply reductions might further amplify oil prices. Additionally, they emphasized that June witnessed a remarkable surge in global oil demand.

We have noticed a consistent increase in the cost of oil, which has continued for seven consecutive weeks. How do you perceive this as a possible obstacle to the economic rebound, not only in the United States but also in countries like China and other parts of the world?

MARTIN SCHULZ: Hey Seana, that's an excellent query. When it comes to oil, whether it goes up or down, it entails a tax both for consumers and producers. Therefore, we anticipate oil to remain steady and even escalate. This prediction is based on our belief that the global economy is reaching its lowest point and gradually recovering.

In reality, China has not been a major purchaser of oil until now. The primary concern is that in the US, we have been selling oil from the Strategic Petroleum Reserve. Therefore, there is a sort of competition happening between oil producers and the US in terms of oil prices.

However, in my opinion, if the United States manages to avoid a recession and if the recession in Europe turns out to be relatively mild as we predict, we anticipate a rise in demand. Moreover, as there is an ongoing emphasis on ESG (environmental, social, and governance) initiatives and the pursuit of a more sustainable world, it is evident that this period of transition will be lengthy.

And this was evident in the PPI figures today. We believe that this trend will persist. Consequently, I believe that investors, on one side, are witnessing a relatively rapid decline in inflation rates. This is certainly an encouraging development. However, I anticipate that it may prove to be more challenging than anticipated.

And that's most likely the single factor, if you dare take a chance, that is prominent in our current situation. Furthermore, as the costs of oil continue to soar or at the very least remain at these levels or above, it is evident that, as previously stated, this places an additional burden on everyday consumers and producers. Hence, it's imperative for us to be cautious of this matter. Moreover, it is plausible that interest rates across various countries may remain elevated beyond initial forecasts due to this particular circumstance.

AKIKO FUJITA: Yes, that definitely increases worries about inflation picking up speed again. So when we discuss where prices are expected to stay, I mean, the IEA suggests that it could potentially increase even more in terms of demand this month. Is your main prediction here that they will stay high until the end of the year?

MARTIN SCHULZ: We are convinced that the oil prices will continue to stay high. Once again, this is partly influenced by geopolitical factors and the developments in Saudi Arabia, Russia, and other significant oil producers at the moment. The issue lies in the fact that the United States used to be the pivotal oil producer for many years.

However, at this moment, due to various factors, we do not possess the same level of influence as we did a decade ago. As a result, we anticipate that prices will remain high in the foreseeable future if they continue at their current levels.

SEANA SMITH: Martin, regarding the United States and the recent data on inflation, we received the producer price index (PPI) this morning, which showed a higher reading than anticipated. This differs from the consumer price index (CPI) that we observed yesterday, where we saw inflationary pressures loosening more than what analysts had predicted. What is your interpretation of these contradictory reports and what does it suggest about the Federal Reserve's ongoing battle against inflation and its future direction?

MARTIN SCHULZ: Well, you're essentially pointing out a fascinating occurrence, wherein interest rates are decreasing at a faster pace than anticipated. However, it's not a linear progression. Due to the aftermath of COVID and the challenges faced by the supply chain, along with other factors influencing the economy, we believe that inflation will decrease but not as quickly as initially predicted.

And going along with that same idea, once more, I believe that the central banks - I refer to the situation in the UK, the Bank of England as well as in Canada and Australia - are adopting a more cautious approach when deciding on interest rate adjustments, taking into consideration the inflation data currently available.

Naturally, the concern lies in the possibility that increased rates could push the worldwide economy, particularly the US economy, towards a potential downturn. However, in the immediate future, I believe the top priority is combating inflation, and that is precisely where their attention lies.

AKIKO FUJITA: So Martin, which side do you lean towards in that discussion? Do you belong to the group that anticipates a slight economic downturn at the very least due to the likelihood of persistently high interest rates?

At Federated Hermes, we had anticipated a period of economic decline earlier this year. Based on our assessment of the current stage of the economic and monetary policy cycles, as well as the observations from other relevant sources, we believe that any potential recession will be postponed and likely occur towards the end of 2024. We'll have to wait and see if our prediction proves to be accurate.

Currently, the indications from the markets are clear. Toward the end of the day, it is evident that we are observing some concerning economic data. However, on the flip side, we are also witnessing other data, both in terms of the economy and market trends, that show a wider scope of growth. This suggests that we are moving further away from the current scenario and possibly heading towards a very different situation.

If you consider the impact of monetary policy in the previous periods, typically spanning from 9 to 18 months, there were noticeable effects on the economy. However, these effects might be less distinct now due to disintermediation. Additionally, the current economy is a post-COVID one, characterized by growth and a catch-up phase that will continue progressing, unlike previous economic cycles. Consequently, we anticipate a slowdown in the upcoming year, but it is unlikely to result in a recession at this moment.

SEANA SMITH: Okay, we'll wrap up the discussion on a positive note. Martin Schulz, it's always valuable to hear your insights. Thank you for sharing your perspective as the Head of International Equity Group at Federated Hermes. Much appreciated!

MARTIN SCHULZ: I express my gratitude.