China faces 'structural headwinds to growth,' strategist says

BlackRock Global Chief Investment Strategist Wei Li joins Yahoo Finance Live to discuss growth in China, the economic rebound and case for investing in the country, and Fed rate hikes.

Video Transcript

- Let's zoom out now for a global look at the economy. Investors have turned cautious after the disappointing release of China's manufacturing and nonmanufacturing PMI. Both unexpectedly contracted in October, pointing to more economic headwinds ahead, this as China continues to grapple with COVID-19 lockdowns. We mentioned earlier today that Disney Shanghai also shut its doors to comply with COVID-19 prevention measures. Our next guest warns that China's economy will not grow fast enough to compensate for the boost in export demand it saw from stay-at-home orders during COVID.

Joining us now with her insight is Wei Li, BlackRock global chief investment strategist. Thank you so much for being here. Appreciate it.

WEI LI: Thanks for having me.

- So as we look at the China situation, we are still seeing lockdowns there, renewed wave of lockdowns, seemingly, at the same time the economy is struggling to break out. So first of all, I guess, when do you see the lockdowns maybe starting to end? And secondly, even when they do, what happens with the economy there?

WEI LI: I think it's really important to recognize that there are some structural headwinds to growth right now in the case of China. So yes, of course, the zero-COVID policy has weighed down on growth expectations so far this year. But it's not just zero-COVID policies, also export drivers that have been such a big contributor to China growth during the COVID pandemic period. That is now fading away as the rest of the world switches back on. So as the export drivers fades, actually, that represents a structural headwinds to China growth, which is why we are forecasting just slightly above 3% for this year and higher than that, of course, next year as China reopens, but not very high. So we're not going to see a V-shaped rebound in the case of China.

- Should investors just avoid investing in China at all right now?

WEI LI: I think the tactical and the strategic case for investing in China right now is challenged because of this also focus from not just growth to broader issues, like national security, all of that representing a bit of a headwind for structural growth, but also in terms of how that headline growth can translate into corporate profitability, which is why earlier on in the year, we downgraded China from overweight to neutral. And actually currently strategically there is an underweight allocation to China government bonds, because the yield pick up attractiveness versus US government bonds has been eroded away, as we now get paid by holding US government bonds.

- Are we just not going to see any of the kind of tit-for-tat tariffs that we had seen during the US-China trade war over the past couple of years and even going into 2020, waiting for some type of resolution on where that would move forward? Or are we just not going to have those conversations reemerge and actually for it to get worse before there's any inkling that it may get better?

WEI LI: I think it's very optimistic to hope for a resolution around the trade war and tit for tat between US and China. In fact, if anything, we have seen an acceleration of some of that geopolitical tension, so thinking about the focus on cheap manufacturing, thinking about the broader decoupling and moving further apart of the spheres of influence between US and China. So I think that is going to be the base case underpinning our structural expectation on the geopolitical front. And for investors thinking about investing in China from our global portfolio perspective, we need to think about what that means from a risk premium perspective when we construct portfolios.

- Let's talk about portfolio construction with regard to the US as well. As you mentioned a moment ago, we're now finally getting paid to hold US bonds, which is an experience we haven't had in a while. In fact, the US Treasury website has been crashing on occasion as retail investors try to get on there. At the same time, obviously, there is a puzzle here for the Federal Reserve as it is raising rates. What is your rate outlook here in the US? What are you expecting to hear from the Fed on Wednesday?

WEI LI: Well, I think the 75 bips of rate hikes is a foregone conclusion that will happen. But what really matters is how far rate hikes can go and also for how long that will stay and also what that means for growth. So earlier on in the segment, you talked about the October rally. We believe the October rally in risk assets is really on shaky grounds because markets previously were looking for a dovish pivot from the Fed. And then they were looking for a pause from the Fed.

And now markets are getting excited about just the pace of rate hike decreasing, which, of course, it will, because you cannot keep hiking 75 bips per meeting. So it feels like markets want to see some positive development in terms of dovish-- dovish message from the Fed. But really we are not at that juncture yet because if you look at core inflation, it's still very, very sticky from last week's core PCE, for example, still really quite persistent.

And at the same time, the focus of the Fed is really solely on the politics of inflation. With inflation where things are, the mandate is to fight inflation at all cost this year. So we believe that rates will continue rising. It will peak at 5%. And not too understate it, that's a very, very restrictive territory. In fact, where we are now at 3.25% is already restrictive to the economy.

So our belief is that in this current supply-constrained environment, the Fed is going to have to engineer a recession in order to bring down inflation. Our assessment is that if they were to want to bring down inflation to 2% reasonably quickly, it represents a 2% shock to the US economy in 2023. It also represents 3 million additional people out of a job, pushing unemployment rate to 5%.

So this is the very heavy and high cost of inflation fighting in the current environment shaped by supply. And that's what we're looking for from the Fed, the acknowledgment of the tougher trade-off from this interest environment.

- The market's on shaky ground, like you mentioned. Just given the potential for more negative news into year end, do you think the gains we've seen in October get unwound?

- It's possible. It's possible because a lot of the bad news are really starting to come together. And they have yet to be reflected in market pricing. So I talked about the Fed and the economy, but we haven't talked about earnings season. Look at the shocking downside surprise of the big tech names last week.

And yet earnings forecasts are coming down, but not down enough. Next year S&P 500 was still talking about mid to high single-digit growth for US earnings in 2023. That is really not aligned with our expectation for a recession next year.

So earnings needs to come down. It's not yet in the price. And I think markets will wake up to that before finding a foundation to then rally on.

- For investors that are still willing to have some type of risk component in their portfolio, they might look at speculative assets that are highly deteriorated from some of their peak values. And I think about crypto. BlackRock has its own blockchain-based ETF as well. I believe you've launched two of them over the course of this year. But I guess more broadly speaking, is this still a time to be looking at crypto, even though the valuations are highly depressed from where we began even at the early points of the year here?

WEI LI: Well, with regards to crypto, there is a demand. That's why we issue the products to address that demand. But assumptions on return and risk needs to be really positive for crypto to justify even a small, very, very small allocation in a whole portfolio context.

So to your point about where to deploy risk, currently we are underweight developed market equities, but we're just modestly underweight. We are overweight investment-grade credit. In this environment, we believe that investment-grade credit offers you income and also are pricing in a version of the growth slowdown that we are forecasting. So this is where we want to deploy risk budget at this point.

- Really great conversation. Wei Li, BlackRock Global chief investment strategist, thanks for coming to studio. We appreciate it.

WEI LI: Enjoy the office. It's fantastic.

- Come back any time.