China’s approach to the pandemic has placed an undue burden on its people and the economy. Furthermore, since China is the largest manufacturing economy in the world, the policy has depressed growth and raised inflation worldwide as well.

For growth, the lockdowns have curbed demand and economic activity overall. With regard to inflation, the policies have added to bottlenecks and shortages across value chains, which has made price rises more sticky around the globe.

Over the past few days, China has signalled a major change in its policy approach. Of course, such a shift in stance always holds further uncertainties, and the stress test to such measures may only be seen by the Chinese New Year in Q1 2023 at the latest. Yet we think it may be a milestone for growth and inflation in China and everywhere else.

Our first humble conclusion is that it will raise the probability of our economic baseline scenario holding up next year. This is already something, given the recent recession fears in markets. Also, more responsive policies and a more stable economy lower the risks of accidents in the financial system.

What does this mean for investors?

When we put it all together, we think the time is right for some final tweaks to investor positions before the close of financial year 2022. Hence, we have upgraded emerging market bonds, as macroeconomic and systemic risks decline and valuations are quite attractive.

That said, we continue to focus on quality, given the still sizeable risks to the world economy. On a different note, we call for a bottom in the EUR/USD rate and – from a technical analysis point of view – a top in the broader USD aggregates in foreign exchange markets. The latter may be due more to US monetary policy, but China is helping mightily here as well.

A closer look at the US dollar

Recent developments have increased our conviction that the best period for US dollar strength is behind us for good. First, recent data still supports our view that the US Fed will end its policy tightening soon, most likely after a final 50 basis-point hike in December, ending the rise of the US interest-rate advantage.

In contrast, the ECB will likely continue hiking in early 2023, reducing the interest-rate disadvantage of the euro vs the US dollar. Second, softening energy prices in Europe are bringing down its price divergences compared to energy-producing economies like the US. The impact of higher energy prices, reflected very dominantly in higher producer prices, was a meaningful headwind for the euro vs the US dollar during most of this year, which is now dissipating.

Third, market risk appetite has improved, removing risk aversion as arguably the strongest driver of US dollar ‘safe-haven’ strength. Acknowledging these factors, we adjust our forecasts for the EUR/USD exchange rate. This implies some restrengthening of the USD from current levels, as uncertainties with regard to the endgame of monetary policy tightening still exist over the short-term horizon.

Furthermore, there are economic uncertainties related to recession risks and how well Europe fares through the winter months with potential energy shortages. We expect further strengthening of the euro to remain rather moderate, as the cyclical outlook for the eurozone, although improved recently, does not provide a convincing tailwind, with the impact of the monetary policy tightening provided so far unfolding next year and accentuating growth uncertainties.