Authors: Asia Investment Strategy Team
Markets caught some relief as 10-year Treasury yields eased back down to below 4.2% and U.S. equities bounced after being pummeled this month, buoyed by strong results and blowout forecasts from Nvidia, which is being viewed by investors as a leading beneficiary of the AI boom. However, conditions continued to deteriorate in Europe with the latest flash composite PMI falling to a 5-month low of 50.3, causing sharp drops in the Euro and German bund yields. Looking ahead, amid still-resilient U.S. economic data as growth momentum slows around the world, markets will be focused on the upcoming Jackson Hole meeting to see if they can glean any clues from Fed Chair Powell’s speech on Friday about the path of policy going forward.
One market where relief seems to be in short supply now is China, where investors endured yet another volatile week. A constant barrage of negative headlines around the troubles of the property developers and slowing growth have severely impacted investor sentiment and dragged markets in recent weeks, while policy support remains tentative. In last week’s note, we deep-dived into China’s economic recovery and some of the headwinds as well as investor concerns. This week we will take a closer look at the housing market – focusing on both its near-term and long-term prospects. We also assess the implications for investors.
Strategy Question: Understanding China’s Property Downturn and its Implications
It’s the housing market, again. Heading into the summer, housing sales took a dive in a clear sign of fragile buyer sentiment. A few weeks later, another big developer missed a bond coupon payment and announced restructuring plans for its onshore debt. Apparently, after having put most of its cash aside to finish pre-sold units, falling sales made restructuring an inevitable outcome. As we wrote in last week’s note, investors were surprised by the sudden distress, as well as dismayed by the apparent lack of intervention from regulators. This triggered a wave of selling pressure in Chinese equities, the currency, as well as the credit market. While technical indicators increasingly point to those markets being in oversold territory, as more time goes by, collateral damage to the economy is also increasing. It is important to understand the various channels through which the housing market can impact growth, as well as broader Chinese assets.
One can safely assume that more policies are already on the way with an aim to loosen restrictions on mortgages and housing purchases. We argued last week that these policy levers should be used to arrest the downward spiral in sales. Indeed, on the current trajectory, housing sales could undershoot core demand for the first time in many years. In 2021, annual new residential housing sales totaled 1.57 billion square meters. In 2022, housing sales fell to 1.15 billion square meters as the default cycle started to worsen. In the first seven months of 2023, housing sales totaled 0.58 billion square meters, 13% less than in 2022. But in July and August, housing sales were only around 70% for the same period in 2022. A rough estimate of household formation and urbanization puts core demand (excluding more speculative buyers) at around 0.8-1 billion square meters per year. This suggests that investment demand has all but disappeared, and that on the current trajectory housing sales will likely undershoot core demand this year. Broad inventory overhang also remains. Of the 56 billion square meters of residential floor space under construction, half is likely unsold at the moment. At the current run rate of demand, clearing this inventory could take three to four years.
Estimating the potential economic impact
Viewing China through the lens of other countries that experienced housing (and credit) booms adds some context to both the necessary adjustments and resulting impact. China is at the more extreme end in terms of property market excesses – relative to other countries that have experienced booms in property investment (U.S. before the global financial crisis, Spain, Ireland, Japan, etc.) it has a higher share of investment in property, larger excess supply, more expensive prices, and a larger share of economic activity derived from property than any of the other “property boom” economies. At nearly 30% of GDP, real estate and construction activities in China are higher than almost any country in history, comparable only to pre-crisis Spain and Ireland.
As these excesses unwind, there is an inevitable impact on economic growth. A paper published last year by economists Kenneth Rogoff of Harvard and Yuanchen Yang of the PBOC School of Finance found that a 20% fall in the housing sector and related activities could lead to a roughly 5-10% decline in the level of economic output. At the moment China is nearly double that estimate with property activities approximately 50% weaker than the 2018-2019 trend. If they stabilize at these levels or even slightly improve, it still implies a significant drag on economic output.
Another way to look at it is to compare previous examples and examine the actual growth impact on a cross-country basis. Using credit-fueled construction booms as the baseline for comparison, of the 25 countries that experienced credit growth of over 40 percentage points (pps) in a five-year period, all experienced a significant growth slowdown. On average, the annual economic growth rate fell from 5.2% to 1.4%. Some of the largest percentage point increases in credit share over a five-year period aligned with some of the heaviest hard landings. For example, Japan (1973) and Malaysia (1997) saw a 52pps increase in their credit shares and Thailand (1996) saw a 49pps rise. Because credit was used to finance construction and investment to promote economic growth, the subsequent process of necessary deleveraging entailed significant contractions in GDP growth. The countries that experienced credit-to-GDP ratios rise by more than 60pps, suffered a more significant slowdown, seeing growth drop from an average of 6% to 0.2%.
China’s credit as share of GDP has been growing at 40% or higher over a rolling 5 year period consistently since the global financial crisis with a peak increase of 76% between 2012 and 2017. Only recently has the pace of leverage started to slow, suggesting the slowing growth China is witnessing is weaker activity resulting from the necessary deleveraging.
While the historical context does not paint a pretty picture, it is how policymakers manage impact of the housing market correction that could determine the growth path for the next few years. We view the economic impact of a slowing property sector through three lens.
- Direct impact to the economy due to slower sales, less construction and less land sales revenues. These directly impact employment, with real estate and construction accounting for around 15-20% of urban employment, and local government revenues, where land sales account for 35% of local government fiscal revenue. This direct employment and revenue impact affects consumption, as well as the government’s ability to offset the slowdown through infrastructure spending.
- The indirect impact on up and downstream industries, such as white goods, furniture, construction materials etc.
- The impact through the confidence and financial market channels. The direct impact of the housing market slump is ongoing but much of it is behind us – after all property construction has been slowing for over two years at this point. The second degree impact is still playing out, and will likely continue to be a drag on growth in 2024. The third level impact is ongoing. News that another big developer is moving towards default could dampen household and business confidence. Media have reported that trust products that are tied to the property sectors have missed coupons. Local government financing vehicles are also tied to property-related projects on both sides of the balance sheet. Our view is that financial stability is likely the bottom line that policymakers will try to defend. Timely actions to arrest any significant contagion will likely help to insulate the rest of the economy. Nonetheless this drag from a shrinking property sector, similar to past examples, will likely create a structural drag on growth over coming quarters. How policies adapt can determine the limit of contagion and financial sector fallout.
Equities are still a trading market in the near term
We have been emphasizing the importance of trading the range in the near-term (3-6 months) due to a lack of clarity on the policy response and implementation. Property market weakness is and will likely continue to impact Chinese equities via two main channels—corporate earnings and equity valuations. As a result of these impacts, in addition to a much weaker currency trend (CNH has already fallen 6% in Q2 alone), we have lowered our earnings forecast and index outlook. We revise down our 2023/24E MSCI China EPS estimates by 13-16%, mostly to factor in weaker macro growth and RMB weakness. This leads us to lower our MSCI China mid-2024 index outlook to 67 (from 80), which implies a 10.8x 2024E P/E. Our CSI300 outlook is also revised to 4250 (from 4800) implying 11.7x 2024E P/E.
Until we see a significant increase in earnings and policy visibility, trading the range remains a key strategy. We set our new trading range at 55-67 for MSCI China, 3600-4250 for CSI300, and 17,000-21,000 for the Hang Seng Index. The upper range will likely be determined by the scale and implementation of the policy response, earnings recovery trajectory, and improvement in international sentiment. The lower range is still well supported by undemanding valuations (-1 standard deviation for onshore and offshore) and a resilient (though delayed) earnings recovery path. We forecast MSCI China earnings per share to grow at 16%/11% for 2023/24E. Every now and then, hopes grow on the back of news about stimulus details that could send the markets higher, but it may not be sustainable if not accompanied by follow-through implementation. Thus, volatility is expected to remain elevated, and using structured products is a key way to monetize these moves.
The overall China beta environment has become increasingly challenging, with select sectors suffering massive earnings downgrades and elevated equity risk premiums. Not only is the healthcare sector undergoing one of the biggest regulatory storms in history, but other property-related sectors (such as property developers, management service companies, basic material suppliers, banks, trust companies etc.) are also facing contagion risk from the slowdown. Stock selection has become increasingly important under current market conditions. We prefer stocks that are unrelated to the property supply chain and have high earnings visibility, low regulatory risks and strong balance sheets that are well-positioned to benefit from the ongoing consumption recovery. This would lead us to focus on the following themes: 1) the China consumer recovery; 2) China SOEs, and 3) Asian high dividend payers. We would continue to avoid property, banks, healthcare and electric vehicles.
Staying safe in credit
Responding to the property developer Country Garden’s abrupt credit event, investors’ risk sentiment on China turned materially weaker, resulting in China high yield (HY) names and high beta China investment grade (IG) names hitting year-to-date (YTD) lows. China IG posted a -1.34% month-to-date (MTD) return and +1.94% YTD return, while China HY posted a -7.64% MTD return and -20.69% YTD return. Spreads in Chinese credit have widened by 47bps MTD and 96bps YTD to 441bps, while the lowest level this year was seen in February at 298bps. Given the volatile market conditions, investors will likely want to position in a very safe and defensive way. Valuations have cheapened but spreads can widen further if sentiment stays weak and the policy response remains muted. We recommend remaining in high-quality IG and staying cautious on HY.
We continue to stay constructive on the following credit sectors:
- Central government state-owned enterprises (SOE) with strong business profiles, good access to onshore funding channels and government support.
- Investment grade TMT (technology, media, and telecom) companies with strong cash flow generation abilities, stable earnings, and very solid balance sheets. For lower-rated companies, prices would be more volatile in a weaker market but we see the valuations (all-in yield of ~7%) as attractive.
- Financials, although valuations are rich.
- Macau Gaming – high frequency data in Macau continues to point to a robust recovery.
We are cautious on industrials, local government financing vehicles, asset management companies, and the property sector.
Remain bearish on the RMB
We remain bearish on the currency and encourage investors to hedge. Weakness in the currency looks set to continue given 1) further rate cuts from the PBOC are likely, which keeps the negative carry against USD in place; 2) macro headwinds as China’s recovery remains bumpy with tail risks of a messy unwind of property developers’ liquidity crunch; 3) continued balance of payment challenges with weak exports and the resumption of outbound tourism.
While the PBOC has ramped up intervention lately, the measures remain mild and largely aim to smooth out one-sided volatility. While China has the capability to carry out forceful measures to temporarily reverse the depreciation trend (i.e. SAFE/PBOC to sell official reserves), it is very costly when fundamentals are not helping, and authorities have refrained from that since 2017. Given the macro backdrop at the moment, policymakers’ tolerance for the currency to gradually weaken could be relatively high as it helps ease domestic financial conditions.
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