Why is China’s recovery stalling?

Market Recap

This week saw significant moves across asset classes as investors reacted to the jump in U.S. interest rates. Driven by intensive Treasury auctions, strong U.S. macro data and hawkish Fed minutes, 10-year U.S. Treasury yields broke above the highs in November last year, while the 2-year again touched the 5% level. Risk sentiment was also dragged by financial turmoil in Argentina and volatile newsflow from China (read on for more). Equities around the world sold off, and the dollar gained against most key currencies. Gold and crude oil both retreated.

Strong U.S. macro data has been a key focus of late. July retail sales data surprised to the upside – and expectations were already firm. The housing sector is showing more signs of recovery with robust growth in new starts. Manufacturing stabilized with industrial production growth turning positive. The fact that consumer goods spending is able to remain solid while the disinflationary trend continues in the face of higher interest rates is one key reason for us anticipating a softer landing ahead. We may be able to see analyst upgrades of U.S. GDP on the back of this slew of strong data, but having said that, it could have limited impact on Fed expectations (we think the July hike was the last one). The next CPI and jobs report will be the key to watch.

Strategy Question: Why is China’s recovery stalling?

Investor concerns around China’s economy have recently intensified. A stream of weaker-than-expected economic data and looming financial stress for one of the country’s largest developers is causing growth concerns to rise. Meanwhile, a pro-growth tone from the Chinese Politburo was not followed up with much in the way of actual policy support. These developments are all challenging market narratives, particularly as consensus growth expectations are still above 5%. While we have had very conservative and below-consensus assumptions for China this year, the speed at which bad news is colliding is still a surprise. There is likely more policy support on the way, and there are parts of the economy that are still growing, such as services. Nonetheless, for growth to improve the housing sector will need to stabilize. The shift in market sentiment and near-term volatility warrant a tactical mindset until we have more clarity on the macro and policy front.

In July, the Chinese economy clearly lost some growth momentum. Economic activity data suggests a modest slowdown across consumption, investment and exports. These were weaker than consensus expectations for sequential improvement. While there were certainly some bright spots – such as transportation and services – overall the recovery is running into greater headwinds over the month. In particular, consumers held back on goods spending, particularly for big ticket items. July investment growth slowed further to merely 1.2% from 3.1%. Manufacturing and infrastructure investment are holding up better at 4-5% y-o-y, but both have also eased. The main culprit was likely the housing sector, which continued to weaken in July. By volume new housing sales are down 25% y-o-y, and construction is down nearly 30% y-o-y. In addition, daily housing sales in August are pointing to further weakness. 

From a bigger picture perspective, the property sector is the key economic factor – and it continues to weaken. After a sequential growth slowdown in Q2, the market consensus is generally for improvement in the second half of the year. So the miss in the July data, albeit small, was consequential enough to lead to more downward growth revisions over the last few days. We have expected a disappointing outcome, but the overall shift in sentiment is still a surprise. This is likely because of other events that are also taking place.

Notably, another big developer is facing financial stress. Unlike some of its peers, Country Garden bonds were still rated Investment Grade until a few weeks ago. And although there is widespread understanding that the company’s existing business focus on lower-tier cities will likely have to shift in the coming years, most newsflow suggested plans are in place to meet the upcoming liabilities. So when the company missed coupon and announced that restructuring discussions were taking place, investors were surprised. There are also trust products that are missing coupons, causing volatility in the onshore markets.

The financial market was therefore already in a more jittery mood. We are likely keeping overall growth assumptions for this year (4.3%) and next year (4.7%), but the July numbers may imply downside risks.*  Even before the distressed trust products hit the headlines, we have been quite selective on financial sector exposures. Overall banking sector exposure to direct loans is not large, although this becomes bigger after adding up indirect exposure through mortgages, as well as local governments. As property as well as related parties go through restructuring, the financial sector will likely see compressed margins and higher provisions in general. That said, regulators will likely allow banks to raise capital, and also release required reserves to help mitigate the impact.

The Politburo meeting in late July adopted a pro-growth tone. As a result, investors expected policy actions that will help to stabilize the housing market, or even further boost demand. But there has been surprisingly slow follow-through over the last two and half weeks. Our view is that more policy easing IS likely. Given speculative demand for housing – a key policy concern in past years – is largely gone, restrictions on mortgage, purchase, or even guidance on prices and volume will likely be phased out. Interest rates on existing mortgages may be allowed to converge towards a lower policy rate. These could go a long way towards stabilizing the housing market if deployed in the right way. In comparison, we would put less emphasis on traditional monetary policy. The People’s Bank of China cut rates by 10-15bps on Tuesday, and market pricing suggests more cuts – albeit modest – are likely. There is widespread recognition that the issue lies with credit spread, not the risk-free rate.

It's been a very volatile week for Chinese assets. Concerns over slower growth are compounded by worries that the property market is not stabilizing, but rather decelerating further. Meanwhile, the pace of policies being rolled out has not been ideal. Until things change, market sentiment and positioning will likely stay challenged. We have had very conservative assumptions this year – anticipating a gradual recovery and no big stimulus – and we’ve been more tactical in our approaches to equities, fixed income and FX. We have been underweight cyclical sectors such as property and financial, and have stayed very high up in the quality of fixed income. On FX, we think it’s worth considering hedging CNH exposure and/or using it as a funding currency. Until market sentiment stabilizes, a conservative position and a tactical mindset will likely continue to be appropriate. 

*PB Outlook figures shown are the midpoint of our view with a range of +/-10 basis points.

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