Author: Asia Investment Strategy Team
Cross Asset Strategy
February was an eventful month for markets. The Fed slowed the pace of hiking to 25bps at the start of the month, signaling an exit from the “crisis tightening model”, however it was followed by a sharp repricing of terminal rates from 4.8% to 5.5% on stronger-than-expected economic data. U.S. Treasury yields surged across the curve with the 2-year jumping +59bps and 10-year up +43bps during the month (both the largest increases since September), sending equities lower and the dollar higher. The pressure extended into this week and the S&P 500 finished February below the 4,000 mark.
Taking into account the latest development, we now expect the Fed to hike to a terminal rate of 5.0% - 5.25%, and finishing the year at 4.50% - 4.75% with cuts coming in Q4 2023. If economic data continues to surprise to the upside, the probability of cuts shifting to Q1 2024 could grow higher. We still expect tight conditions to cause a recession within the year, which could eventually send long-end yields lower (we think the 10-year will likely end the year around 2.85%). At the current level, core fixed income remains high conviction as it provides attractive yields and protection during downturns.
In China, equities went into consolidation over the past weeks after a sharp rebound following reopening. This week, all eyes are on the annual Two Sessions, and the expectation that more guidance on policy direction may come. Read on for a deep dive on what to expect.
Strategy Question: Will China’s “Two Sessions” be a turning point?
China’s National Party Congress (NPC) and the Chinese People's Political Consultative Conference (CPPCC and also known as the Two Sessions) kick off this weekend and will likely last until March 20. Over the course of these meetings the government will set major economic targets and lay out key priorities and reform initiatives.
Some of the key questions likely to be addressed include: What will be the GDP growth target? Will the government jump-start market-oriented reforms? Will speeches address the concerns of foreign businesses? And importantly, how will the government look to revive consumer confidence? In today’s note we assess how China’s recovery is progressing, while reiterating our views on the economy and markets. We’ll also preview what to expect at the Two Sessions and follow up in coming weeks with key takeaways.
After a rapid normalization catalyzed by re-opening policies, we expect China’s economy to recover more gradually in the coming months. While there is pent up demand, as well as excess savings, there is also considerable slack in the labor market (see chart below), as well as the overall economy. Sectors with secular tailwinds, for example consumer services and industrial sectors, will likely recover faster than others, such as the property sector. But from a broader point of view, it will likely take a few quarters for the economy to return to a higher overall utilization rate and kick off a virtuous cycle of economic growth. Policies will likely turn more supportive under the new economic leadership. We expect 2023 GDP growth to average 4.0%, and improve further to 4.9% in 2024. We are below consensus largely because we see a significant drag from weaker exports, as well as a still sluggish housing recovery. The three key factors – exports, consumption, and property – will likely be the key to China’s recovery. If global demand is stronger than we expect, or property sector confidence rebounds more quickly, then there is upside to our forecasts. On the other hand, if consumption underperforms then it will be a challenge for the economy to reach government targets. The tone set at the Two Sessions and the extent private sector confidence can be restored will be the factors to watch.
SLACK REMAINS IN THE LABOR MARKET
THE GAP BETWEEN PRODUCTION AND CONSUMPTION INDICATES SLACK IN THE ECONOMY AND IT TAKES TIME TO RETURN TO A HIGHER OVERALL UTILIZATION
Index 2019 = 100
On the consumption front, high frequency indicators point to a swift rebound in consumer sentiment. Services consumption, like restaurants and domestic tourism, have all bounced off the lows. We expect the recovery in services consumption to continue in the coming months. In contrast with seemingly strong tendencies towards spending on services, goods spending growth looks more moderate. Auto sales, for example, were down 30% y/y in January, and were only recovering slowly in February, partly due to the phase-out of buyer subsidies. We expect the overall consumption recovery will slow to a more moderate pace of growth in line with income growth in 2023. We expect headline retail sales to grow 7% in 2023, up from 1% in 2022 but slower than the 9% pre-pandemic due to the drag from housing-related big ticket items.
The restricted mobility brought on by the pandemic has meant that consumers have RMB15trn more in savings than pre-pandemic. Estimates of how much of this is “excess savings” will be imprecise, but our guess is that it’s around RMB4-5trn. While some will be drawn down this year and spent on holidays, we think a lot will only be spent over time. This is partly because a lot of the savings arise from deferred home purchases, which is not easily redirected, at least in the near term. More importantly, in China, consumer sentiment is cyclical, just like business sentiment. After several years of significant upheavals in the economy, such as the trade war, Covid restrictions, and the property market downturn, households are likely going to be more focused on job security, and income, in the near term. As the economic recovery makes further headway, and income prospects improve, households will likely feel comfortable to gradually draw down the rest of their excess savings in the coming quarters.
WE EXPECT CHINA’S ECONOMY TO RECOVER MORE GRADUALLY IN THE COMING MONTHS AS A MORE THOROUGH RECOVERY WILL REQUIRE A REBOUND IN HOUSEHOLD CONFIDENCE
PBoC household survey, diffusion index
In regards to the corporate sector, anecdotal evidence suggests that production normalization has been swift after the holidays. That said, in the backdrop, global demand has been slowing at a rapid pace (see below chart). For example, export figures from China and other East Asian economies, which tend to act as bellwethers for global demand, have shown a very sharp decline. Korean exports were down 7.5% y/y, in February following a 16.6% decline in January. Similarly, indicators of Chinese exports all showed weakness to start the year. The China Containerized Freight Index, which measures the average shipping price of containers from China’s 10 major ports to other parts of the world, declined by 13.9% from end-December to mid-February, while the Freightos Baltic Index, a measure of international freight rates, dropped by 11.3% over the same period. In addition to an expected global downturn, many global consumers are continuing the shift from goods and towards services spending, which is exacerbating the Asia export slowdown.
The late cycle global downturn will likely constrain capex plans in the near term. Meanwhile, property developers are still paying down their debt, and are likely still a few quarters away from fresh Capex activity. In the property sector, confidence is key. Despite looser measures over recent months, sales and activity haven’t bounced back. This stems from key concerns around price expectations and developers’ ability to deliver properties. With lingering concerns about unfinished properties, and prices that remain sky high in many cities, would-be purchasers are largely staying on the sidelines. It’s unclear whether “animal spirits” will return to the sector, but our sense is that the overhang of still-high prices, excess inventory, and shaky developers will take some time to normalize and continue to be a drag on overall economic activity.
EXPORTS WILL LIKELY BE A SIGNIFICANT DRAG TO GROWTH THIS YEAR
China export growth, %
As the Two Sessions unfold a lot of focus will be on the new economic leadership. Transition does not occur in a day, but rather spans the whole year, as the incoming ministers and governors get acquainted with their tasks at hand, and develop new policy initiatives. The Two Sessions is the beginning, rather than the end, of the personnel transition. In the near term, the key focus will be the government work report, annual budget, as well as press conferences. We think this year’s policy focus will likely be on supporting the post-pandemic growth recovery, and the language around the GDP target will send an important signal. A positive message will likely be welcomed, although we are not expecting an outsized stimulus. On the fiscal side, while the pandemic has been quite costly from a fiscal perspective, we expect the government to maintain most of the fiscal support, such as local government bond quotas, and support for small and medium-sized businesses. Adding the two main fiscal books together, this may translate into an overall fiscal deficit of around 6-7% of GDP, (similar to 2022), with spending focused more on infrastructure necessary for the green transition and industrial upgrading. On the monetary policy side, the PBoC will likely look through some post-pandemic price increases and even lean accommodative by encouraging banks to do more business lending. The new PBoC governor will also be announced alongside the cabinet. In recent years, policy coordination has become a big focus and we may see some institutional change to improve this.
In addition, foreign investors will likely be particularly interested in how the new economic leadership approaches sector regulations, after some big policy-induced adjustments over the last few years – first with the internet, and then with the property sector. While major adjustments such as those are probably behind us, we expect to see signals of policy stability ahead. That said, the attention will turn to policies around economic restructuring, and particularly the interaction between the government and private sector. In recent years increased government involvement in the economy has driven productivity, and in some direct cases, return on investment lower. Speeches during the Two Sessions will give key insight into how the new economic leadership team plans to address stalled economic reforms and the broad operating environment.
Geopolitical tensions could continue to be a wild card, but the NPC could potentially set the tone on what to expect. Increasingly, investors are learning to accept that geopolitics is part of the new normal when seeking returns. While geopolitics are impossible to predict (and the market impact is even harder to predict), the one area where we could see a continued impact is on the global flow of capital. An easing of U.S. tensions and clear signs of economic re-opening drove sharp inflows at the start of the year, but as events unfolded in recent weeks there are signs that global capital has turned more cautious. If the U.S. measures move to restrict capital flows into China or worsening tensions turn investors more cautious, geopolitics could continue to play a role in global sentiment, and also have an impact on China’s recovery.
From an investment perspective, the RMB will likely be influenced by broad USD directions in the near term. We think the RMB will likely remain range bound against the dollar from here, despite screening relatively rich versus a basket of currencies due to balance of payment pressure. Given the uptick in both onshore and offshore bond yields, we also see some select opportunities in the fixed income space, with some FX overlay to boost returns.
On equities, we are positive on outbound consumption / brokers / oil / renewable energy, and cautious on property / banks / EVs / exports. From the Two Sessions we expect more policy stimulus for green energy (positive for renewable companies); financial market reform will be re-emphasized and probably accelerated (positive for brokers); banks will be encouraged to promote lending, likely at the expense of higher bad debt / lower margin (negative for banks). Markets have currently priced in low expectation in policy support to the internet sector, so any surprises are likely on the upside. The oil sector may not be a focus in the NPC, but this sector remains under-allocated, with a decent dividend yield of 10%+. A faster-than-expected China economic recovery may provide upside to oil prices.
CHINA EQUITIES: SECTOR PREFERENCE
Fundamentally we are cautious on export-related sectors given the uncertain outlook. On the other hand, consumption sectors, especially service sectors like restaurants and households, will likely continue to rebound. Nonetheless, most of the short-term positives are priced in regarding the consumption rebound, so we prefer to wait for a dip to add to this sector. The outbound tourism-related sector remains our preferred consumption proxy. The outlook for big ticket items like auto and housing remains challenging given the lack of consumer confidence, so excess savings will likely stay in the consumer’s bank account in the next few months. Although potentially nearing a bottom, property sales remain sluggish, hence we only suggest tactically buying selected high-quality privately owned developers with strong balance sheets, while staying cautious on distressed developers.
We are particularly cautious on the electric vehicle sector given the increasingly competitive industry landscape since Q4 2022 and the lack of funding sources from the capital market (or at much higher interest expense). A price war has already started and most of the smaller EV companies will face huge margin pressure, with the breakeven timetable prolonged (if they can survive this round). On the other hand, we are increasingly positive on the renewable sector as share prices have corrected meaningfully in the past few months, making their valuation attractive again, especially versus the broader market.
We expect China onshore to outperform offshore from here. Traditionally onshore China shares outperform offshore China in a policy-driven market rally1, which is likely the case in 2023. Onshore equity investors currently remain relatively calm and do not have high allocation to the A-share markets.2 If business and consumer confidence continue to recover over the next few months, we expect higher onshore participation as the IPO reform (i.e. New Registration System) and SOE reforms help to reshape China’s onshore equity market. Meanwhile, MSCI China inclusion provides longer term liquidity support.
Recent consolidation provides an appealing re-entry opportunity. The post-Chinese New Year consolidation in February is largely within our expectation, given the 50%+ sharp rebound in MSCI China / Hang Seng Index since last October. We take this as an attractive re-entry opportunity. Our year-end outlook is unchanged at 23000-24500 / 75-80. We overweight China (both onshore and offshore) as the macro and earnings recovery story remain intact. China onshore is expected to outperform offshore shares given its higher leverage towards policy stimulus, and stronger resilience in the case of intensifying geopolitical tension. The recent consolidation in A-shares is an opportunity to add exposure. We are confident that the upcoming reporting season in March/April, together with more fund inflows, will likely lead the second stage of a China market rebound in Q2.
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Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.
The MSCI China Index captures large and mid cap representation across China A-shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 740 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A-shares represented at 20% of their free float adjusted market capitalization.
The CSI 300 is a capitalization-weighted stock market index designed to replicate the performance of the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange.