China Mid-year Outlook 2024: Waiting for policy

What we think

This July there are two important meetings in China that may provide further insight into the macro outlook: the Third Plenum and the Politburo meeting. The two policy areas we’ll closely watch are domestic demand and fiscal reform. The economy appears to be at an inflection point. The resilience of the manufacturing sector is a bright spot, while other parts of the economy look mixed, but could start to improve.

Investment implications

We retain a relatively cautious view on offshore China markets. The downside is limited, but the upside is capped by a mixed macro backdrop and earnings that have yet to show meaningful upside. We expect the A-share market to be relatively more resilient thanks to lower exposure to geopolitical risks (and foreign outflows), limited FX impact, and its ability to more directly benefit from the government’s supportive policies. The risk of escalating trade tensions with the U.S. and Europe could weigh on the Chinese yuan (CNH). Investors may consider hedging long CNH exposure, taking advantage of the carry, or using the currency as a funder for taking advantage of opportunities elsewhere.

A mid-year check-in

China has been in a different economic cycle to the rest of the world. Over the last few years the economy has been under pressure from a historic housing downturn, but coming into 2024 some promising signs have started to emerge. In particular, outperformance in the manufacturing sector has contributed to economic stability and improved the growth outlook. High-end manufacturing such as electric vehicles, industrial automation, digitalization, together with supply chains are all growing at a fast pace. While these higher value-add sectors are a decade in the making, they are now having a bigger impact on the macro cycle.

Elsewhere, after two years of deceleration, a range of indicators are looking more mixed. This could be a sign of a bottoming out from a cyclical perspective (retail sales surprised a bit on the upside in May). While the overall state of consumption is weak, and “consumption downgrade” is still a clear theme, volume growth is staying resilient. Purchasing Managers’ Indexes (PMI) are still diverging – but with more cyclical components bottoming out. Exports have started to do better. In the housing market, we think policymakers are now more focused on preventing further slowdown. While structurally slower growth in the housing sector is still our base case, stability and marginal improvement are good news for the rest of the economy. So taken together, we think the economic cycle may be at an inflection point, but we will likely need more data to be sure.  

Looking ahead to the Third Plenum

This July there are two important meetings in China that may provide further insight into the macro outlook: the Third Plenum and the Politburo meeting. Historically the Third Plenum has served as a forum for high-level decisions on economic issues, specifically around long-term institutional reforms. Broadly we expect this Third Plenum to reiterate existing priorities rather than change the existing framework. As the Third Plenum focuses on reforms, we can expect a reiteration of the long-term goal to transition to an innovation-led economy. In addition, the two policy areas we’ll closely watch are domestic demand and fiscal reform.

On supporting domestic demand – the focus will likely be on building the national market, rural-urban integration, household registration and social security reform. As China has already reached a 65% urbanization rate, at least on the headline level, the next phase will likely be more focused on redistribution – for example, broadening the access to social services and the social safety net, improving support for lower income families, alongside a further relaxation of household registration policies and the pension system.

On fiscal reform, we expect various topics such as revenue sources, spending priorities and redistribution to be discussed. The current policy design dates back to the 1990s when China was at a very different developmental stage. Given the changing nature of the economy such as digitalization, an ageing population, and a transition from housing to manufacturing upgrades, major reforms are likely. For example, local governments may need a greater share of tax revenue and more options to monetize state assets, even if the central government balance sheet expansion will likely have to do the heavy lifting in the short-term. There may also be discussions to re-direct fiscal spending from investments to social security spending, alongside some pension reforms. Lastly, value-added tax (VAT) codes still need fine-tuning, so investors may expect further consumption tax and individual income tax changes to be delayed until then.

Meanwhile, the Politburo meeting (also slated for July) will likely be more focused on near-term policymaking. In recent months there has been a shift to macro policies focusing on the demand side. We think further policy measures are likely coming to stabilize the property sector, support the equipment renewal/upgrade cycle and reform capital markets to encourage innovation. In the property sector, following the destocking policy in mid-May we have observed some signs that the pace of contraction has started to ease, led by a marginal improvement in Tier 1 and 2 cities. We think further policy support measures are likely to expand on existing schemes.

On monetary policy, the PBoC has recently pushed back expectations for a China-style quantitative easing (QE) campaign. Overall, we think monetary policy will likely stay accommodative, with targeted easing more likely than aggressive broad-based stimulus.  

Implications for macro and markets

We think the Third Plenum and Politburo meetings are likely to be both modestly growth-positive. The Third Plenum’s focus on improving domestic demand through reforms is potentially helpful for supporting income and consumption growth, though we continue to stress that actions matter more than words. A restatement of pro-market or pro-reform policies is welcomed, but the gap between talk and action has been a source of disappointment. Reforms to fiscal policy are more about making economic growth more sustainable over the medium-term. Meanwhile, the Politburo meeting will likely reinforce the earlier policy shift, with a bigger focus on stabilizing the housing sector and private sector confidence.

In this cycle, policymakers have largely abstained from conventional stimulus, and are instead focusing more on allowing the economy to find a more sustainable pace of growth, as key drivers shift away from housing. Compared with conventional stimulus like the multi-trillion-RMB infrastructure spending in 2008, or direct housing market rescues in 2015, policy measures are slower and more indirect in terms of impact. Therefore, it’s important to watch implementation as well as the results by closely examining  economic data and micro and macro developments.

The economy appears to be at an inflection point. The resilience of the manufacturing sector is a bright spot, while other parts of the economy look mixed, but could start to improve. Whether these new growth drivers create more broad-based economic benefits would be interesting to see. At a time when the economy is going through major structural transitions, such as a secular decline in the housing sector – as well as entrenched geopolitical tensions – manufacturing upgrades could play a role in stabilizing business confidence.

Economic imbalances and the risk of trade tensions

A key feature of China’s growth in advanced manufacturing has been the continued divergence between supply and demand. The growth in manufacturing capacity and production, largely driven by external demand has been a key driver of growth. But this reliance on external demand also sets the economy up to be more vulnerable to trade tensions.

On the surface, exports’ contribution to GDP growth has been small in recent quarters, subtracting 0.2pp in Q423 and adding 0.8pp in Q123 year-over-year real GDP growth. However, the headline statistics understate exports’ importance to China’s economy. For example, looking at domestic value-added (DVA) content of Chinese exports, exports accounted for 19% of China’s total DVA, and real export growth contributed 2.4pp of the 5.3% y/y real GDP growth in Q1. If the spillovers from export-related manufacturing activity to manufacturing investment were taken into consideration, then it’s likely that more than half of the 5.3% y/y real GDP growth was driven by exports. It is fair to say that exports have been the largest driver of Chinese growth this year, while domestic demand growth has been weak underneath the solid headline growth number.

Whether you’re looking at capacity utilization, the gap between production and demand, or simply China’s net manufactured goods exports it’s clear that the focus on manufacturing upgrade is adding capacity that isn’t matched by growth in domestic demand. Trade tensions with Europe has been rising as a result, and with the U.S. election campaign starting to heat up, the risk of trade restrictions on Chinese exports becomes a more acute risk. We have addressed some of implications of these trade tensions.

FX implications

We continue to expect depreciation pressure on the Chinese yuan (CNH). For the currency to reverse its current weakening trend, several conditions need to be met: 1) a meaningful improvement in the domestic economy that improves sentiment and triggers a reversal of capital outflows; 2) a reduction in trade tensions and/or a strong rebound in global exports; 3) a marked decline in global interest rates to offset the carry disadvantage.

On the first and second points, the risk of escalating trade tensions with the U.S. and Europe could increasingly weigh on the currency as we approach the U.S. elections – a factor that appears to be underpriced at the moment. Recent currency weakness has occurred amid a strong exports backdrop, which highlights how impactful the other forces – notably capital outflows – have been. It also emphasizes the outsized risk to the currency from a trade downturn, either driven by tariffs or weaker global demand.

In addition, it could take some time for incremental improvements in certain sectors of the economy to translate into a more meaningful boost in overall China sentiment. Before that happens, the prospects for sustained capital inflows remain uncertain.

As for the third point, our baseline scenario for the Federal Reserve suggests that U.S. rate cuts are unlikely to commence until the tail-end of this year and into 2025, and even then, they will likely proceed at a gradual pace. Consequently, the CNH is expected to remain a funding currency for an extended period.

Thus, investors may consider hedging long CNH exposure and taking advantage of the carry. In addition, a weak and low-yielding CNH also opens the door for using the currency as a funder for taking advantage of opportunities elsewhere.

Equity market outlook

We retain a relatively cautious view on offshore China markets. The downside to equity markets is likely limited, but the upside is capped by a mixed macro backdrop and earnings that have yet to show meaningful upside. Low expectations heading into the Third Plenum could offer a short term bounce, but the sustainability of such a move is likely to be short-lived. We believe a structural improvement in real estate, employment and consumer spending is needed to drive a more sustainable turnaround in China equity markets. Before that happens, we would continue to expect HSI and MSCI China to trade range-bound. We believe opportunities can be found in high-dividend state-owned enterprises, and consider buying pullbacks in the communication services sector.

Meanwhile, we expect the onshore A-share market to be relatively more resilient and less volatile, thanks to its lower exposure to geopolitical risks (and foreign outflows), limited FX impact, and its ability to more directly benefit from the government’s supportive policies in the capital market. That being said, the recent crackdown on the financial sector in China has also dampened sentiment in the A-share market.

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