After a short relief rally earlier in the week, Wednesday saw another large sell-off in U.S equities. Fears are rising that stubbornly high inflation may force the Fed to hike the economy into recession. As some signs point to cooling inflation, worries are now turning to whether the Fed will hike too much in the face of already slowing growth. While macro data out of the U.S. still points to healthy consumers and strong industrial activities, tighter financial conditions continued to pressure on equity valuations. On the commodities front, Oil retreated to $110/barrel on growth concerns, and gold continued to weaken due to dollar strength.
Sovereign bonds also saw some big moves across regions. Fed Chair Powell stated at a press event that they “won’t hesitate” to hike rates above neutral levels if needed. An ECB official also hinted of a 50bps hike in July, which is larger than suggested in previous communications. The hawkish comments drove up U.S. 2-year yields (+12bps), the 10-year (+10bps), and short-end European yields. The Euro is volatile with EURUSD breaking 1.05, a key psychological level.
In our view, volatility and uncertainty will remain acutely high for some time under the current macro backdrop. Risk assets have priced in a 30-60% recession probability (depending on which part of the market you’re looking at), and will likely still remain choppy in the near term. Though we still believe the Fed is able to engineer a soft landing in growth, risk management is a high priority for investors. We’ve been advocating for increasing allocation to core fixed income for some time, and the case has become more clear recently – U.S. IG is showing signs of bottoming, and the negative correlation between equities and bonds, after being absent for months, is hinting at a comeback.
Strategy question: Can China avoid a recession?
China’s April data highlighted the severe impact of lockdowns, marking the biggest downturn in growth since the initial Covid outbreak. While the data came in weaker than expectations, the direction of economic growth was of little surprise. What is more important is what the policy response to this will be.
So far the stimulus response to weaker growth has been restrained by the broad policy priorities around debt, real estate and Covid-19. What matters is the extent to which these policies are being adjusted. There have been some signs of movement on this front, with the PBOC indicating that leverage ratios could rise this year to support growth, and then following this up with a 20bp cut to mortgage rates. April fiscal stimulus also increased.
However, these adjustments fall well short of the stimulus measures that the Chinese economy needs. Macroeconomic confidence in China has now deteriorated to the point where what is required is not a loosening around the edges of these broad policy priorities, but wholesale policy U-turns. One stark indication of how poor household and business sentiment is at present – and how ineffective this renders any marginal loosening in policy – is the fact that bank lending to the economy (i.e. total outstanding value of bank loans excluding bill financing) in April fell to the lowest level since 2008, even as policymakers have moved to gradually ease lending rates. Supportive rhetoric on the economy has been ramping up, but the credit data and property numbers show there’s still no impact on the real economy.
In this note, we first review China's recent economic performance. The latest data release suggests that China's growth may be negative in Q2, which is prompting us to revise our 2022 growth outlook down to 3.9%. Next, we look at why China needs much larger stimulus, not just to avoid recession, but also to prevent systemic risks. Last, we explore the government's policy options on three fronts of Covid, fiscal and monetary.
Chinese growth turned negative in April
- Consumption shows a deep downturn. Headline retail sales were down -11.1% yoy, within which catering services tumbled -22.7% yoy.
- The urban unemployment rate rose further to 6.1% (vs 5.8% in March), the highest since the initial outbreak.
- Industrial production is down -3.2% yoy, the first negative record since March 2020, due to factory shutdowns and logistic disruptions in major production/commercial hubs.
- Export growth slowed significantly from the high teens to flattish, due to a combination of production disruptions domestically and a slowdown in external demand.
- Credit growth plunged with bank loans and social financing flows both slowed significantly due to 1) very weak medium/long term credit demand from corporates 2) contraction in household loans mostly due to the collapse in housing transactions.
As a result of the Q2 impact from current lockdowns, we are lowering our growth outlook for 2022 to 3.9%. That assumes no further lockdowns and significant stimulus in the second half of the year. To hit that number requires an annualized growth rate of nearly 12% in the second half of the year, highlighting the downside risks if there are additional lockdowns or underwhelming stimulus.
The economic situation in China has reached a point that is not just about higher or lower growth, but about preventing potential systemic risk events. Rebuilding confidence will need more than policies in the right direction. What is now needed is bold and determined policy commitments that could even go against some of the policymakers’ other objectives.
Vulnerabilities are building up under today's low-growth environment, and there are signs that risks are accumulating at a pace that is comparable to, or even faster than that of 2020. We have to acknowledge that the 2020 and 2021 rebound was driven in large part by global stimulus and the incredible surge in global exports (see above chart). That, however, is set to fade, and potentially fast – not only is global growth slowing, but the transition from spending on goods to services is well underway. This could turn China’s strongest tailwind into a headwind. This could also pose long-term risks --If supply chains remain impacted due to continued rolling lockdowns, manufacturers could begin to diversify and move supply chains to other locations.
Key risks emerging:
- The labor market. The official urban unemployment rate surged to 6.1% in April, just slightly off its 6.2% peak in February 2020. Yet, unlike in 2020 when the unemployment rate rapidly declined after lockdowns were lifted, today's jobs outlook is much more uncertain, with many companies still unsure if they can return to business as usual over the coming months. A key risk lies in unemployment among youth, which has been on an upward trend since 2019, and reached a historical high of 18.2% in April. This deteriorating jobs outlook, especially among young adults, could imply social costs if not dealt with in a timely manner.
- Financial stability. A prolonged and continued property downturn is emerging as a risk to financial stability. The property sector is large enough – constituting 20% of the economy, and 25% of bank loans– to cause systemic financial risks. While it is true that the majority of property sector loans are mortgages that have historically had few defaults, there is no guarantee that mortgage delinquency rates will always stay low amid a declining labor market.
What options does the government have?
Covid policy: While each risk area has a somewhat different set of causes, one common factor is the serious disruption from Covid outbreaks and lockdowns. Before policymakers can employ other policy tools, a workable solution will be needed to prevent further serious COVID-related disruptions. Unfortunately, as anyone paying attention would know, that’s not easy. And the answer is not simply to open up and “live with it.” In our view, that’s not an immediate option. There’s the issue of low vaccination rates among the elderly, low efficacy of existing vaccines, a fragile healthcare system outside of tier 1 cities, and a lengthy campaign that would be needed to shift the population’s mindset (and Beijing’s political objectives) away from Zero Covid. Furthermore, with a population still largely unexposed to Covid, a shift to “living with it” risks further outbreaks among unprepared populations that can carry the risk of overwhelming healthcare systems and seriously damaging business and consumer confidence.
The key is to stabilize business conditions without resorting to full-scale lockdowns, while limiting the health risks to the population. This would be difficult, but there are possible options: it could mean regular mass-testing, accelerating vaccine coverage, and securing adequate medical supplies. Building healthcare capacity will all need to be done simultaneously so that the population will be ready to open up in the not-so-distant future.
It’s important to stress, as we have many times over the last year, that as long as lockdowns are in place, other stimulus measures are rendered ineffective. And as long as the threat of future lockdowns persists, consumption and business investment will likely remain weak. In terms of timing, as current lockdowns ease, it will be July or August when stimulus and easing policies could start flowing through to the economy. In the meantime, cases could spike and things could get pushed back.
Fiscal policy. A total fiscal stimulus amounting to 6% of GDP was implemented in 2020. So far in 2022, the government has signaled a fiscal increase of 2.5% of GDP. More is needed. Given the downside risks, we would suggest a stimulus package that is at least comparable to (if not larger than) that of 2020 should be on the cards. Such a stimulus package would go against the government's long-term goal of reducing public debt levels, but that is likely an acceptable cost in order to restore growth.
One possibility is for the government to give more cash handouts and/or consumption coupons to consumers and small businesses, many of which are worse off compared to two years ago. There is ongoing domestic debate about the efficacy of such a policy, with some economists calling for their use, but policymakers have questioned if they are unsuitable for China due to the possibility of exacerbating inequality given the uneven development across regions.
Monetary policy. The PBoC's policy options have become more limited than they were two years ago, given higher debt levels, a rapidly hiking Fed, and still very high house prices. Large monetary easing is simply not on the cards due to the negative ramifications of higher debt, currency depreciation risks, plus the risk of exacerbating house prices. It’s a very difficult policy tightrope. First, given the sharp property downturn, the PBOC may want to reduce banks' exposure to the property sector. In this area there is some positive progress; banks' property exposure is now shrinking faster than it has at any time in the past. However, in order to prevent financial contagion from a property hard landing, the PBOC will likely need to do the opposite, by encouraging property lending similar to every previous round of stimulus. The 20bp cut in mortgage rates for first-time home buyers on Sunday was a first step, but more is needed. In 2014-2015, it took a 226bp cut in the effective mortgage rate to turn the property sector (although it was arguably too much and resulted in a large property boom in 2016-2017).
When will the turning point occur? Generally a policy turning point can only be identified in hindsight. What we can say is that despite supportive rhetoric, so far policymakers (and economic data) show little indication of delivering a more overt change in course. On the monetary policy side, there are no indications of an aggressive reduction in borrowing costs. The rate on the central bank’s one-year policy loan remained unchanged with this month’s injection of MLF funds. There is also no indication of a meaningful loosening in real estate or infrastructure policy to drive an increase in spending in these sectors. Policymakers are still signaling their desire to prevent an increase in home prices, meaning that investment demand for property will likely remain moribund. Infrastructure stimulus, meanwhile, continues to be constrained by the shortage of productive investments in this sector and Beijing’s continued refusal to green light spending on unnecessary projects that risk generating future bad debts.
If policymakers move away from their structural objectives around debt and the property sector and deliver more substantial stimulus, this could put a floor under home sales and lay the groundwork for a further increase in fiscal spending. But any increase in economic activity resulting from this may be swamped by the drag on growth from the continued weakness in other parts of the economy. The immediate impact from lockdowns will fade after restrictions are eased, but it is clear that this headwind is not going away.
While the overall policy position is certainly now more fluid, for as long as the government continues to put relief above stimulus, and defeating Covid above growth, the outlook for near-term growth will likely remain negative.
China equities: More patience is needed
Given our cautious near-term economic growth outlook, we believe the Q2 China equity market outlook remains challenging. Lockdown-induced supply chain disruption and imported inflation from higher commodity prices are all valid concerns that may lead to further earnings and margin deterioration in Q2 2022, which may delay the earnings recovery and re-opening timetable.
We believe the situation could get better in H2 2022 because 1) margin could start to bottom out (consistent with recent management guidance), and 2) there might be stronger policy support once current lockdowns ease. Investors in China onshore A Shares and offshore HK-listed shares need to have some patience (i.e. 6 months+ investment horizon) and should be prepared for the reality that the market may overshoot on the downside. In terms of sectors, we believe new infrastructure (e.g. renewables) offers the high visibility with one of the strongest policy tailwinds. In the near-term, we would not be surprised if the MSCI China/CSI300 re-test their mid-March/end-April lows, but we believe risk is skewed towards the upside by year-end, and we maintain our CSI300/MSCI China year-end outlook at 4,600-4,800/77-80.
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