Cross Asset Strategy
This week, the S&P 500 briefly touched 4,300 before falling off its high. The FOMC minutes released on Wednesday revealed that the committee is well-aware of the risk of overtightening as policy rates reached neutral levels. However, inflation is still a long way from the Fed’s two percent target, wage growth may stay sticky given the resilient labor market, and the broad-based risk asset rally has helped undo a decent amount of overall tightening – the combination of which may prompt the central bank to keep rates at restrictive levels “for some time”1. This is in line with our view that the risk/reward of equities from here looks less attractive and we prefer core bonds.
In Europe, stagflationary worries are top of mind. Eurozone Q2 GDP disappointed, suggesting slowing momentum across the continent. UK CPI hit 10.1% in July, the highest since 1982, and markets now expect the Bank of England (BOE) to double its policy rate by February next year. Overall we remain cautious on European assets, and see opportunities in select high quality bank papers providing attractive yields.
In Asia, offshore Chinese equities were pressured by risks in the property sector, sluggish earnings and concerns over tech regulations. This week’s Strategy Question is focused on one of the biggest challenges facing the Chinese economy…
Strategy Question: When will China’s housing market bottom?
China’s economy is showing signs of a hard landing. Mounting pain and losses in the real estate sector, a broad loss of confidence among consumers, and businesses putting investment on hold are causing a sharp drop in economic activity despite stimulus efforts aimed at boosting infrastructure investment. China’s post-Covid economy has been stuck in a very lopsided growth path, with exports the lone bright spot in a hark back to pre “rebalancing” days. With global growth set to turn weaker, and global consumers turning away from spending on goods towards services, this boost may soon fade.
We highlighted in our mid-year outlook that the path of recovery in China would be bumpy. After a relatively strong June boosted by supply chain resumptions and pent-up demand as lockdowns lifted, July economic data released early this week disappointed across the board. While the slowdown was broad-based, weakness centered in the service sector and the housing market. Service activities continued to be pressured by lingering Covid impact, and homebuyer confidence deteriorated due to the mortgage non-payment issue in July. As a result, housing sales weakened further (-28% y/y) after a brief rebound in June, and contracted sales data published by developers suggested a wider divergence between state-owned firms and private players. Housing investment continued to plummet (-12.1% y/y vs 9.7% in June).
In other words, the stimulus is still overly focused on the supply side rather than the demand side. Beijing has focused on boosting liquidity, lower rates, tax rebates, and improved logistics. This has worked to the extent that global demand has remained strong and China’s supply stimulus could deliver cheap exports. However, domestic demand has remained weak, causing most of the private sector to hold back. Until policy shifts towards treating this demand deficit, it’s hard to see a substantial turnaround any time soon.
An emerging crisis of confidence
The larger risk is a collapse in confidence that creates a further downward spiral. China’s economy has been buoyed by years of unabated confidence in the future. Consumers spent because they had faith that their future incomes would be higher, property sales soared on expectations prices would continue their unrelenting rise, and businesses invested on the view that growth was the top priority of the government and, crucially, that the government would step in whenever growth faltered. Guiding expectations with high-growth targets and bolstering confidence with regular rounds of stimulus provided the backdrop for continued growth. Despite the private sector taking up a larger and growing share of the economy, it was these signals from Beijing that guided the economic cycle.
And now these signals have shifted. Covid Zero has remained the clear priority of the government, and was just reaffirmed at the recent Politburo meetings. This policy impacts growth in two ways: first, rolling lockdowns are causing consumer confidence to plummet, pushing consumers towards reducing spending. Second, the uncertainty caused by rolling lockdowns is causing businesses, especially the private sector, to forego investment. This intuitively makes sense, as businesses require certainty over the path of policy and the economic cycle before investing to expand or hire. As the main driver of fixed asset investment and the largest employer, private enterprises cutting back this sharply is a strong warning sign. Taken together, the economy appears to be suffering from a sharp drop in confidence that is filtering through to weaker economic activity across the board. We published weeks ago saying China needed a substantial stimulus program that could reverse this downward slide, but so far the actions have been piecemeal. The problem is now more serious – requiring a larger and swifter policy response. Should that not materialize, China is facing a higher likelihood of a sharper slowdown.
More structural than cyclical – the growth model is out of runway
China has been able to avoid anything resembling a normal business cycle since the global financial crisis due to near constant counter-cyclical stimulus, predominantly delivered through the property sector. Every time China slowed (which it did in 2009, 2012, and 2015), money supply spiked, credit growth increased, property sales and construction boomed and growth picked up overall.
This model now appears to have run its course. Beijing rightly know this – and it’s a key reason why they are targeting property developers with the three red lines, and why senior policy makers repeat the mantra “property is for living, not for speculation.” There are significant constraints on all the old policy tools: monetary loosening would either exacerbate existing property price bubbles (which are already the most expensive in the world) or liquidity would flow offshore creating further currency depreciation pressure. Fiscal policy directed at infrastructure risks creating additional bad debts.
There are few, if any, low hanging fruit, in the sense that most infrastructure projects that could create a positive economic return have already been built. Capital is abundant, the shortage is in productive projects. The injection of infrastructure stimulus is likely to further increase the debt/GDP ratio, something policy makers have been loath to do. Furthermore, infrastructure has never been enough to turn the cycle, which has been primarily driven by property and exports. The property market simply matters more: spending on real estate flows through to more parts of the economy (including both upstream raw materials and downstream consumer goods) than spending in other sectors – giving it a unique force in driving the business cycle. Research by the Asian Development Bank also shows the importance of real estate. According to its calculations the value-added multiplier for real estate was the highest among all sectors, meaning it’s hard to turn around the cycle without a boost from property.
A closer look at the property slowdown
In our beginning of the year outlook we specifically cited China property as one of the biggest potential growth risks, and asserted that policymakers would have a tough task avoiding a loss of confidence and downward spiral in sales and prices. It now looks like that downward spiral is upon us. Following the initial spurt after Omicron lockdowns were lifted, property sales have further declined near their all-time lows. Property prices, especially for existing properties, are turning down sharply. Land sales are also cratering, sapping a key source of financing for local governments, and a key reason why any stimulus will be subdued.
Part of the slowdown is policy induced, resulting from policy makers cracking down on developer financing, but a key part is structural. Policymaker actions could be considered a response to the structural unsustainability of China’s housing model.
Years of excesses have built up. On the developer side, they relied on the pre-sale model to pursue rapid growth, particularly using pre-sales to plug financing gaps whenever domestic liquidity tightened. However, developers sold vastly more properties than they completed. According to official data, the amount of sold but uncompleted properties in the current construction pipeline is staggering at nearly 700 million square meters (see chart). This is the crux of the mortgage non-repayment issue and the scale of yet-to-be-completed properties suggests it’s a large hole that needs to be filled. Assuming bailouts eventually allow these to be completed and delivered, that simply represents money that can’t be spent on stimulus elsewhere. Even with this level of unfinished properties, excess supply remains a serious problem. Recent data points to a vacancy rate of 7% in tier-one cities including Beijing, and 12% in tier-two cities, the China household Finance Survey puts it at 21.4% in 2017, and the official data puts it at 25 months’ worth of sales. Averaging across these suggests a vacancy rate that is substantially higher than the global average. Furthermore, these same surveys show that over 70% of purchases since 2018 were by buyers who already owned one or more apartments, meaning the vast majority of purchases were for investment or speculative purposes. This sharp rise in speculative buying was a key reason prices sharply increased in 2015-2016, and a big reason policymakers eventually cracked down on the sector. Turning to prices, on a price-to-income basis China has the most expensive house prices in the world. And importantly, this is a recent phenomenon. The massive monetary stimulus and money supply increase from the 2015-2016 period caused house prices in many cities to double over a 12 month time horizon. These bubbles are a key concern for policy makers (hence the ‘property is for living’ mantra) and a key reason why they can’t stimulate in any large way.
The music is now stopping as they say. Developers have massive liabilities they can’t meet. Excess construction created the world’s highest vacancy rate, and massive speculation created the most expensive housing markets in the world. This is all a result of 10+ years of easy money flowing into housing as the primary engine to boost growth. The excesses of ten years of printed money flowing into this sector has created a systemic risk that policymakers are now intent on addressing. Now that the taps are turned off, unsustainable developers are going bust and speculative buying is being removed. The broad real estate sector – which estimates put at 20-30% of GDP – is deleveraging and shrinking down to a more sustainable size. For context, the U.S. property sector at its height prior to the GFC was approximately 18% of GDP. While efforts at deleveraging the sector makes sense, shrinking the world’s largest sector and the world’s largest asset class entails significant risks and tradeoffs. Avoiding a sustained economic decline could be challenging. Nonetheless, policymakers could step in and stem the rapid decline by restoring confidence and bringing back the natural demand (for example new homebuyers, upgraders) that is now on the sidelines.
What does a policy response look like?
The basic characteristics of a credible plan can be simply stated: it needs to be central rather than local, and large not small. More direct involvement by the central government would be a change, as the central government has so far consistently indicated that local governments should take the lead on real estate issues. So far this is the extent of policy responses -- targeted actions on the local government level. On July 20 the municipal government of Zhengzhou (one of the cities with the most unfinished projects), introduced a targeted relief strategy prioritizing seven top developers and RMB 100 billion bail-out funds to facilitate housing delivery. A few other cities made soft promises to address the issue. So far we haven’t seen concrete support measures from the central government, which might be due to a limited policy space and an unwillingness to reverse course on policies aimed at shrinking the property sector. Much like Zero Covid policies, changing paths is more difficult than most assume. As we mentioned above, these targeted remediations have not seemed to help restore overall confidence, as indicated by the July data.
Finishing properties and delivering them to homebuyers, facilitating the orderly unwind or merger of unsustainable developers, and putting property on a sustainable growth path could restore confidence and allow the economy to avoid a sharper collapse. A credible plan has yet to emerge. Eventually it will, but the longer it takes the larger the risks become.
What does this mean for markets, both in Asia and globally?
At the moment it is hard to predict when the property sector will bottom. We don’t expect a clear rebound in the sector for the remainder of this year. We recently downgraded our outlook for 2022 GDP to 3.1% from 3.9%, taking into account further downside risks in the property sector. We also remain below consensus for next year at 5.0%. From here, we are likely to see a pickup in policy support in response to the weakness in data. However, there is no easy fix to the weakness in underlying demand, and further stimulus may not be as effective without a clear roadmap to exit the Covid Zero policy.
For investors, we remain patient on Chinese equities while we await stronger policy actions to restore confidence. In terms of the RMB, we’ve been bearish on the currency since April given the now negative carry against the U.S. Dollar. For clients who have RMB exposure, we think it makes sense to hedge at current levels. Strong exports and a strong balance of payments have been a key support for the CNH. But as growth across developed economies decelerates, that strength could fade over time. In addition, capital flows tend to be well correlated to property prices, with prices now in decline there is a chance capital outflows pick up putting further downward pressure on the currency. In addition, the PBOC’s easing bias may create a larger divergence in policy direction with most of the major DM central banks. The global impact of a struggling Chinese economy is generally felt through commodities and sentiment. China-driven commodities could see further downside, especially because property investment is the key driver of commodity demand. European companies could see fewer capital goods exports and lower corporate earnings. However, the global impact is fairly concentrated, and despite being the world’s second largest economy, China’s role as a global consumer is much smaller than its role as a global producer (except in commodities).
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