Our thoughts on investing in China during a growth slowdown

Measuring the slowdown

China’s economic growth has slowed this year, from 18.3% year-on-year in Q1 2021 to 4.9% in Q3 2021. Base effect played a large part in the slowdown, given that GDP growth in two-year CAGR has been more stable, at 5.0% year-on-year in Q1, 5.5% in Q2 and 4.9% in Q3. Current market consensus expects Q4 growth at 3.8% year-on-year, but taking out base effect, this actually implies a two-year CAGR growth rate of 5.1%, which is slightly higher than in Q3.

Of the various headwinds to China’s growth in the next 12 months, the property sector slowdown tends to get the most investor attention. The property sector has expanded rapidly over the last two decades due to a combination of demographics, urbanization, and in recent years, higher gearing. In order to reduce the financial stability risks in this sector, and put the housing market on a healthier footing, China’s regulators have gradually tightened credit policies in recent years. In 2020, regulators introduced the so-called ‘three red lines’ policies, which limited the most indebted developers from raising new debt. Over the last few months, a few still expansion-minded developers have seen their financing avenues dry up, which caused liquidity problems that quickly grew to threaten certain companies. This caused heighted market sensitivity towards other developers.

In our view, regulations on property developers’ leverage are unlikely to materially ease in the near term. As such, this deleveraging cycle will exacerbate the housing cycle downturn. We have factored in a 10-20ppt drop in sales growth, and a further 10ppt contraction in housing investment in the next six months. Together these amount to a 1ppt drag on GDP growth over a 12-month period, in terms of both direct and indirect impact. In terms of the magnitude of the decline, this is similar to past downturns, although from a lower starting point (as trend growth in the housing sector has also declined over time).

While we cannot fully rule out a bigger, more systematic downturn in the overall market, regulators do appear to be closely guarding against just this type of scenario. The PBOC has in recent days assured markets that developers will not face cutbacks on regular credit flows from onshore banks and that banks’ prudential risk calculations will not prematurely change for the sector as a whole. The regulators are also keen to ensure orderly asset sales by impacted developers. In order to support the physical market the PBOC also highlighted that banks still have a lending quota for mortgage loans that are not yet used up. Local governments have continued to ease mortgage rules, and broadly, mortgage interest rates have edged lower. While these don’t necessarily help the most indebted developers, we believe this should limit the magnitude of the overall slowdown. 

In addition to the housing market slowdown, energy shortages have in recent days prompted more analysts to downgrade industrial production and hence GDP growth. While industrial production growth has slowed since the summer due to the impact of chip shortages (which impacted auto production), the energy shortages have caused more concern. In our view, the crux of the issue is strong industrial output (particularly in steel, metal) in an environment of generally low coal inventory. Given the government has already reversed some of the coal plant shutdowns, and will also likely look to boost alternative energy shortages, we think the negative impact on growth will lessen over time. We do, however, expect bigger curbs on several so-called highly energy-consuming sectors, such as steel and metal. This could have a marginal impact on growth to the tune of 0.1-0.2ppt of annualized GDP growth. Over time, we believe China’s reliance on energy for growth will continue to decline due to changing economic structures, equipment upgrades, as well as higher efficiency prompted by more market-driven electricity tariffs. Regulators will also look to gather better data on industries’ carbon usage. As such, while we cannot rule out that such episodes won’t happen again, their overall impact on growth should be smaller over time. 

Beyond property and energy shortages, some investors are more worried about a broad-based slowdown. Other data points, such as industrial production volumes, industrial sales, freight shipping, and auto sales have continued to decline in sequential level terms and could soon turn negative in year-over-year growth terms. Even if activity stops falling on a sequential basis and simply stabilizes from here, many data points will show y/y growth at or below zero in November and December. Regardless of what the official Q4 GDP print turns out to be, actual weakness will be hard to ignore. It’s important to keep in mind this isn’t that bad, year-on-year growth may look bad but it reflects a comparison to data when the economy was rapidly recovering and overall activity levels are still well above where they came into the pandemic at end-2019. Nonetheless how policymakers respond, if at all, will be a crucial question determining the 2022 outlook.

From the brakes to the accelerator?

Amid these more visible signs of weakening growth, markets have begun to question not if, but when policymakers will ease, and by how much. This question is particularly important for onshore equities where bull markets tend to coincide with accelerating credit growth. We don’t think the structural tightness in the housing market, or regulations, are likely to materially shift. When it comes to monetary policies, we expect some moderate easing to come, but not an aggressive easing cycle.

Since the summer, the authorities have been making some policy shifts at the margin. There are more signs that policymakers have started to work on preventing a disorderly debt restructuring of Evergrande, ensuring funding for healthy developers, and relaxing mortgage lending and housing purchase restrictions at local levels. In addition, the State Council has pressed local governments to provide support to small and medium enterprises through the reduction of rents and utility bills.

Nonetheless, the PBOC and other “authoritative” persons continued to talk down expectations for more broad-based easing, such as Reserve Requirement Ratio (RRR) cuts, and credit growth has not yet rebounded. We think it is possible that the policy framework is increasingly becoming less purely counter-cyclical, or at least it is now also putting more emphasis on longer-term structural objectives, such as putting the housing market on a more stable footing. With these more long-term objectives in mind, we don’t expect an aggressive easing cycle. Instead, the authorities may favor more targeted easing to support key objectives like industrial upgrading, as well as focus areas such as small and medium enterprises.

In the 2Q21 monetary policy report, the PBOC repeated that its goal is to “maintain growth in the money supply and aggregate financing basically in line with nominal economic growth”. Since consensus forecasts put nominal GDP growth in 2022 around 8%, we may guess that the “normal” rate of credit growth should be 8-9%. The PBOC does have significant discretion around how ‘basically in line’ is interpreted, and credit growth is rarely exactly the same as nominal GDP growth – neither is the latter generally accurately forecasted. But the more conservative messages from the policymakers lately suggest that a 8%- 10% is a sensible base case to have which represents some easing from here but not that much.

Will this be enough?

The current policy stance is objectively very tight. Aggregate credit growth is at all-time lows. And for the property and housing sector in particular, net new mortgage lending as  a  share  of  new  housing  sales  (i.e.,  the  current  flow “loan-to-value” ratio for the residential market) has already plummeted close to an all-time trough, reflecting not only low borrower sentiment but also the restrictive stance on mortgage lending imposed by the authorities. 

With this in mind, the market, and particularly credit sensitive parts of the economy would likely react positively to signs of more determined easing. This could help with sentiment, but in our view they are unlikely to fundamentally alleviate the problems faced by companies that are under regulatory pressure to de-leverage. As mentioned earlier, regulations are unlikely to materially reverse.

What does it mean for investors?

In summary, growth is slowing down across most parts of the economy. Regulations on the property sector have been playing a big role, and will likely continue to weigh on growth despite signals of slight easing to keep systemic risks under control. The negative impacts from energy shortages are relatively limited and could wane over time as coal production ramps up. From a monetary policy perspective, credit growth should bottom out toward the end of the year, but is unlikely to rebound much.

Overall, our base case has already incorporated a notable downturn in the property sector next year, and only a gradual recovery in domestic demand. That said, while we still don’t have full clarity, markets have already priced in a lot of the slowdown in the macro economy, which brought valuations to a more attractive level, especially compared with stretched valuations across other major markets. Given regulations have already tightened significantly, monetary policies have troughed, and fiscal policies will likely start to ease on the margin, the case for Chinese assets could turn more positive from here. But the policy response will be key; a larger response to the growth slowdown in Q421 and Q122 would likely elicit a larger market reaction, whereas a more tepid response in line with the new policy framework would be viewed less enthusiastically by markets.

In terms of adding China exposure to portfolios, we see opportunities across asset classes, but it is important to be selective. Within equities, we prefer A-shares over offshore equities, given that there is less exposure to sectors prone to further regulatory risk, and more that will likely garner policy support. We also like secular themes that benefit from China’s long-term structural policies, such as industrial upgrading, automation, and clean energy. As for fixed income, we are constructive on select high quality credits that have been oversold during the recent indiscriminate selloff, as well as Chinese government bonds (CGBs) amidst continued interest rate differentials versus developed markets and a stable currency outlook. The bottom line is that prudent diversification and risk management is key.

All market and economic data as of October 28, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.

There can be no assurance that any or all of these professionals will remain with the firm or that past performance or success of any such professional serves as an indicator of the portfolio’s success.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice. 

Although third-party information has been obtained from sources believed to be reliable, JPMorgan Chase & Co. and its affiliates do not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use.

By visiting a third-party site, you may be entering an unsecured website. J.P. Morgan is not responsible for, and does not control, endorse or guarantee, any aspect of any linked third-party site. J.P. Morgan accepts no direct or consequential losses arising from the use of such sites.

Structured products involve derivatives. Do not invest in these products unless you fully understand and are willing to assume the associated risks. The most common risks include, but are not limited to, risk of adverse or unanticipated market developments, issuer credit quality risk, risk of lack of uniform standard pricing, risk of adverse events involving any underlying reference obligations, risk of high volatility, risk of illiquidity/little to no secondary market, and conflicts of interest. Before investing in a structured product, investors should review the accompanying offering document, prospectus or prospectus supplement to understand the actual terms and key risks associated with each individual structured product. Any payments on a structured product are subject to the credit risk of the issuer and/or guarantor. Investors may lose their entire investment, i.e., incur an unlimited loss. The risks listed above are not complete. For a more comprehensive list of the risks involved with this particular product, please speak to your J.P. Morgan team. If you are in any doubt about the risks involved in the product, you may clarify with the intermediary or seek independent professional advice.

In discussion of options and other strategies, results and risks are based solely on hypothetical examples cited; actual results and risks will vary depending on specific circumstances. Investors are urged to consider carefully whether option or option-related products in general, as well as the products or strategies discussed herein are suitable to their needs. In actual transactions, the client’s counterparty for OTC derivatives applications is JPMorgan Chase Bank, N.A. and its affiliates. For a copy of the “Characteristics and Risks of Standardized Options” booklet, please contact your J.P. Morgan team.

This document may also have been made available in a different language, at the recipient’s request, and for convenience only. Notwithstanding the provision of a convenience copy, the recipient re-confirms that he/she/they are fully conversant and has full comprehension of the English language. In the event of any inconsistency between such English language original and the translation, including without limitation in relation to the construction, meaning or interpretation thereof, the English language original shall prevail.

RISK CONSIDERATIONS 

• Past performance is not indicative of future results. You may not invest directly in an index. 
• The prices and rates of return are indicative as they may vary over time based on market conditions. 
• Additional risk considerations exist for all strategies. 
• The information provided herein is not intended as a recommendation of or an offer or solicitation to purchase or sell any investment product or service. 
• Opinions expressed herein may differ from the opinions expressed by other areas of J.P. Morgan. This material should not be regarded as investment research or a J.P. Morgan investment research report.