The Big Conversation
Episode 114: A growth pickup in China?
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Garett [00:00:00] Global equities are encountering a turbulent start to the year in a market short of a positive catalyst. As many of the world's major central banks battle to bring inflation under control by hiking rates, China's dovish policy pivot demands our attention. With leading indicators of a credit cycle showing improvement, we ask whether China could once again be the world's growth engine in 2022. But at what cost? That's the big conversation.
Garett [00:00:30] During a time of growing uncertainty around interest rates and inflation in developed markets, to which there has been added turmoil in Europe, investors may well be turning their attention to Asia for new ideas. So far in 2022, there have been few hiding places for equity fund managers. Energy is the only major sector in the green year-to-date, as one of the few beneficiaries of higher inflation. After a year of broad gains in 2021, virtually every other group has taken a hit as rising costs and a sudden surge in bond yields globally have led to a significant re-rating of risk assets. Western policymakers face a seemingly impossible task in combating stubbornly high inflation without crushing growth to the extent of recession. The consensus seems increasingly sceptical that this fine balancing act will be achieved, which is evident in souring risk sentiment in key global markets, even before the additional impact of tensions in Europe. But amidst all of this, the recent improvement in China might be being overlooked. As one of the main drivers of the world economy, there are some important shifts that will likely impact both the domestic and global equities markets, especially broad-based emerging markets, over the coming months. Total social financing, which represents a broad measure of credit and liquidity in the Chinese economy, increased a record level in January and came in well ahead of forecasts at 6.7 trillion yuan versus 5.46 trillion expected. The China Credit Impulse Index tells a similar story, having seen expansion in each of the past 3 months. Both of these indicators have been trending lower since peaking in late 2020, which makes the current upswing all the more interesting as perhaps the start of a new cycle. According to research by Stouff Capital, China's credit cycle tends to lead not only to domestic economy, but also the level of economic activity in the US and Europe, by approximately 11 months. The regional PMIs for the US and Europe are rolling over, following their respective peaks in March and June 2021. Whilst their latest readings remain well above the 50-threshold seen by many as signalling 'expansion', the year-over-year momentum has now turned negative. The timing of this is not ideal given a swathe of hawkish policy which looks to assert further downward pressure on the business cycle. The Fed is leading the liquidity squeeze as they finally bring their quantitative easing operation to a close and start their rate hiking cycle, both in March. By contrast, the PBOC actually loosened their policy earlier this year with a surprise rate cut. 70% of traders and analysts polled predicted no change to the medium-term lending facility loan rate, which was cut by 10 basis points, 2.85%. And a 5-year Loan Prime Rate, followed, with the first cut since the initial response to the global pandemic in April 2020. This was further justified as being in response to the threat of Omicron and further downward pressure to an already bruised economy. But they had already been cutting elsewhere. The Reserve Ratio Requirement for China's big banks was lowered to 11.5% in December 2021 in an attempt to inject more liquidity into the financial system, which followed a similar move in July. Whilst still relatively high by international standards, the direction of the trend shows a clear bias towards easier conditions in the banking sector. And China's central banks have since moved to slash mortgage rates for home buyers, whilst urging banks to boost loans to developers in an attempt to stimulate the all-important property market which accounts for around 30% of GDP. Despite the sector's widely-reported malaise, economists in the region reported that the state's intervention arrived sooner than was anticipated, and is seen as being the most important change in policy that the property sector has seen for quite some time. And China's economic stimulus is looking increasingly more coordinated. Local governments are under fiscal strain as a result of the real-estate slowdown, and a state has pledged greater support in the form of transfer payments given the significantly weaker equities. Most of the provinces expect lower income this year, while more than a third forecast growing the deficits. As part of a package of measures, Premier Li Keqiang has also hinted at further tax cuts to help businesses cope with rising costs and high demand, which are expected to exceed the 1.1 trillion yuan in tax breaks granted last year. So, has the stimulus taken effect? It may be a little early to conclude from the widely watched monthly data... It will require at least two consecutive increases above 50 in China's Manufacturing PMI before we can say with any real confidence that the stimulus is being felt. After a period of tighter policy in the previous year, the slowdown has been apparent in this indicator. Given how recently this took place, it may warrant being more cautious in looking for confirmation of the stimulus in the China's PMI survey. And it may only be a matter of time before the pick-up is felt. Traders seem to agree, and have already moved in to begin pricing in the policy loosening, with some interesting trends showing up in the equities market. The first example can be seen in the outperformance of domestic property-related equities to the broader market. In this particular example, China Resources Land shows a double-digit gain year-to-date, whilst the China large cap ETF (FXI) is down over the same period. On an international level, the relative performance of Chinese versus US equities also points to the growing divergence between the economic stimulus China, and a hawkish backdrop in the West. China's Large Cap stocks are showing outperformance of the equivalent S&P 500 ETF in the year-to-date. And even the beleaguered tech sector is now holding its ground against his US counterpart in Nasdaq - a recovery that could pick up if the worst of the Chinese state's regulatory attacks growing seemingly more distant. Perhaps, than the impact of the policy pivot is to be believed. And if indeed this does gather momentum, then there may be a wider-reaching implications for asset markets beyond equities. Given the ongoing sensitivity around inflation, commodities seem an obvious area to focus in on. China is of course the world's largest consumer of most commodities, so this year's policy shift will almost certainly serve as an additional tailwind for prices throughout the sector. Indeed, in the days following the PBOC's announced cut to its base rate, and later mortgage rates, of copper and iron ore futures saw gains. But the bigger picture is that China's growth is heavily dependent on fossil fuels, with its longer-term position only being fortified through the 'Energy Transition' theme. Coal output is already at record levels in the face of an energy shortage. And in terms of oil, China has yet to follow the footsteps of the US-which now requires half as much to produce a dollar of GDP as it did 30 years ago, according to EIA data. With the global benchmark crude oil already having sold through $100 dollars, additional demand creation through new stimulus could well keep prices elevated. Whilst great for the energy sector, the threat of further inflation could have profound implications for the public markets more broadly, with Western policy makers battling to bring inflation under control. China, meanwhile is seemingly not as concerned by the risk of inflation given its relatively low rate of CPI. Although there is often some degree of scepticism regarding the data, the level is nowhere near the US, which is clearly off-the-charts. This puts the PBOC at a potential advantage in having greater leeway to stimulate growth without the fear of stoking already rampant inflation. It seems that by adopting a supply-side rather than demand-side policy to stimulate the economy during the pandemic, there hasn't been the same inflationary shock as is being felt elsewhere in the world.
Garett [00:08:46] The global economy seems in desperate need of a positive catalyst, and China's potential upturn might well deliver that given his influence on the world stage. But the benefits of this will likely take a few months to filter through, and in the meantime global investors might well see China as a potential safe haven in the current storm, as its equity market tends to be relatively uncorrelated to major peers.