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#61 - China trades like a swimmer with lead boots on: how heavy are they?

Chinese equities continued to trail global equities in the second half of this year, attributed to mixed economic data and elevated uncertainty about local developments. Investors remain cautious, reflecting the profound crisis of confidence the country is experiencing, as the economic recovery has yet to establish strong roots. On the positive side, Beijing is finally mobilizing its fiscal resources to support growth, though the general consensus is that more stimulus is still needed, given the extent of domestic growth challenges.

The housing slump still presents headwinds for China’s growth outlook, and we approach a level where a necessary and nearly sufficient condition for recovery is the strengthening of the housing market. Once the indicators begin to improve, the heavy weight on economic growth will be gradually lifted.

With the additional stimulus and improving growth conditions, the Chinese equity market will become attractive again. For now, the time dimension for this recovery seems to extend into the future, longer than many would like or expect.

The fight against deflation and growth weakness.

This time, we observe a new development in China's shaken economy. Consumer confidence plummeted and created an unexpected situation similar to Japan in 1990s. Chinese home sales dropped 40% from peak, mortgage borrowing reached very thin levels, household savings have raised at levels never seen until now and a worsening demographic can result in recession and deflation.

There are some interesting parallels between China's and Japan's economic and social situations, drawn by reputed strategists:

- Peter Tasker (Strategist Arcus) – “In 2021, price to income ratios in Beijing were at 25x and near 20x in Shanghai. In the Japanese bubble, affordability was less strained with ratios over 10x, but that marked a doubling in three years, and price rises in the commercial sector were equally explosive.”

- Edward Chancellor (British financial historian) – “the total value of Chinese real estate is equivalent to 5.5x the country’s Gross Domestic Product (“GDP”). By comparison, Japan’s land-to GDP ratio peaked out at 4.8x when the bubble burst in 1991. Any way you look at it, China’s real estate excesses are of a monumental scale and purging them will be a painful process.

The deflationary symptoms in China are mild, with small declines in the consumer price index and the GDP deflator similarly to Japan, in 1990s. Deflation was persistent in Japan but never deep, which is why policymakers ignored it for long time. Instead, a risk-averse 'deflationary mentality' spread, where people began to believe that the natural trajectory for wages, rents, and stock prices was downward.

China’s export price deflation, coupled with the fall in its trade-weighted currency, can reinforce the ongoing slide in global core goods inflation.

Several headlines suggest that China's apparent foray into deflation is evidence that its long-standing property woes will snowball into spiralling defaults, a financial crisis, and a hard landing. However, as indicated in the chart above, China's core Consumer Price Index (CPI) — which excludes volatile food and energy prices — is still rising, showing a 0.6% year-on-year increase in October.

China is a significant player in the world market, and its economic health can influence global trade, investment flows, and commodity prices. Deflation and economic weakness in China pose obvious risks for U.S. investors exposed to Chinese stocks or emerging market exchange-traded funds (such as iShares China Large-Cap ETF), as well as certain sectors closely tied to China's economy, like manufacturing and technology.

Although China has been reducing its U.S. Treasury holdings since 2012 to diversify its foreign reserves, China remains the second-largest foreign holder of U.S. Treasuries after Japan. Therefore, potential selling may have a significant negative impact on U.S. Treasury bonds.

Is it sentiment or the economy that weighs heavily in China?

In response to the property market’s woes that could plunge China into a ‘balance sheet recession’, Beijing has initiated a series of short-term measures to bolster the economy and the real estate market.

To support growth, China’s ‘dual circulation’ development strategy implemented in 2020, targets additional resources for sustaining long-term growth such as supply chain security, high-value manufacturing, high-tech development and new infrastructure. This includes inter-city railways, research and development on energy and environmental technology, 5G/6G networks, artificial intelligence and the Internet of Things.

While we acknowledge China’s property slump as quite challenging, it is important to recognize that it is:

- extensively known and factored into stock prices

- actively being addressed by government actions

The government’s chief aim to maintain social stability and Beijing’s formidable financial firepower to step in if needed, support the fact that although Chinese growth may be relatively slow and uneven, it is far from a systemic event.

The main cause for worry is not supply-driven abundance, but the persistent demand weakness, especially if accompanied by protracted money supply contraction—like during the Great Depression in US. It looks like the problem isn’t deflation per se, but when protracted and deep, the economic and monetary conditions it stems from.

Currently in China, although M2 money supply and total social financing (a broad measure of aggregate credit creation) have decelerated this year, they remain far from contracting (see the following chart).

Prolonged deflation is unlikely to take hold when both money supply and credit are expanding. For now, it seems that the weight lies more heavily on sentiment rather than the actual effects of deflation on the economy, and perhaps, in this case, on Chinese society as well.

Bottom Line

Investors worldwide are eagerly anticipating a return to positive growth as the National Bureau of Statistics of China prepares to release its year-end and early next year numbers. Continued flat or near-flat Consumer Price Index (CPI) figures could pose real risks of deflation, potentially leading to a self-perpetuating loop similar to the case of Japan, where consumers delay spending, anticipating lower prices in the future.

At MACROMETR, we advocate for investors to reassess China’s growth expectations, considering the new direction of its structural reforms and Beijing's active efforts to support economic growth and the real estate market, rather than dwelling on past challenges.

Due to de-globalization and the strategic competition policy enacted by the U.S. towards China, we anticipate China hedging its bets by shifting resources to its science and technology sectors, aligning with the dual circulation policy framework. In an extreme scenario of decoupling, the world’s two largest economies could end up dominating their respective technology-supply systems, each with its own set of rules and standards.

China’s growth story still has room to unfold, and this upside growth potential is currently not priced in by financial markets. A major and uncertain factor in this process remains time, specifically when opportunities will outweigh challenges for China, and consequently, for the global economies.


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