“China – a close monitoring of policy shifts, consumer sentiment, employment dynamics, and trade imbalances will be crucial…”
The Chinese economy’s recent trajectory has been a blend of promising growth and underlying challenges, reflecting a delicate balancing act that policymakers and investors are closely watching. In Q2 2023, the Chinese economy expanded by 6.3% year-on-year, surpassing the 4.5% growth of Q1 but falling short of the market’s consensus forecast of 7.3%. As we delve into the macroeconomic data, it becomes apparent that while growth remains a priority, the emergence of bearish factors and the need for policy recalibration warrant a comprehensive assessment.
Growth Dynamics and Policy Response
The first half of 2023 witnessed a 5.5% GDP growth in China, positioning the economy on a trajectory that aligns with Beijing’s targeted 5% annual growth. However, this achievement is shadowed by the lingering effects of the post-Covid-19 recovery, which have dampened market sentiment. The bankruptcy of China’s Evergrande Group further accentuated these concerns, contributing to an environment characterised by uncertainty and caution.
Responding to these challenges, the People’s Bank of China (PBOC) undertook measures to stimulate economic activity. Notably, the PBOC lowered the one-year loan prime rate, which serves as a basis for most household and business loans, to 3.45% from 3.55%. However, policymakers remained cautious due to mounting debt risks, as China’s private debt relative to nominal GDP reached 190% in April 2023, surpassing levels seen in the US, Euro Area, and Japan.
Navigating Consumer Confidence and Employment Concerns
The China Consumer Confidence Index (CCI), a pivotal gauge of economic sentiment, has also remained below its 5-year median of 122. This index, derived from a nationwide survey, serves as a crucial indicator for stakeholders, including investors, retailers, and manufacturers. As the CCI continues to languish, it underscores the fragility of the country’s economic recovery.
Simultaneously, the troubling statistic of a seventh consecutive monthly increase in youth unemployment, reaching 21.3%, demands attention. This concerning trend reflects a challenging landscape for young job seekers, further contributing to weakened domestic demand. The suspension of information release by the government on this issue highlights the need for improved data collection methods to accurately gauge the depth of the problem.
Trade Imbalances and Future Prospects
A 21.5% decline in China’s trade surplus in July 2023 on a year-on-year basis further underscores the persistence of weak demand both domestically and internationally. This contraction in trade activity serves as a reminder that full recovery is still a work in progress. As the economy seeks to rebound, monitoring China’s deflation rate becomes paramount, particularly in light of the associated risk of increased debt burden. Therefore, a close monitoring of policy shifts, consumer sentiment, employment dynamics, and trade imbalances will be crucial.
Fixed Income Macro
Upcoming moves by DM central banks appear to be in the direction of a September pause by both the ECB and the Fed. For the ECB, lower than consensus Euro area composite PMI (-1.6pt to 47.0) hints at intensifying weakness and postponement of a September hike to October. For the Fed, there is probably enough disinflationary data to skip September without removing the risk that estimates of the long-run Fed funds rate are revised higher. Although US August flash PMI prints disappointed with the manufacturing survey declining from 49.0 to 47.0 and the services survey moving down from 52.3 to 51.0, if overall labour market and services price strength persists, the Fed probably holds off rate cuts until inflation has fallen substantially further or more tangible signs of a slowdown appear. At the weekend’s annual central bank conference, Fed Chair Powell indicated a hawkish bias amid data dependency: “we will proceed carefully as we decide whether to tighten further or, instead, to hold the policy rate constant and await further data.”
A major flashpoint in Asia credit is occurring as concerns about potential spillovers from the recent debt repayment troubles in China’s private sector, worsening economic data and profit warnings from corporates shake investor confidence in the efficacy of policy to manage financial risks and stabilize growth. Given Asia ex-China credit has been relatively unscathed in the past two months from the China property sector stress, questions are being raised whether this outperformance can continue. To compound challenges, outflows from EM hard currency bond funds deepened from $1.2 billion in July to $5.3 billion month-to-date. In a stark and quick reversal, over the past two weeks the Bloomberg Asia USD Credit spread widened to 266 bp from 246 bp. Expect this spread decompression continues until global rates volatility subsides and/or downside risks in the China economy are addressed adequately.
In China, the most concerning sector remains the housing market. Compared to 2019 levels, new housing starts have plummeted 63% by July, property sales are down 34%, and property fixed asset investment (FAI) is 12% lower. Headlines about Country Garden, China’s largest real estate POE developer by 2022 revenues missing bond interest payments and troubles faced by trust companies with significant real estate exposures raise further concerns on property market spillovers. The negative impact on the economy is material, as retail investors in trust products likely cut spending, households refrain purchasing new homes and construction companies face slumping demand. Meanwhile this month, the PBOC cut rates 10 bp, the second time this year, and banks lowered the mortgage benchmark 1-year loan prime rate by 10 bp to 3.45% but left the 5-year loan prime rate unchanged. Rules are being revised for homebuyers who have repaid previous mortgages to be considered as first-time purchasers, qualifying for lower downpayments and less restrictive borrowing limits. These incremental policy reactions are so far ineffective at restoring market confidence.
Fixed Income Strategies
The narrative of higher rates for longer has seen broad repricing in terms of both nominal and real Treasury yields, anecdotally driving some liquidation of long positions amidst lower seasonal liquidity in the market. 10-year nominal yields increased 29 bp month-to-date, exceeding the highest levels of 4Q 2022 and approaching the highest levels since 2007. At the same time, 10-year inflation expectation-adjusted yields approached the highest levels since 2009. Forward pricing for Fed cuts has been pared back, which seems fair, yet yields may have not peaked as a wider budget deficit increasing the supply of Treasury issuance and adjustment of the Bank of Japan’s yield curve control, support this reset to a higher range. Meanwhile, should the resilience of US consumer and labour markets be sustained, that likely caps any bond rally. We are inclined to maintain shortened rates duration of bond portfolios.
Multi-Decade Highs for US 10-Year Yields
Source: Bloomberg Finance L.P.
In credit, Asia HY bond yields rose at the sharpest rate since March over the past two weeks, on the back of concerns that the issues in Chinese property markets and trust products may get worse before they get better. Expect some further China credit underperformance as trust product defaults are likely to have a negative impact on investor sentiment and tighten credit conditions onshore, risking the ability to roll over existing wealth management products and potentially impact systemic financial stability. Another risk to credit markets is the recent ratings downgrades and watches on US regional banks and comments from the ratings agencies on potential future downgrades for the large banks. While these ratings actions are lagging indicators for the risks that became apparent with the regional bank stress in March, it suggests limited upside risk. Regardless, expect IG credit to remain relatively orderly due to positive technicals and strong balance sheets especially for commodity producers. We are inclined to reduce credit beta while positioning in quality oil and gas credits.
For the China property sector, recent payment failures by Country Garden and Sino-Ocean on their dollar bonds, trading suspension of their onshore bonds, solicitation to extend maturity of bonds, highlight the continued challenging environment faced by POEs. At this juncture, majority of USD China property bonds have either defaulted or conducted bond exchanges, therefore rising stresses amongst non-defaulted HY developers are unlikely to have a broader impact on the offshore bond market. Of greater concern is whether rising stresses will spillover to IG developers, most of whom are state owned enterprises (SOEs). Whilst pre-sales performance continues to be under pressure for the overall sector, lower debt and better financing have helped SOEs gain market share. The top five developers by sales in 1H23 were SOEs. Evidently, property policies over the past several years have not spilled over to broader credit concerns amongst SOEs. We are inclined to maintain positions in SOE investment grade developers vs underweight HY developers.
In the US, inflation is steadily coming off while the economy continues to hum along with positive GDP growth. Recent results of Big Tech counters have also been positive, driving a rebound of the positive momentum and market sentiment in US Equities post the recent pullback. In addition, the probability of recessionary risks has also greatly declined. Taken together, these market observations bode well for further positive momentum in the US Technology sector and Us Equities in general. As previously reiterated, we recommend to gradually accumulate on any material market dips at more reasonable valuations in selected US technology counters as well as in defensive and laggard sectors such as consumer staples and healthcare, which offers more attractive risk/reward should the US economy enters into a soft landing in 2H’23.
For HK/China, we remain highly cautious of the inadequacies of the policies and smaller scale stimulus implemented to revive the economy to date. The Chinese government will probably continue to monitor these implemented measures for some time before any major step-up in stimulus, if any, is likely considered. Hence, we believe any further major stimulus, if materialize, will likely come later rather than sooner. Against these backdrops, we recommend investors to consider gradually adding some selected Equities exposure in HK/China in a staggered approach on significant market pullbacks while we patiently await 1) signs of recovery in the Chinese economy as a result of the current slew of smaller scale stimulus implemented or 2) further major stimulus, in particular those targeted at the real estate sector, that could revive rapidly slowing growth. Furthermore, we recommend a significant portion of Equities exposure to be gained through Index ETFs rather than individual securities in order to mitigate market and P&L volatility and in the worst case, further major stimulus fails to materialize.
Our preferred sectors are Technology, EV-related and Travel-related industries. We are also inclined towards infrastructure-related names in view of a potential accommodative policy stance. These sectors are still trading at attractive valuations and deserve our attention be it from a longer-term fundamental perspective or that of a short-term swing trade. We also continue to be advocates of defensive sectors such as Telecoms and Utilities that provide reasonable dividend yields with decent valuation upside. While we continue to monitor the market for data points, in particular those that could lift the real economy, market sentiment and hence a rebound in Equities.