China’s Shanghai Composite Index is down by a non-trivial 15% from the February peak (chart 1). The big picture question is whether the decline is corrective or the start of something much deeper? From a macro perspective, China was first into the COVID crisis and was also the first to recover. The recovery in China’s activity data was distinctly V-shaped. However, the market is relatively expensive in a regional context and regulatory changes for sectors like internet have been a negative surprise. US-China trade tensions have also escalated again in recent weeks.
From our perch, Chinese equities have always been heavily influenced by liquidity. The ebb and flow of the credit cycle (whether credit is accelerating or decelerating) has tended to be the best reflection of the mini business cycle in real estate, infrastructure, corporate profits and asset prices over the past decade or more. Liquidity (credit) is important in a real economic sense. However, it also tends to be correlated to risk perceptions. Stated differently, the P/E multiple also tends to be pro-cyclical or correlated with the liquidity and profit cycle (chart 2). Another way to frame this is that the liquidity (credit) cycle tends to reinforce positive or negative risk perceptions when it is either accelerating or decelerating. The onshore Chinese market also has greater retail participation which reinforces the influence of psychology, liquidity and (leverage, via trading on margin).
Another concern in China is that policymakers have already started to moderate the pace of credit and lending to the real estate sector. Indeed, the credit impulse actually peaked in October last year. From a structural perspective, China’s GDP recovery in 2020 was still driven by supply side measures. Hence the economy is now more unbalanced than ever. This has two important implications according to Michael Pettis. First, China’s debt burden deteriorated materially in 2020, rising by 25% points or roughly 3-4 times the previous year’s increase. Second, the trade surplus soared. That put pressure on the rest of the world and maintained trade tension with the United States.
Looking forward, this means that China must reverse the consequences of 2020 if policymakers want to contain leverage, control financial risks and rebalance toward domestic consumption. Of course, every time the authorities moderate credit growth that leads to a material slowdown in activity, investment, real estate and asset prices. Eventually, that leads to a reversal in policy tightening, a renewed cycle in credit growth and even more leverage. Thus the structural challenge in China is similar to the West is the dependence on ever rising levels of debt. China has similar total debt to GDP as the United States. As an aside, this is a key reason why China still has a relatively closed capital account.
The good news is that super-abundant global liquidity and the synchronized world macro expansion should continue to support external demand and asset prices. While the current cycle is moving at warp speed compared to previous expansions given the unprecedented policy support, it still likely has much further to go. For Chinese equities and markets more broadly, the recent correction is likely a consolidation within the bull market, rather than an end to the market cycle. Within the Chinese market, we would have a preference for secular growth or companies levered to the domestic consumer rather than traditional cyclicals dependent on investment and bank credit. In other words, the correction in Chinese internet (technology) is probably an opportunity to scale up exposure.
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