The way price responded to China’s NDRC Press Conference today raised two key observations about recent developments. First, the rally had already been large, impulsive, and emotional in stocks levered to China’s cyclical fortunes. Bloomberg’s China Reopening Basket had rallied 50% from the September low (chart 1). Second, the series of policy announcements, more accurately promises, suggested that some market participants had anticipated a much larger commitment (up to RMB 10 trillion) and greater detail on implementation of the fiscal stimulus package today. Stated differently, the authorities again fell short of a “whatever-it-takes” moment. While further measures (and detail) might be announced over the coming weeks or months, from our perch the policy officials failed to “read-the-room.”
Chart 1
We have consistently argued for some time (see previous notes) that China’s structural debt and growth challenges are widely appreciated and priced. Earlier this year (5th of February) following a 3-year bear market and waterfall price action, equity valuation positioning and sentiment reached episodic or revulsion levels. While pessimism was warranted, there was widespread capitulation by domestic and global investors. The Shanghai Composite Index was trading at 4.7 times two year forward earnings.
However, as we also noted, the series of policy measures introduced throughout this year fell short of a “big bazooka” moment. What troubled us most was the sustained weakness in the credit impulse (rate of change in credit growth). The performance of assets directly levered to the business cycle in China such as real estate, iron ore, European luxury goods and the re-opening basket (above) were also making new lows prior to the September 24 announcement.
It was not until the special Politburo meeting indicated a shift to larger fiscal easing that bond yields and reflation expectations improved. The pivotal moment was recognition that greater fiscal easing was necessary. Prior to that several measures aimed to stimulate credit growth had failed. They probably failed because China is likely in a balance-sheet driven cycle where the private sector has been attempting to reduce leverage. The good news in China is that policymakers can direct state-owned banks to lend to state-owned corporations to boost investment.
Of course, in parallel with Japan domestic savings exceeds investment. While investment spending has risen as a share of GDP, savings have increased even further. The impact of additional investment has been diminishing over time. As Gerard Minack has noted, encouraging banks to lend to fund more investment is not the solution when the structural problem is too much investment. The structural fix for China’s malaise is reducing domestic saving, boosting consumer spending – not lifting investment.
On the positive side, some of the policy announcements since late September do aim to achieve higher household spending. That was also a notable shift in the policy mix. On the negative side, the size appears to be less than 1-2% of GDP or insufficient and not outlined in more detail today. To reduce the household savings rate, China will also likely need to improve the social safety net. That observation is widely appreciated, but still inadequate in the policy announcement. From an equity market perspective, if there is a genuine shift to greater household consumption away from investment that likely favours consumer names relative to past-cycle beneficiaries such as commodity producers.
In conclusion, the disappointment and correction in China levered equities today likely reflects the speed and magnitude of the rally from the September low. It also probably reflects legitimate disappointment with the size and detail of the fiscal support package. To be fair, greater policy detail and action might still follow over the coming weeks and months. Risk compensation on the global risk proxy (S&P500) also remains inadequate. Our net equity exposure remains tight and light.
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