China: Deceleration and Equities

ERIK NORLAND, SENIOR ECONOMIST AND EXECUTIVE DIRECTOR, CME GROUP 8 JANUARY 2016 China: Deceleration and Equities All examples in this report are hyp...
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ERIK NORLAND, SENIOR ECONOMIST AND EXECUTIVE DIRECTOR, CME GROUP

8 JANUARY 2016

China: Deceleration and Equities All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience. Chinese stocks opened 2016 with a tumble after a tumultuous

Figure 1: Both Real and Nominal GDP Growth is Slowing.

2015, which saw the FTSE China A50 Index trade in a range China Real and Nominal GDP Growth Rate

swinging from 8,450 to 15,100 points. Much of the volatility in China has to do with a changing macroeconomic environment:

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China’s economy is slowing, export growth is weak, commodity prices are collapsing, the People’s Bank of China (PBOC) is lowering interest rates and the country’s currency

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policy is changing. We will look at each of these factors as well as various valuation measures and discuss what they might

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mean for the Chinese equity market in 2016 and beyond. Real

A Slowing Economy China’s economy grew “only” 6.9% in the quarter ended September 30, 2015. By the standards of most countries, this

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is an enviable pace, but for China it represents a significant slowdown from the 10% pace that the country has enjoyed for much of the past few decades (Figure 1).

We expect China’s growth to decelerate further to 5.5% during the second half of this decade before falling to around 3% annually in the 2020s. Not only has real GDP growth cooled, nominal GDP is also growing much more slowly than in the past. Nominal GDP, which doesn’t adjust for the rate of inflation, is a much underappreciated measure of economic health. It represents the sum total of cash flows available to service debt, equity shareholders and to fill government coffers. China’s nominal GDP has been decelerating even faster than its real GDP as a result of declining inflation (Figure 2).

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Figure 2: Inflation Has Been on a Downtrend Since 2011.

Figure 3: China’s Private Sector More Highly Leveraged Than its Emerging Market Peers. Private and Public Sector Debt

China: Inflation Year over Year 10.0% 250

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Source: Bloomberg Professional, CNCPIYOY

In many respects, declining inflation is a good thing. It permits

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Source: "Deleveraging, What Deleveraging?" Buttiglione et al, International Center for Monetary and Banking Studies

Figure 4: High Levels of Private Sector Debt are Manageable if Interest Rates are Very Low.

the central bank to ease monetary policy. The combination of Private and Public Sector Debt

lower inflation and slower real growth, however, can make life difficult for debtors. This is a problem because China’s private

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sector is awash in debt. In fact, China’s private sector debt market countries and are more akin to those seen in Western Europe, U.S, Canada and Japan (Figures 3 and 4). Having high levels of private sector debt isn’t necessarily a problem if one of the following two conditions is present:

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Debt as a % of GDP

levels are much higher than those in most other emerging

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1) Nominal (and preferably real) GDP is growing quickly: there will always be more money to service interest and principal repayments on existing debt. 2) Interest rates are extremely low: this is the case in Western Europe, Canada, Japan and U.S. but not (yet) the case in China, where the cost of borrowing is still relatively high.

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Source: "Deleveraging, What Deleveraging?" Buttiglione et al, International Center for Monetary and Banking Studies

China’s equity market appears to be especially sensitive to credit concerns. This is probably because financial stocks represent 69% of the weighting of the index, dwarfing any other sector. Financial stocks have a similar weighting in the Hang Seng Index, which correlates highly with the FTSE China A50. By contrast, financial stocks have a much lower weighting in the tech-heavy S&P 500® and in the FTSE 100 (Figure 5). Any development that calls into question the credit worthiness of China’s private sector is likely to upset the equity market.

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Figure 5: The FTSE China A50 is Heavily Weighted to Financials.

Figure 6: Euro (EUR) and Yen (JPY) Have Fallen Sharply Against the Renminbi and Dollar (USD). USD, EUR and JPY versus Renminbi 120

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Currency

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High debt levels are probably contributing to slower growth in China but are not the only one. Another major factor is an overvalued currency. For many years China has tied its

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currency to the value of the U.S. dollar (USD). When USD was weak during the period from 2002 to 2011, China allowed the Renminbi (RMB) to appreciate by roughly one third. This made sense at the time as it allowed China to contain inflationary

Figure 7: Emerging Market Currencies Have Plunged Versus the Renminbi.

pressures while not damaging competitiveness. Since 2011,

Real, Rupee and Rouble versus Renminbi

however, a stronger USD has lifted the RMB along with it,

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degrading China’s competitiveness (Figures 6 and 7).

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dependent on exports and has relatively weak internal demand, especially on the consumer side. In fact, much of China’s expansion was driven by investment, both private and public, that transformed the country into a global export powerhouse. Now, however, export growth is stagnating (Figure 8) and China is beginning a delicate transition to a

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This is a big problem for China since its economy is strongly

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more consumer-led economy. We expect that the equity market will be very sensitive to export growth as well as to information that indicates how the transition from an

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Source: Bloomberg Professional: CNH, BRL, INR and RUB

investment and export-led economy to a consumer-led economy is proceeding.

Now that the RMB has become a global reserve currency with International Monetary Fund (IMF) special drawing rights, China is moving to a currency basket and is expected to loosen controls on RMB trading. If RMB weakens, it will likely boost the equity market.

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Figure 8: Exports are Stagnant but Imports are Plunging, Which Adds Back to GDP. China Trade

In the face of an overvalued currency and high levels of private sector debt, the PBOC has been steadily reducing interest

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In USD Billions over Rolling 12 Month Period

Interest Rates

rates (Figure 9). On balance, lower interest rates should be supportive for Chinese stocks as they will make debt burdens

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more manageable while encouraging growth in consumer spending and stability in investment spending. Higher rates

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in the U.S. won’t necessarily be bad for Chinese stocks either, especially if higher U.S. rates coincide with a weaker exchange rate for the RMB.

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Figure 9: PBOC is Likely to Ease Policy Further and Focus More on Rates than Reserve Requirements.

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Commodities

Given the breadth and scale of the collapse in commodity prices and the perceived role of China in bringing that about, some have even questioned if China’s economy might be in a much steeper slowdown than the official GDP numbers suggest. We don’t think so, for two reasons:

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1) The collapse in commodity prices isn’t explained entirely

energy and metals.

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of a wide range of products, including agricultural goods,

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by China. To a large extent, it reflects the boom in supplies

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Source: Bloomberg Professional: CNDR1Y, CHLR12M and CHRRDEP

2) GDP is the sum of government, consumer and investment spending plus exports less imports. While China’s

China announced on the first business day of 2016 that it

investments and exports have been slowing, imports are

would be moving away from using the reserve requirement

collapsing (Figure 8) and this adds back to GDP. In fact,

ratio as its main monetary policy tool. Rather, reserve

the collapse in energy prices alone probably added about

requirements will be used mainly to ensure the stability and

1% to GDP. The collapse in imports is mainly a price effect

solvency of the banking system while interest rates will gain a

related to lower commodity prices and not primarily a

more prominent role in the management of monetary policy.

reflection on the weakness of Chinese domestic demand.

We expect that China’s rates will most likely fall.

The effect of lower commodity prices on Chinese equities is somewhat counterintuitive: while many people blame softer growth in China for the collapse in commodity prices, lower energy prices in particular, is actually good news for China and probably, on balance, good news for Chinese equities. To some extent, weaker demand for Chinese goods in commodity-producing countries will be bad for China’s growth, but this should be outweighed by domestic gains as well as gains in other commodity-importing markets that buy Chinese goods such as the United States, European Union and Japan.

Valuations At the start of 2016, Chinese equities don’t look particularly expensive compared to their international counterparts. While there is no perfect measure of valuation, using a variety of measures such as price earnings, price/sales, price/book, and dividend yields shows Chinese stocks have valuation levels that appear to be fairly unexceptional when viewed against both emerging market and developed market indices (Figure 9). By most measures China’s stocks fall in the middle of the range for valuations (Figure 10).

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Figure 10:

Regression Model A simple and admittedly not very sophisticated regression model largely confirms our intuitions regarding what influences Chinese stocks. Our model seeks to explain the monthly return of the FTSE China A50 Index from December 2010 to December 2015 using six variables: changes in the S&P 500®, West Texas Intermediate oil prices, Fed Funds, Copper prices, JPYUSD and the PBOC’s policy lending rate.

In short, there is nothing to suggest that Chinese stocks are in

Together, these inputs explain only about 29% of the variation

a bubble. Even when Chinese stocks peaked in May and June

in the index – leaving the rest unexplained (Figure 12).

of 2015, they didn’t look alarmingly expensive. If there was a

Figure 12:

bubble in Chinese stocks it was probably back in 2007 and early 2008, not in 2015 and 2016 (Figure 11). As such, while we fully expect Chinese stocks to remain volatile and cannot rule out substantial further downside, we think that if Chinese stocks sell off a great deal further they will eventually be seen as a bargain. Overall, we suspect that the bearishness expressed by many commentators regarding Chinese stocks has probably gone too far and that over the next five to ten years Chinese stocks are likely to achieve average or perhaps somewhat above average returns. This, of course, doesn’t rule out the short-to-intermediate term possibility of a retest of the August low of around 8,500 points on the FTSE China A50 or

A few things here are of interest: during the five-year period

even a retest of its 2014 lows around 6,300 points.

in question, Chinese stocks tended to benefit from lower oil

Figure 11:

prices. Copper prices and Chinese equities moved in line, but this is likely Chinese equities moving copper rather than the

FTSE China A50 and the S&P 500

®

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other way around. The same can be said of the FTSE China

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A50 future and the Japanese Yen future. Lower Chinese stocks 20000

may put further downward pressure on the Japanese currency.

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Chinese interest rates are only after-the-fact moves in policy

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FTSE China A50 Index

U.S. and Chinese interest rates exert a weak influence BUT rates and do not reflect market expectations. Going forward, we expect that a weaker Chinese currency will most likely be positive for stocks as will any further easing of monetary policy.

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Source: Bloomberg Professional: XIN9I and SPX

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Lastly, what is most interesting and perhaps ultimately most important to equity investors both in China and elsewhere is the lack of correlation between the S&P 500® and the FTSE China A50 Index. What this implies is that Chinese stocks are potentially a very good diversifier for investors in the U.S. and elsewhere and that Chinese investors would also likely benefit from diversifying abroad.

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