Expectations of Chinese policy stimulus rise again

Straits Financial Chief Economist Commentary (May 2024)

Summary

• Starting from late April, global investors’ sentiment towards the Chinese market has clearly turned optimistic, reflected by large net inflows into A and H shares and the strengthening of the offshore RMB and Hong Kong dollar. This may be due to the convening of the Politburo meeting on 30th April and the confirmation that the 3rd Plenary Session of the 20th Central Committee of the Communist Party is to be held in July this year. Many global investors interpreted it as an indication of possible major changes in domestic policies such as the introduction of stronger policy stimulus, especially in the real estate sector.
• Real estate remains one of the negative factors affecting China's economic growth. In the past two years, the government has offset the decline in the real estate sector by increasing investment in the “new productivity sector”. However, many of these industries, including wind, solar, and EVs are facing overcapacity and declining profitability as of today.
• Under current market conditions, it may take several years for the real estate sector to achieve destocking and its pessimistic investment outlook will continue. It is doubtful whether the “new productivity sectors” can continue to maintain their high investment and output growth in the past two years due to insufficient domestic demand and a huge uncertainty in exports. Therefore, investors expect the government may return to the old policy of supporting the real estate sector.
• Judging from the central bank's Pledged Supplementary Lending (PSL) operations and the pace of government bond issuance from January to April 2024, there is currently no data evidence to show that the policy has increased stimulus for the real estate sector in terms of fiscal and monetary policies.
• The recently released Q1 GDP and non-farm payroll data were both slightly lower than expected. As a result, the market has rekindled expectations that the Fed may begin to cut rates in Q3, thus boosting the performance of the stock market. We believe that these data are not enough for the Fed to ignore inflation and start cutting rates.
• The rebound in A-shares and Hong Kong stocks driven by inflows of global investors is expected to continue. However, investors need to pay attention to subsequent domestic policies, especially whether the pace of government bond issuance accelerates. We believe that the chance of large-scale economic stimulus is low. Therefore, we think that current rally in A and H stocks is just a rebound from being oversold. Since the incremental inflows mainly come from global investor’s re-allocation, Hong Kong stocks may perform stronger than A-shares in the near term. On the commodity front, as oil prices are down, industrial metals may become the strongest commodity in the near term.

Macroeconomic Views

Continual inflationary pressures in the US may delay rate cuts. It is also expected that the Fed will tighten liquidity in Q2, thereby suppressing rising inflation expectations, but this may also put pressure on the prices of risk assets, including stocks and commodities such as crude oil. The current pressure on China's economy mainly lies in manufacturing overcapacity and declining profitability caused by insufficient demand. Without further policy easing, especially fiscal policy easing, this situation is difficult to change in the short term.

Views in May:

I. Global investors become more optimistic about the Chinese market.

Starting from late April, global investors' sentiment towards the Chinese market has clearly turned optimistic. This is specifically reflected in the rapid inflow of foreign funds into Hong Kong stocks and A-shares. In the six trading days from 24th April to 6th May, the net northbound funds buying A-shares reached 38.9 billion RMB, setting the fastest net inflow rate in a year (Figure 1).

In addition, the offshore RMB exchange rate was also lifted by a quick appreciation. HKD appreciated and USD/HKD dropped from 7.83 to 7.81 since 23rd April (Figure 2). As can be seen from Figure 1 and 2, before23rd April, northbound funds showed a slight net outflow, while the offshore RMB and Hong Kong dollar also showed a slight weakening against the US dollar. What had caused foreign investors to suddenly become optimistic about the CChinese market in just a few days?

We believe that the biggest change affecting market expectations came from the convening of the Politburo meeting on 30th April and the confirmation that the Third Plenary Session of the 20th CPC Central Committee will be held in July this year. Many global investors interpret this as a possible major change in domestic policies, especially the expected introduction of more policy stimulus, specifically targeted at the real estate sector. We believe that overseas investors have such expectations mainly due to the following reasons:

First of all, real estate is indeed the main factor affecting China's economic growth at this stage. Although China's GDP achieved a growth rate of 5.31% in Q1, it was mainly driven by the growth of consumption and exports. These two areas contributed 3.91 and 0.77 percentage points to the growth in Q1 respectively, while the contribution of investment was only 0.63 percentage points, which is the lowest level since Q2 of 2022, which is another significant drop from the 1.2 percentage point contribution rate in Q4 of 2023. From the perspective of the three major components of investment (manufacturing, infrastructure and real estate investment), real estate investment is undoubtedly the biggest reason for the slowdown in investment growth. Manufacturing investment growth in Q4 was 9.9%, further accelerating from the 6.5% growth rate in 2023. At the same time, the infrastructure investment growth rate of 8.75% in Q1 was also higher than the 8.24% growth in 2023. However, while real estate investment fell by 9.6% in 2023, it further fell by 9.5% year-on-year in Q1 (Figure 3).

In the past two years, China has basically hedged against the negative impact of the real estate investment downturn on the economy by increasing investment in manufacturing, especially in so-called “new productivity sectors” including wind power, solar, EVs and energy storage equipment. However, as the decline in property investment spreads into its third year, these new productivity sectors that were previously promoted by the government are now also experiencing overcapacity, and it becomes increasingly difficult to find more manufacturing industries with actual increased demand. That is why investors expect the government may have to return to the old policy of revitalizing the property sector.

Indeed, local governments have introduced more property relaxation policies recently, ranging from lifting the purchase restrictions to repurchasing of vacant houses and promoting the swap of old houses with new ones. However, in our view, due to the limitations of local government fiscal policies, these small-scale policies ?have little impact on the entire domestic property market, regardless of whether it is in the first-hand or second-hand housing market. Taking the first-hand housing market as an example, China's new housing sales in 2021 were 1.565 billion square meters, but in 2023 it dropped to 948 million square meters, equivalent to the level in 2010. However, the current housing under construction is still as high as 5.89 billion square meters, which is still higher than any other year except 2019 to 2021. Even if China's housing sales can maintain at the level of 950 million square meters in the future, the construction sector may continue to fall. Taking the construction sector in 2010 as a reference, it was only 3.15 billion square meters. The construction sectormay continue to drop from the current 5.89 billion to nearly 3.15 billion square meters to match with the current new home sales. As there is a possibility for the construction sector to drop, which also means that China's economy will be affected by the decline in real estate investment in the next few years. Another hypothesis is that China can use certain policies to stimulate the housing sales to pick up again. Even if it cannot rise to the level of 1.5 billion square meters in 2021, it will help speed up the housing destocking. However, domestic new home sales in Q1 were only 189 million square meters, another 19.4% year-on-year decrease from Q1 of 2023. This sales volume is even lower than Q1 of 2020 when the Covid19 pandemic broke out (Figure 4).

Under such circumstances, it is not surprising that investors, especially foreign investors, have expectations that domestic policies may use large-scale stimulus to revive the real estate sales. However, from a more realistic perspective, we need to figure out how much policy strength is needed to make it possible for China's real estate sector to recover in the future?

II. What type of macroeconomic policies are required to revive property in China?

Using the past property stimulus cycle in 2015 as a reference, China was bullish in the real estate sector from 2016 to 2019 by launching extensive housing reform policies. Property sales, property investment and housing prices continued to make new highs during that period. The source of funds that promotes the rise in housing prices came from the joint leverage-up of the central government, local governments and households. Firstly, the central bank launched the pledged supplementary loan tool (PSL) in May 2015 to specifically promote old town renovation and reconstruction. By mid-2019, the total scale of PSL reached a maximum of RMB3.5 trillion, and its scale since began to decline. In Q4 of 2022 and 2023, due to the various needs such as ensuring the continuation of construction, the scale of PSL rebounded, but it has never reached a new high. The overall scale of PSL has declined slightly this year. As of the end of April, the scale of PSL was RMB3.02 trillion? (Figure 5).

The second level of funding comes from the local government. In May 2015, the balance of local government debt was RMB1.2 trillion, and by the end of 2019, it ballooned to RMB21 trillion. In addition, the liabilities of local governments increased through other financing platforms are also more than RMB10 trillion. These funds are mainly used for infrastructure and property development. The third level is household’s leverage. In May 2015, China's total residential loans were RMB24.5 trillion , which was roughly 36% of their GDP. By 2019, the balance of residential loans had reached RMB55 trillion , which was close to 60% of GDP. Based on these data, it is unrealistic for local governments and households to repeat that kind of rapid leverage-up from 2015 to 2019. Therefore, if real estate sector were to have a fast recovery, the only way is for the central government to increase its leverage on a larger scale. A net increase of 3 trillion PSL is obviously far from enough. We believe that if the central government does not have a scale of more than 10 trillion incremental debt, the impact on the current domestic housing market ?will be very limited.?

However, the reality is that the central government's fiscals also have little room to expand at present. In addition to normal expenditures on social security, the central government has also increased investment in “new productivity sectors”. Now it is more urgent to solve technology bottlenecks and achieve a comprehensive improvement of China’s self-sufficiency and its industries’ self-reliance. Therefore, we do not believe that the central government will cut back on these investments and instead invest these funds to revive the property market. So, is it possible for the central government to do both? What about increasing investment in new productivity sectors and significantly stimulating the real estate sector at the same time? We believe that in this case, it is obvious that the current quota of 1 trillion special treasury provided by the government is inadequate to achieve that target. In fact we think that even 5 trillion new special treasury per year may not be enough. This will also lead to a rapid increase in the government's debt and deficit ratio, and further intensify the interest burden in future fiscal outlays.

Therefore, we believe that the more likely scenario is not the central government’s large-scale debt issuance and stimulus, but the relaxation of some local policies, together with policy narratives trying to change market expectations and revive home buyers’ interest. With this, it may help to drive a marginal improvement in housing market conditions.

Of course, there are uncertainties about whether this policy intention will succeed, especially for a non-liquid asset like property. For assets with good liquidity like stocks, it is not necessary for the policy to be implemented or the policy to be effective. If there are optimistic expectations given by the policy and its narratives, it is enough for the market to rebound due to mass speculation.

Global investors are relatively more optimistic about it because overseas liquidity is relatively more accommodative. Since 2021, China's domestic liquidity situation has become tighter, while in overseas markets, liquidity has loosen since 2023. This has also led to the impact that global funds continue to underweigh A and H shares, and A and H shares continue to underperform most of the surrounding stock markets. Therefore, from the perspective of overseas investors, especially short-term traders, if China shows signs of marginal improvement, even if it is not a comprehensive reversal of the economy, it will be sufficient for the market to usher in a wave of oversold rebounds caused by marginal re-allocations.

From the perspective of Chinese investors, there is no such rebound factor of re-allocations, so it is inevitable that A shares are relatively weaker than H shares. At the same time, domestic investors are also more concerned on when these stimulus policy expectations will be confirmed or falsified. Although the third Plenary Session of the Central Committee of the Communist Party of China is still more than two months away, investors can continue to observe the recent situation of domestic government bond issuance. According to our previous analysis, if there is a stimulus policy in the future, we must first see the government's large-scale debt issuance, which may also include lifting restrictive constraints on local government financing. As of the end of April, we have seen that the financing amount of various government bonds this year has continued to decline. Although this does not mean that the speed of government bond issuance and financing will not accelerate again in the future, at least it shows that as of now, the bond issuance market still has no indication of the central government’s policy intention to increase stimulus.

III.?Fed still needs to wait for inflation to fall further.

The recently released Q1 GDP and May non-farm payroll data in the US were both slightly lower than expected. As a result, the market has rekindled expectations that the Fed may begin to cut interest rates in Q3, thus boosting the performance of the stock market. However, we believe that these data are not enough for the Fed to ignore inflation and start cutting interest rates.

For example, although the QoQ GDP annualized rate in Q1 was only 1.6, it was mainly due to the negative contribution caused by increased imports (-0.96). The contribution of service consumption, which is the core of the US economy, was actually accelerating (+1.78). Meanwhile, private investment, both property and non-property, continued to increase. To sum up, it shows that the overall demand in the US, especially the private sector's service consumption demand, is still going strong in Q1, with the exception that both goods and government consumption have slowed down. The impact of high interest rates on property investment has been significantly weakened. Under such circumstances, if the Fed begins to cut interest rates soon, there will indeed be a greater risk of "second round inflation." And if inflation remains high in the second half of the year, it will be detrimental to the Biden administration's chance of second term. Therefore, we believe that it is impossible for the Fed to choose to ignore inflation and start cutting interest rates under the current economic conditions. If the stock market becomes more optimistic about interest rate cuts, it cannot be ruled out that the Fed will once again make hawkish remarks to control the market's inflation expectations in the future.

Another important factor affecting inflation trend is oil prices. Recently, the Biden administration has tried to reduce the intensity of the Palestinian-Israeli conflict through greater diplomatic endeavors. We believe that an important factor behind the Biden administration's move is to reduce geopolitical risks in the Middle East to suppress the rise in oil prices and its impact on US inflationary pressure. In addition, it can also reduce the possible negative impact on its re-election in the second half of the year due to the recent riots caused by the Palestinian-Israeli conflict in the US, especially by university students. If this diplomatic effort by the Biden administration can achieve certain results, it will put downward pressure on oil prices in the short term.

IV.?Market strategy

The rebound in A-shares and Hong Kong stocks driven by inflows of global investors is expected to continue. However, investors need to pay attention to the implementation of subsequent domestic policies, especially whether the pace of government bond issuance can be accelerated. The risk may lie in the failure to fulfill these expectations, but that time will be after June. We believe the probability of domestic large-scale economic stimulus policies is low. Therefore, we believe that this round of A-shares and Hong Kong stocks is just an oversold rebound. Since the incremental funds come from global investor’s re-allocation, H shares may perform stronger than A-shares in the near term.

Maintaining a neutral view on US stocks. It is currently difficult for US stocks to rise significantly, because rising stocks will cause the market's inflation expectations to rise again. ?The Fed and the Biden administration urgently needs to lower the market's inflation expectations. Therefore, although the US stock market is very resilient, it is difficult for the U.S. stock market to make another sharp rally at this stage when inflation is currently not suppressed. The recent favorable factor for US stocks is the fall in international oil prices. If the US government can slow down the Palestinian-Israeli conflict and promote the reduction of geopolitical risks in the Middle East, then the fall in oil prices will be good for the US market.

On the commodity side, as oil prices are down, industrial metals may become the strongest commodity in the near future. Industrial metals have a relatively weak impact on US inflation, if the Fed does not need to significantly tighten liquidity to lower oil prices to control inflation, it will be good news for other commodities.

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