After the slowdown that has seen China’s GDP growth decelerate in recent years from a peak of 10.6% in 2010 to 6.7% in 2016, Chinese authorities embarked on an aggressive monetary and fiscal policy stimulus programme that led to a sharp pick-up in nominal GDP growth: reflation was achieved. This came together with efforts towards maintaining the stability of currency and capital outflows. As a result, asset prices linked to China (such as cyclical commodities and materials exporters) were robust in 2016.
However, policy stimulus is now waning and the authorities are starting to tighten the screws on extended borrowing. We explore what this could mean for China’s growth outlook and for asset prices that are linked to it.
Fading stimulus may threaten China’s GDP growth
The policy actions taken by China can be clearly tracked by the expansion of credit relative to nominal GDP, sometimes referred to as the credit impulse. Exhibit 1 shows that such a credit impulse tends to increase sharply when the economy slows and to fall (stimulus is reduced) as the economy recovers.
A little more than a year has passed since the credit impulse in China peaked in April 2016 and typically the economic cycle (nominal GDP growth in Exhibit 1) follows with an average lag of 18 months. If we use recent history as a guide this means that the growth cycle should start turning in the next few months.
Exhibit 1: Credit stimulus is slowing in China and weaker growth usually follows
Source: Bloomberg and Reuters, as of 17/05/17
As well as slowing credit, the authorities have also embarked on a series of measures aimed at reducing debt in some sectors of the economy. They are doing so mainly in response to the activities of small, regional banks and other non-bank financial institutions (shadow banks), that have financed activities beyond the real economy, including investments in property and equity markets. The main measures include macroeconomic prudential regulation and higher interbank rates to limit credit to these small, regional and shadow banks. Even though that tightening is not intended to slow the broader economic recovery, deleveraging can hurt growth if it leads to corporate defaults or household insolvency. The negative feedback loop from deleveraging to slower growth may gain traction in the context of a slowing credit impulse.
Is the transmission channel to global markets different this time?
When it comes to assessing the implications for global financial markets it is important to understand the transmission channel of a slower GDP growth path in China. There were significant capital outflows from China in mid and late 2015, and the authorities let the renminbi depreciate versus the US dollar. Risk aversion rose because global investors feared a major disinflationary shock from cheaper imported goods from China and became more concerned about the true state of the Chinese economy. This time is different because the authorities are putting the brakes on credit expansion internally, while keeping the exchange rate and capital outflows stable. In short, the adjustment is being made domestically rather than externally. So far the repercussions in global markets have been contained, but some cracks are starting to appear in assets linked to China’s ‘old’ industrial cycle (see Exhibit 2).
Exhibit 2: Valuations of assets dependent on China’s economy are starting to suffer, performance of emerging market equities is resilient so far
Source: Bloomberg, as of 17/05/17
Valuations of assets dependent on the state of China’s economy are starting to weaken: will those in other emerging markets follow?
To understand the possible implications of a weaker outlook on asset prices we analysed the behaviour of nominal GDP growth and various asset prices that are linked to China’s economic cycle. In particular, we assessed the path of growth and asset prices from the peak to the trough of the credit cycle. The following results stand out:
- Commodity prices within China (e.g. iron ore and steel) tend to fall in line with the cycle, roughly 18 months after the credit peak. Chinese equities have a less clear pattern.
- China-linked assets quoted abroad (e.g. copper prices, basic resources stocks, Australian dollar) tend to anticipate the turn in the growth cycle; this usually happens 12-18 months after the credit peak.
- Emerging market (EM) assets (total returns on equities, local debt and hard currency debt spreads) tend to coincide with the cycle turn and EM debt is generally more resilient than EM equities (see Exhibit 3). EM equities have tended to fall 18 months after credit peaks and we are 12 months past the peak now.
- EM foreign exchange returns are vulnerable, but interest rates outperform protecting local debt returns; EM credit spreads returns fall broadly in sync with those from equities.
Source: Bloomberg and Reuters, as of 17/05/17
Asset allocation implications: still too early to reduce EM equity risk; prudent to hedge
To sum up, the slowdown in credit stimulus in China poses risks to the economic recovery. But this is still some six months away using recent history as a guide. The recovery may hold up until the autumn Plenum, prior to which the authorities will likely err on the side of stability. But the risk that markets anticipate the slowdown is increasing.
From an asset allocation point of view, we do not think it is yet time to reduce EM equity risk exposure to an underweight. Indeed, there are other positives for EM such as more diversified growth drivers in China; a global synchronised recovery; and the prospect of broadly stable US bond yields and US dollar. However, history suggests it is prudent to hedge against the increased risks of a renewed China slowdown, so this is what we have implemented in various multi-asset portfolios.
Written on 17 May 2017 by Guillermo Felices and Lydia Rangapanaiken
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