Will the Year of the Dog mean China is markets’ best friend or a foe?

While drops in the US dollar, the American Treasury market and even the US stock market are grabbing all of the headlines, China’s currency is storming higher, buoyed by solid economic data and the political stability which seems to be the result of last autumn’s 19th five-yearly Party Congress.

China’s Shanghai Composite index also made good ground last year, taking the Hong Kong market along for the ride, as the Hang Sen reached an all-time high in late January.

However, both indices have proved susceptible to wobble in risk appetite discernible as January turned into February. Hong Kong lost over 2% in the first trading day that followed Friday 2 February, which saw the biggest daily loss in US stock markets for two years, and Shanghai lost ground before America’s stumble, with local, specialist small-cap and technology indices taking a bigger drubbing, as the ChiNext and CSI 500 benchmarks lost more than 5% in a week.

Stock indices in China and Hong Kong are riding high

Source: Thomson Reuters Datastream

As such, now seems like a good time to revisit China, especially as the Year of the Dog takes over from the Year of the Rooster in the Chinese zodiac on Friday 16 February, as events in Beijing and Shanghai still have the capacity to move a range of markets and asset prices on a global basis. Note, for example, how the Bloomberg Commodity index seems to take its lead from market and economic events in China.

Commodity prices still seem to take their lead from China in particular

Source: Thomson Reuters Datastream

The dog that didn’t bark in the night

It is easy to be sceptical of Chinese economic data. The GDP numbers are released incredibly quickly and are never revised. For such a large economy – the world’s second biggest no less – this can look suspicious, especially as this is such a contrast to the UK and USA, where the published numbers are reassessed twice after the initial estimate.

Doubters will also comment about how the headline GDP growth numbers are remarkably consistent and tend to neatly meet or just beat the Party’s target for the year.

But, in the end, advisers and clients who are long-term bulls of China can take home three positives on the economic front.

  • First, GDP growth of 6.9% exceeded Party targets and consensus forecasts in 2017. The International Monetary Fund expects further strong progress in 2018 and 2019 and does not seem unduly concerned by prospects of a ‘hard landing,’ whereby China slows very suddenly.

China is expected to keep delivering annual GDP growth of 6%-plus

Source: International Monetary Fund

  • Second, external demand, via exports, appears to have helped here, to tie in with the consensus market view of a synchronised global economic recovery, where more than 90% of the world’s GDP can be found in countries that are forecast to increase output in 2018. This should help to compensate for a (necessary) cooling in the domestic Chinese housing and property markets.
  • Third, a surge in the currency, the renminbi, will help calm fears of a devaluation, were China to need to find a way out of any unexpected growth slump. Such concerns hit global markets hard in summer 2015 and early 2016 as markets took flight amid fears that China may have tried to devalue its way out of trouble and export price cuts and deflation around the world.

China’s currency is reassuringly strong

Source: Thomson Reuters Datastream

The dog that may still bite

Nevertheless, China does still have questions to answer.

  • Doubters will argue that the foundations for domestic growth are too weak, given the reliance on debt and cheap funding. (They may now also point out that a strong currency could hamper export growth, too.)

China’s government debt-to-GDP ratio is below 20% using the official numbers, a figure which makes the 80%-plus of the UK and 100%-plus of the USA look pretty sick. But there are three issues here.

First, the annual deficit and aggregate deficit are both rising.

Second, a lot of additional debt sits in a sort of accounting neverworld with the State Owned Enterprises, who lie between the government and the private sector.

Finally, China is now the world’s biggest market by banking assets, with data from the China Banking Regulatory Commission showing that total bank assets had reached $38 trillion by the end of 2017 – up from just $6 trillion a decade ago. That sort of growth, say the doubters, can’t come without a few sour loans and some poor capital allocation along the way.

China’s public finances are apparently healthy but debt is rising

Source: International Monetary Fund, Société Générale

  • Sceptics will also question how long China will continue to prime the economic pump. Growth in 2017 did seem to rely heavily on old, industrial China, rather than the one beloved of bulls of China, which is booming owing to the rise of the middle class, increased consumption, technological advances and the rise of web-services giants such as Baidu, Tencent and Alibaba.

This is because the so-called Li Keqiang index made a comeback last year. This is based on the three economic indicators which the Prime Minister is believed to follow in preference to official Government statistics, namely demand for loans, rail cargo traffic volumes and electricity consumption.

The Li Keqiang index’s loss of momentum is a concern

Source: International Monetary Fund, Société Générale

However the index began to lose momentum in late 2017, something which may inform the International Monetary Fund’s view that Chinese GDP growth will, while staying above 6%, still slow in 2018 and 2019.

  • Finally, the Party, under Xi Jinping, continues to push for reform, combat corruption and push back on excess borrowing within the economic system, not least because the People’s Bank of China warned last year of the risk of a Minsky Moment, when excess debt and poor allocation of capital come home to roost in the form of a financial crash and economic downturn.

The Financial Stability and Development Committee is already looking to rein in financial leverage, while the National Development and Reform Commission is publicly supporting the use of debt-for-equity swaps by State-Owned Enterprises to repair their balance sheets. Both could, in the short term, weigh on economic growth, the domestic stock market or both.

Conclusions

The Chinese authorities probably deserve a lot of credit for keeping so many plates spinning, as they do face the same dilemma as many Western governments – namely how to maintain legitimacy in the eyes of the people by delivering growth at a time when indebtedness is high and a potential obstacle to future growth.

Not everyone can have a weak currency at the same time, coupons and interest have to be paid (and principal repaid, eventually) and trade flows between the global economic powers are still a potential source of friction as well as benefit.

Three handy indicators which might help advisers and clients keep an eye on events in China and whether their global influence could be benign or malign:

  • The first is the currency. Renewed weakness in the renminbi could be a source of concern for markets. This is because of the precedent offered by the 1994 devaluation which, accompanied by a sharp tightening of monetary policy by the US Federal Reserve, caused chaos in global stock, bond and currency markets alike.

Source: Thomson Reuters Datastream

  • The second is inflation. Capacity cuts in basic industries such as steel and mining mean producer prices (PPI) have risen fairly sharply, even if the consumer price index (CPI) has been subdued. Markets will not want to see China export too much inflation any more than they will want to see it export deflation in the wake of any devaluation.

Source: Thomson Reuters Datastream

  • The third is the Chinese Government bond market, which may well take its cue from inflation. Just like its UK, US and European equivalents, the market for traded sovereign loans in China has seen prices slowly fall and yields slowly rise, as global markets have priced in this long-awaited global synchronised recovery (if that is what it is).

Source: Thomson Reuters Datastream

But markets will not want to see China run too hot, for that could mean a surge in yields to a level which could suck cash out of stocks and back to bonds across the world, or too cold, as that could mean a growth disappointment. Yields rising quickly could mean too hot and falling quickly mean too cold – so advisers and clients will be hoping to see something from the middle ground from the Middle Kingdom.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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