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Eternal Hope or Revulsion?

From our perch, a behavioural error analysts and investors often make is to extrapolate cyclical dynamics as structural. The macro cycle in China probably has elements of both and is complex. There likely has been a slow down in China’s trend potential growth. Recall potential growth is population growth plus productivity growth. The latter is difficult to estimate, but we know the former has slowed materially in China. Trend consumption or retail sales has slowed meaningfully over the past decade and has been particularly weak since the pandemic in cyclical terms (chart 1).

While China’s households also had pent up demand and revenge spending post reopening, the Chinese consumer did not benefit from direct fiscal support like the United States or Europe. That might explain why the recovery has been disappointing compared to elsewhere. Labour market conditions and confidence will likely be important for households in China.

As we often note and has been widely observed, debt dynamics are important for both the secular and cyclical outlook in China. The rate of change in credit growth has been a reliable indicator of the mini cycle over the past two decades in China. Put another way, credit is inflationary when taken on and deflationary when paid back. Phases of acceleration in the credit impulse have led a rally in commodity and asset prices as the largest driver of growth over the period was real estate (~25% of GDP) and infrastructure (chart 2). Note the credit impulse has rolled over and turned negative again.

Of course, there has been an interplay between cyclical weakness in real estate and the structural challenges facing the Chinese economy. Several phases of rapid growth in housing and infrastructure since the 2008 crisis contributed to imbalances – overbuilding, large total debt accumulation and overvaluation relative to income or debt-servicing capacity in the property sector itself and local governments. The already large total debt burden is a constraint on the cyclical policy response in the current cycle. On the positive side, the weak recovery in the credit impulse after reopening and disappointing growth momentum has probably motivated the recent Politburo announcement and more concerted focus on housing, infrastructure, and the private sector. Albeit there is a greater desire from policy makers in this cycle for a rotation to consumer led growth.

For markets, stocks linked to China’s reopening have still been correlated to the traditional drivers of the mini-cycle in China – spot iron ore, steel, and industrial commodities (chart 3). However, looking forward, the greater beneficiaries might be the large consumer and platform stocks. The good news from a pure price perspective, is that the focused reopening basket and the broad Chinese stock market remain above the June lows. Valuation is also closer to trough levels.

From a behavioural perspective there is a sense of revulsion in the investor preference for Japan and observations from some that China is “un-investable” or a sense of revulsion. While we have sympathy for many of the arguments; geopolitical risk; impact of common prosperity on shareholder returns; weak trend growth; and elevated debt, the best investment opportunities are often made when we are deeply uncomfortable. Tactically, there is likely to be an opportunity to accumulate more China and related exposure over the coming three months. In the very short term we remain “light and tight” on our net exposure to equities and credit.


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