Newsletter commentary Oct 2023

In October, the overall market remained weak. Even though after the release of third-quarter economic data, the market continued to decline. The economic data was slightly better than market expectations. However, during a period of poor market sentiment, it was interpreted as a potential weakening of future stimulus policies. The market became trapped in a self-reinforcing narrative and struggled to break free from it. Subsequently, the recent announcement of issuing trillions of yuan in government bonds indicated that the market's concerns were excessive.

After experiencing a rapid improvement at the beginning of the year, the Chinese economy saw a slight decline in April and May, followed by a renewed improvement starting in June, which has continued to the present. Based on the data from the third quarter, consumer spending has largely recovered to pre-pandemic levels, contributing 4.6% to the economy for the quarter. The two-year average contribution stands at 3.5%, compared to 3.4% in 2019.

Whereas the consumer spending rate of 65.1% based on household surveys in urban areas, it has returned to pre-pandemic levels for the first time. In recent years, although there has been a slowdown in income growth for residents, savings have increased. This creates some uncertainty regarding the impact on future consumption decisions. However, we believe that the long-term trend of increasing consumption rates will remain unchanged. The uncertainty lies in how quickly and in what manner we return to the previous trend. As time goes on and with new income expectations, it is highly probable that the consumption rate will continue to rise.

In terms of the low base of last year, this year's economic growth rate of just over 5% is not considered high. The current low inflation level indicates that the economy is still below its potential growth rate, suggesting that further measures to promote consumption can aid in the recovery.

The real estate sector remains a major drag on the economy, with its contribution to the overall economy dropping to around 6-7% this year. This is a level that many countries can sustain. Considering China's significant underlying demand, the short-term impact is gradually diminishing. However, we do not believe that the assessment of China's economy should be solely tied to the real estate sector.  As real estate sales and new construction have reached a relatively sustainable level, and the focus will shift more towards the completion and absorption of projects currently under construction. This process will take some time to recover and absorb.

Moreover, the pandemic has disrupted the inflow of urban population in China. However, it is highly likely that after the pandemic recedes, population inflows into cities, both large and small, will resume. Although the potential increase in secondary housing transactions, our basic assumption regarding real estate is that it will not make a significant contribution nor pose a major drag on the economy.

Overall, we believe that the lately issuance of government bonds has added some certainty to the stability of infrastructure investment next suggests that it should also remain stable. The investment in the manufacturing sector can maintain a stable recovery trend based on the recovery of corporate profits. In terms of exports, the share of physical exports has been relatively steady this year.

Policy wise, fiscal policy is becoming more proactive, and there have been gradual announcements regarding personnel appointments in key financial positions. In September, the amount of financing in the stock market has significantly declined.

There has not been a significant improvement in the outflow of foreign capital. However, we think that there are signs of a phased easing in the relationship between China and the United States, which gives us a bit more optimism. We believe that the current state of the relationship is different from what it was in the past years. It has entered a new equilibrium and transitioned into a phase of strategic competition, where both sides have identified areas where cooperation is necessary. The costs of continued suppression are becoming increasingly evident.

Outside of China, overseas markets have started trading, and it is challenging for US inflation to continue declining. The current level of interest rates is restrictive in nature. With very proactive fiscal policies and a tightening monetary policy throughout this year, there has still been good nominal growth. However, the market perceives that inflation is about to ease, leading to expectations of an imminent interest rate cut. As a result, there has been strong trading in the earlier period. While long-term interest rates are only temporarily high, and the market is now indicating that this trading logic may not hold.

Looking forward the sustainability of proactive fiscal policies is uncertain. There are uncertainties regarding both the willingness and ability to maintain such policies under high interest rates. Plus, excess savings are expected to be depleted soon. Recent market trading information suggests that the original trading logic has changed dramatically.

Although the Chinese market has around 3% foreign investors ownership, considering the higher proportion of circulating shares, it is still predominantly driven by domestic investors. At present, the risk premium for stocks and bonds is attractive, with levels positioned around two standard deviations. We also observe that there have been signs of some investors shifting from high-dividend stocks to growth stocks, indicating a partial rebound in risk appetite.

China’s stock market is substantially huge and policy changes now have a more delayed impact compared to the past. The real estate sector, which used to be the primary driver for economic regulation, has already undergone adjustments, in the past, the probability of changing one’s faith and belief overnight has decreased. To the extent that the pursuit of high-quality development, the probability of sudden policy shifts has decreased. However, our view is that a gradual recovery and improvement in the market are highly likely. Over the course of three years, the overvaluation from 2019-2020 is gradually being absorbed. Furthermore, certain industries for instance electronics are showing signs of bottoming out. The profitability of Chinese stocks is expected to gradually recover, which will be the most effective way to attract both domestic and foreign investors.