"One country, two systems", a famous phrase coined by the late Chinese leader Deng Xiaoping, has served China well: letting Hong Kong’s western-style economy co-exist alongside a state-controlled system has helped fuel spectacular growth rates in the past decades.....
Christophe Bernard, Chief Strategist Vontobel - Market Comment - February 03, 2016
Chinese officials were able to take credit for that. However, belief in the leadership’s economic savvy has waned amid sagging growth and heavy-handed government interventions in the country’s equity markets.
There is little doubt that China has achieved a lot since it opened up to the world under Deng Xiaoping in the late 1970s: GDP growth rates have been stellar and the improvement in the standard of living impressive. However, this success has been increasingly credit-driven and overly dependent on investment in areas such as real estate and heavy industry. At the third plenum of the central committee of China’s Communist party in November 2013, the country’s leadership recognised the need to rebalance the economy towards consumption and services, outlining an ambitious long-term plan to allow market forces to play a larger role. This is easier said than done: the slowdown of the economy has turned out to be sharper than expected. In addition, economic and monetary policies have lacked coherence to the point that a crisis of confidence has emerged. This can be seen from the massive drop in Chinese foreign-exchange reserves over the past 18 months (see chart 1).
Chart 1: Chinese foreign-currency reserves have dropped from a high level
in billions of US dollars
Source: Thomson Reuters Datastream, Vontobel Asset Management
Yawning gap between stated intention and action
It seems that the government is trying to pursue objectives that are mutually exclusive. For instance, fighting a depreciation of the Chinese yuan by selling foreign-exchange reserves is preventing the Peoples’ Bank of China (PBoC) from easing monetary policy at a time when it is sorely needed. By the same token, the authorities have identified massive overcapacity in industries such as steel, cement or coal, but balk at addressing this issue for fear of a surge in unemployment – a development that could threaten social stability. Likewise, the authorities correctly assume that a higher degree of freedom for economic agents is necessary for climbing up the GDP-per-capita ladder; but they resort to intervention when markets behave “badly” – i.e. when they do not follow the leadership’s script. The Chinese government’s massive and recurrent tampering with local bourses since the summer of 2015 bears witness to this policy incoherence.
The core issue in China is that there is no easy way of doing away with the mountain of debt that has piled up over the years from massive investments in areas with sharply declining profitability (see chart 2). The result is a downward trend in economic profits at a time when disinflation has become pervasive, making debt sustainability a major challenge. As a rule, countries facing such imbalances experience a full-blown crisis with a sharp drop in their currencies and economic output, eventually setting the stage for a sustainable recovery. Given plentiful foreign-exchange reserves, a positive trade balance and the ability to control the yuan, China has the capacity to delay or smoothen such a downward adjustment. However, it cannot defy gravity forever.
Chart 2: Loans to Chinese companies and private households have risen dramatically
in percent of GDP
Source: Thomson Reuters Datastream, Vontobel Asset Management
Oil price should rebound in the second half of 2016
The Chinese economic slowdown has hit commodity prices badly, with ominous consequences for emerging markets in general and commodity-producing countries as well as mining companies in particular. While we identified such issues relatively early and kept our exposure to emerging market and commodity-related assets to a minimum, we have moved to an overweight stance on equities (via developed-market stocks) into the December 2015 correction. This proved to be premature given the sharp sell-off of risky assets so far in 2016. We have retained our moderate overweight stance towards equities as we consider the sell-off excessive and expect some relief due to central-bank action given subdued inflation readings and downward risk to economic growth. However, corporate earnings remain lackluster and the upside potential of equity markets appears limited. Tactical flexibility remains key, as well as a strict selective approach.
Commodity holdings increased
We have used the plunge in crude-oil prices below 30 US dollars to move to a neutral position in commodities (from underweight) as we expect oil to recover in the second half of this year. In addition, we have re-established an exposure to gold on an increased likelihood of further policy accommodation from central banks and potential safe-haven flows. Last but not least, we have reduced the magnitude of our US-dollar overweight as we deem the near-term risk/reward ratio to be finely balanced.
Given the developments mentioned above, it is evident that our scenario 3 for 2016 (“Markets face a crisis of confidence”) – one we considered unlikely a short while ago – has gained in probability. We still believe that scenario 1 (“Robust US economy, sluggish global growth”) remains the most likely one. Meanwhile, scenario 2 (“US economy pulls ahead, global growth improving”) can be discarded at this point (see our scenario overview in the December 2015 issue of the Investors’ Outlook). For our central scenario to prevail, further policy action from monetary authorities will, however, be required. Such actions are needed to prevent financial conditions from tightening excessively – i.e. wider credit spreads and lower equity markets – and affect the real economy. In this respect, the European Central Bank (ECB) has recently reaffirmed that it remains fully committed to reaching its inflation target. We therefore expect ECB President Mario Draghi to announce further monetary-policy easing at the upcoming March meeting.