Conclusion: Is an intermediate-term hard landing for the Chinese economy priced into global equity markets? We don’t think so.
Though we focus exclusively on research, our internal buyside process and exclusive network of client feedback provides us with some rather sophisticated questions that often lead to key conclusions which shape our global macro framework. One question that came up recently was:
“Will China experience a hard landing and, if so, is the spectre of that priced in?”
Addressing the question in reverse order, I’d have to say there’s negative data priced into any market that closed 2010 down (-14.3%). Further, the Shanghai Composite is down (-10.6%) since it peaked on November 8, suggesting new concerns may be on the horizon. Those concerns are born out of the possibility that China may aggressively tighten monetary policy in 2011, as China looks to ward off inflation currently at 28-month highs:
For months, we’ve been getting explicit signals from China’s central bank that they will be “prudently” fighting inflation in 2011, so the prospect of a hard landing as a result of aggressive tightening doesn’t seem that far from the realm of possibility. Liquidity is slowly and surely being removed from China’s financial system. In fact, that’s what the Chinese money market is telling us currently:
- China’s Seven-Day Repurchase Rate, which measures interbank funding availability may average 2.9% in 1Q11 up from a two-year high of 2.75% in 4Q10, according to the median estimate from a recent Bloomberg survey. The rate is currently at 3.14% after dropping (-320bps) this week.
- The one year-interest rate swap (fixed cost needed to receive the seven-day repo payments) has gained +120bps since August, which reflects concerns over a potential cash shortage within China’s financial system.
- Contracts linked to the yuan’s future value now predict a +2.7% appreciation in one year – up from just +2% less than a week ago! We read this as the Chinese currency market just got 35% more hawkish in their forecast for Chinese monetary policy and the resulting speculative inflows.
Bloomberg consensus forecasts for Chinese GDP growth in 4Q10 and 1Q11 are +9% YoY and +8.4% YoY, respectively, indicating consensus expects a moderate slowdown, yet still robust growth. What if, because of a potential shortage of cash to support China’s investment-driven economy, growth slows to something closer to +6-7% YoY in 1H11?
While I can’t say we have a definitive answer for that at this juncture, the question is worth bringing to your attention. While news of past and potential future rate hikes dominate the Chinese headlines, we posit that a shortage of cash brought on by the collective fears of additional tightening by Chinese lenders may end up causing the Chinese economy to slam harder on the breaks than currently anticipated.
The obvious inference is that, should this occur, it would likely be a very negative event for global equity investors, as the country which led the world into a global recovery in 2009 experiences a meaningful slowdown. While +6-7% YoY GDP growth is nothing to scoff at, an incremental (-200bps) draw-down in Chinese growth relative to already “slow” expectations for the next 2-3 quarters is a risk worth considering if you’re pondering getting long anything equity-related right here and now.
A tail risk worth considering here as well is China’s new 5-year plan, which is to be released in March 2011. Many investors expect it to be bullish for China’s consumer sector, as it attempts to rebalance the economy to a more sustainable growth model. To date, I haven’t heard anyone mention the possibility that it may come with a more explicit slowdown in the Chinese growth model from the current high-single-digit-to-low-double-digit trajectory to a more modest mid-single-digit pace. While we won’t know until we know, we do know that this scenario is outside of consensus expectations.