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CONCLUSION: While Deflating the Inflation remains a bullish catalyst for the Chinese economy, the lag between this event and the turn in both the reported growth data and growth expectations may have just increased. As such, we are of the view that waiting and watching for clarity is the best strategy in the immediate term for China.

 

VIRTUAL PORTFOLIO: Sold our long positions in Chinese equities (CAF) on MAY 21.

***This is an adjunct to our MAY 16 note titled, “CHINA: LESS BORING; MORE CONFUSING”. If you haven’t yet seen it, we encourage you to check that out in conjunction with our update below.***

The incremental growth slowdown in China has been confirmed. Per the State council: “We must proactively take policies and measures to expand demand and to create a favorable policy environment for stable and relatively fast economic growth.”

We can’t stress this enough: this is a dramatic rhetorical shift from guiding down growth expectations to trying to support falling growth expectations. Easing to support growth is a far superior driver of improvements in investor sentiment than easing to save growth, with the latter potentially being a bearish catalyst.

As outlined in the previous note, we anticipate that Chinese GDP bottoms here in 2Q – function of our Deflating the Inflation theme and the accompanying policy maneuvers giving us the scope to roll with our proprietary median forecasts for Chinese growth. That led us to the following conclusion (from last week’s research note): “… while we don’t view a material acceleration in Chinese economic growth in 2H as a probable event absent a removal of the property market curbs, we do think further RRR reductions and actual interest rate cuts will start to filter through the economy and provide an eventual boost to Chinese economic growth.” If we start accepting our predictive tracking algorithm’s downside guidance as the highest probability scenario, the range of Chinese GDP expectations is unlikely to bottom over the intermediate term.

CHINA’S INCREMENTAL GROWTH SLOWDOWN CONFIRMED - 1

Mixed signals make it too soon to tell which is the correct interpretation, however. Chinese rate sensitive sectors (Financials; Industrials) are not outperforming in the face of accelerating easing expectations in the interest rate swaps and currency forwards markets, while property developers have accelerated their outperformance over the last 6-8 weeks.

 

CHINA’S INCREMENTAL GROWTH SLOWDOWN CONFIRMED - 2

 

CHINA’S INCREMENTAL GROWTH SLOWDOWN CONFIRMED - 3

 

CHINA’S INCREMENTAL GROWTH SLOWDOWN CONFIRMED - 4

As an aside, we continue to wrestle with the thought that accelerating FX deprecation speculation is a sign of accelerating capital outflows – which would coincide with an acceleration to the downside in Chinese property prices and a potential Chinese banking crisis. That’s far from our baseline TREND-duration expectations currently, but we’ll adjust our outlook according with real-time data (i.e. market prices). Chinese banks sold a net CNY60.6B of foreign currency in APR (-0.2% MoM) and, while modest, this marks the first sign of a sequential capital outflow since DEC.

CHINA’S INCREMENTAL GROWTH SLOWDOWN CONFIRMED - 5

Regarding our market price indicators, the broader Chinese equity market is in the process of confirming a TREND breakdown on our proprietary quantitative models – a clear signal to us that investors should get to the sidelines here and wait for further confirmation. Sometimes the hardest thing to do in a business that demands positive P&L on an increasingly high frequency basis is “doing nothing”. In spite of such institutionalized pressures to act, our new call on China is just that for now.

Jumping back to the point regarding Chinese property developers’ recent outperformance, there are a handful of potential catalysts that can shift both sentiment and operating metrics in a positive direction over the near term that warrant keeping an eye on as it relates to the Chinese demand curve (Gross Fixed Capital Formation = 46.4% of GDP): 

  • Per today’s statement out of the State Council: “China will start a series of key infrastructure projects that are vital to the overall economy and can facilitate growth and speed up construction of existing railway, environmental protection and rural projects.”
  • Per Chen Guoqiang, Vice Chairman of the China Real Estate Society: “China is unlikely to expand a property tax trial to more cities in the near term and the government will continue home purchase restrictions.”
  • Per the Ministry of Land Resources, China will boost land supply for housing by 21 percent from last year to 172,600 hectares... Regardless of the unsustainable nature of adding incremental supply of unoccupied apartment buildings and shopping malls, stepping up construction here is bullish for Chinese growth from a TREND-duration perspective; bearish for property prices over the long-term TAIL, however.
  • Per the Ministry of Housing and Urban-Rural Development, China’s municipal governments were recently asked to submit by end-May a report on the progress of social housing construction over the past 2yrs and plans for 2013-2015. The reports are designed to help decide if adjustments are needed to social home construction targets in the 5yrs through 2015 (i.e. likely an acceleration in construction if anything). 

All told, while Deflating the Inflation remains a bullish catalyst for the Chinese economy, the lag between this event and the turn in both the reported growth data and growth expectations may have just increased. As such, we are of the view that waiting and watching for clarity is the best strategy in the immediate term for China.

Darius Dale

Senior Analyst