China stocks are selling off in some profit taking on Tuesday following Monday’s mega-rally. One thing the market seems to be discounting, however, is the level of stimulus Beijing can pull off this time.
For now, part of the euphoria in China’s outperforming stock market is due to President Trump's extension of the 90-day trade truce. That extension comes with a pause in planned tariff increases to 25% on $200 billion worth of Chinese imports. Trump also appeared to soften trade-related actions this week by holding off on an executive order that would ban Huawei from the U.S. telecom market. He also opted to pause on auto tariffs, something the Department of Commerce recommended. This should be viewed as temporary. The 60-day reprieve ends in May. Tariffs are not going away.
“The U.S.-China trade dispute has been a drag on the global economy and world trade for over a year, and Asian export growth has slumped. Now a key negative for both the global economy and global markets looks as though it is being removed,” says Neil MacKinnon, an economist for VTB Capital in London.
Jerome Powell’s Senate testimony today also didn’t add any stresses to the market at this time, though most investors are still digesting what the Fed chairman said. A pause in the hiking cycle is good for emerging markets.
China has been a runaway train. It is beating the MSCI Emerging Markets Index. It’s beating its BRIC counterparts. It’s beating the S&P 500 and the FTSE Europe.
On Tuesday, Northbound Connect trade between Hong Kong and mainland China stock exchanges witnessed another day of high volumes matching Monday's levels. Foreign investors were net buyers. Monday and Tuesday Northbound Connect volumes were 50% higher than they were during MSCI’s 2018 inclusion trading days. MSCI’s decision on their China A-shares index comes out Thursday.
All of this has led to this here ...
China is massively overbought.
The 1% correction in the Deutsche X-Trackers China A-Shares (ASHR) ETF is a drop in the bucket. Chinese equity market sentiment was in the gutter at the end of 2018. Today it has gone from “optimism” to “euphoric.” Investors believe that the trade war will not escalate, and if it does then the People’s Bank of China and other market movers in Beijing’s government will support the economy any way they can. The problem is no one really thinks China will overstimulate its economy. In fact, the consensus is that Beijing has very little runway to stimulate more in the eventual case of an escalation in the trade dispute, as the Chinese like to call it.
“Markets are too optimistic about the speed, scale, scope, and efficiency of Beijing’s stimulus measures this time, and they may be unprepared for a significantly worse growth slowdown in the first half of 2019,” says Ting Lu, a top China analyst for Nomura Securities in Hong Kong. “This is especially true of those investors that have recently converted to the belief that Beijing has talented technocrats, with quick decision making, perfect execution and deep pockets, and will deliver stable growth whenever the economy is in trouble. Like those that were overly bearish on China several years ago, we would caution those who are overly bullish.”
Compared with the last three major stimulus programs, room for monetary easing and fiscal stimulus is much smaller due to surging debt at the provincial level that has Xi Jinping cracking down on shadow banking; a smaller current account surplus and falling forex reserves. The decision-making process is longer now because there is no consensus on direction and strategy within Communist Party leadership. China is a hybrid capitalist-communist system. They’ve hit a crossroads.
Beijing’s last stimulus came in 2015 following a steep market decline after MSCI rejected A-shares inclusion in the MSCI Emerging Markets Index, something everyone in China was banking on. And changes to the yuan trading band in order to propel China’s currency into the IMF's Special Drawing Rights currency basket.
The People’s Bank of China was unable to prop up the market and likely has little appetite to do as much as they did three years ago.
Nomura’s China analysts think the economy will get worse before getting better. That’s because conventional easing measures may not be able to resolve many of the problems resulting from non-market-based policy measures and interventions imposed on the economy in the past few years. In a report published Tuesday morning, Ting Lu and his team said that freeing up the economy via market-oriented reforms is still key to growth. But more market access for foreigners will take time and “things will get worse before Beijing strengthens its resolve to free up the economy,” the report authors wrote.
Moreover, Beijing’s room for stimulating demand appears much more limited. The trade war talks have resulted in China agreeing to keep the renminbi stable-to-stronger, rather than let it weaken against the dollar as it should if extra tariffs were ordered. It is hard to believe that China will agree to maintain a stronger currency in the event Washington hikes tariffs from 10% to 25%.
China is equally unlikely to introduce new subsidies—especially for agriculture, after promising to import more U.S. commodities. Instead, they are likely to ramp up existing subsidies for tech sectors, the exact sectors the U.S. fears will run them out of Asia someday.
Xi Jinping is not totally sold on subsidies as they tend to lead to overcapacity and oversupply. Beijing has mentioned several times that it will stimulate the purchase of cars and home appliances. This could be a boon for consumers, primarily in the discretionary consumer segments.
BlackRock strategist Richard Turnill says investors will have to pick their spots. The trade war is not over, and the stimulus packages won’t be what the market had before.
“The Chinese stock market has rallied sharply this year ... after finishing 2018 near the bottom,” he says. “Is there still opportunity left? We have a positive view on China’s stock market but see rising risks and reason for greater selectivity.”
