Key Points:
- We do not expect the Chinese government to push forward fiscal and monetary stimulus policies in the future. After two rounds of large-scale fiscal and monetary stimulus policy cycles in 2015-2016 and 2020-2021, it is difficult to have a third round of larger-scale stimulus due to the pressure on the government’s debt ratio and interest payments.
- Since the structure of Chinese government debt is mostly local government debts with higher yields, we believe that the primary goal of the current government is to reduce the overall interest rate level of government debt through replacement, to release future fiscal room. And this requires maintaining a low level of the risk-free rate in the market. A large-scale fiscal stimulus will once again push up the interest rate in the domestic market, thus hurting the effect of government debt replacement.
- The Chinese government may also have noticed that the deposits of Chinese households have increased at a historically high speed in the past two years. Policymakers believe that the current lack of confidence in the market is the main problem. Therefore, we think that the main focus of future policies will be on restoring market confidence and risk appetite
- However, it is difficult to quantify and observe whether the market confidence, especially the confidence of entrepreneurs in the real economy, has recovered. We suggest that investors watch the recovery of market confidence by observing indicators such as domestic property sales and net issuance of non-financial corporate bonds.
- The market’s expectations for a US recession reached their lowest point this year. The resilience of the US economy is thanks to an expansion of US fiscal outlays, resulting deficit level near 8.5% of GDP now. This has offset the adverse effects of interest rate hikes and bank credit contraction. Although there is still room for US government debt to increase before interest expenses outpace fiscal deficit expansion 2 years from now, its long-term sustainability in the future is in doubt, so Fitch has recently downgraded the rating of the US treasury.
- Our suggestion for US stocks is to sell near the previous high and for A shares is to buy near the previous low.
- For commodities, we are relatively more optimistic about crude oil because the peak consumption season in July-August and the reduction in supply from Saudi Arabia and Russia may cause short-term oil price rises. As fears of a US recession subdued, one of the main factors that had previously weighed on oil prices has also declined markedly recently.
Hou Zhenhai
Straits Financial (China) Chief Strategist
Previous Views:
If the US congress reach a debt ceiling agreement in June, it means that the US Treasury will drive a net liquidity around 800billion USD out from the market, which may cause a short-term liquidity crunch. Therefore, we believe that investors must pay attention to a possible negative impact on the financial markets. We believe that in the context of the lack of economic drivers and incremental inflows, the A-share will continue its range-bound trading and shifts quickly among different thematic sectors. But we expect the rising household willingness to save and the decline in investment return expectations will continue to support a Chinese treasury bond bull market with a flattening yield curve.
I. Chinese domestic market has over-expectations for more fiscal stimulus.
With the weakening of China’s economy in Q2, domestic stock and commodity markets are increasingly expecting more policy stimulus, especially for a new round of economic stimulus after the Politburo’s mid-year economic work conference held in late July. However, we believe the market expectations for more policy stimulus may be too high. The general tone of the mid-year economic work conference is still “seeking steady economic growth and pursuing high-quality development,” which means that it is not difficult for this year’s economic growth to reach the 5% target set by the government at the beginning of the year. The main economic goal of the government is to pursue “steady growth” and “high-quality development” rather than strongly stimulate its economy. However, because some investors, both domestic and abroad, based on experience and thinking, always one-sidedly interpret “stabilizing growth” as simply increasing fiscal and monetary stimulus, they may have high expectations for stimulus policies after the conference. However, if there is no fiscal and monetary stimulus policy of the magnitude they expected in the subsequent period, then they will be disappointed again.
And we do not expect the government to have a strong fiscal and monetary stimulus policy in the future. It is not just based on speculation on the government’s mindset but also the current domestic situation. After the past two rounds of large-scale fiscal and monetary stimulus policy cycles, it is difficult to have a third round within an extremely short time. And this point can be seen from the trend of the broad-based Chinese government debt growth. (Note: The broad-based government debt in our statistics include treasury bonds, policy financial bonds, local government bonds, local government special project bonds, and municipal investment bonds, but do not include bonds issued by SOEs and ministries, such as railway construction bonds, and debts hiddenly guaranteed by local governments). From Figure 1, we can see that after 2015, the annual incremental debt of the Chinese government rose rapidly from the previous 3 trillion RMB to 7 trillion RMB per year, and in 2020, with the impact of Covid, it soared to reach 13 trillion and 11.6 trillion in 2020 and 2021 respectively, and is close to 10 trillion RMB in 2022. In the first seven months of 2023, the incremental government debt was 5.6 trillion RMB. According to the current speed, it is expected that the incremental government debt will still exceed 9 trillion RMB for the whole year. Considering that the Covid impact on the economy has subsided this year, the current speed of government leverage is still not low, at least still significantly higher than before the pandemic.
Source: Bloomberg, CEIC, Wind
Of course, the overall economic trend has not met market expectations due to the household sector’s weakening ability and willingness to further increase leverage. Therefore, there is a strong call in the current market for more fiscal stimulus, in which the government is expected to expand its efforts to increase debt, and, at the same time, transfer funds to the household sector to promote consumption. The biggest problem with this policy proposal is that it ignores the fact that the Chinese government has been accumulating debts rapidly in the eight years since 2015. Specifically, the annual increase in generalized government debts has exceeded 8% of GDP. In this situation, it is difficult to ask the government to further increase the stimulus, especially considering this is the first year after Covid. The government is reluctant to raise more debt, such as by issuing several trillion special treasury bonds and making the growth rate of government debt close to the level just as fast as in the pandemic. Moreover, even if this can make the domestic economic recovery stronger this year, it will cause a further increase in government debt pressure in the next year and afterward, resulting in greater downward pressure on the economy in the future.
Therefore, we believe that the current policy orientation of the domestic government is not to promote economic recovery by more fiscal stimulus but to encourage market confidence and undo some restrictive policies that have previously caused certain pressure on the economy, such as restrictions on property purchases. The government also wants to support the economy by boosting the stock market’s confidence. In short, the government hopes to stimulate the economy by promoting the market’s risk appetite rather than the government’s monetary and fiscal policies.
The government made this policy choice mainly for the following two reasons. First, due to the rapid increase in government leverage over the past few years, the current government debt ratio is already very high. And more than half of outstanding government debt is local government debt, while treasury accounts for only 25%, which led to the overall interest rate of government debt also being at a high level. Therefore, we believe that the primary goal of the current government is to reduce the overall interest rate level of government debt through debt replacement. And this requires the government to maintain a low level of risk-free interest rates in the market. Therefore, the PBoC lowered the market benchmark interest rate again, but the rate cut by the central bank alone cannot fully guarantee the reduction of the market interest rate, especially in the context that the ECB and Fed are still in their interest rate hiking cycle.
Source: Bloomberg, CEIC, Wind
Moreover, we believe that the inability to engage in a large-scale fiscal stimulus is also an important prerequisite to ensure that the Chinese market risk-free interest rate does not rise again. Because large-scale fiscal stimulus not only means a substantial increase in the supply of treasury bonds in the future but also means that both economic growth and inflation may rebound, the interest rate in the bond market will inevitably rise again due to the large-scale fiscal stimulus. At present, what the government needs to do most urgently, is the goal of gradually replacing some high-interest rate local government debt with lower-interest debt that may fail. If the debt replacement is not completed, it means that the fiscal expenditures of local governments will be unsustainable due to the pressure of high debt interest rates every year in the future, and it will cause increasing social risks. Therefore, under the current background, the rational choice of the central government is not to use large-scale fiscal stimulus to promote short-term economic recovery.
The second reason why we think the government will not engage in large-scale stimulus is that the government is likely to have noticed that in the past two years, the increment in household deposits in the Chinese household sector has hit a record high. For example, taking the net incremental household savings (incremental household deposits minus incremental household debts) as an example, the numbers in 2022 and the first half of 2023 will reach 14 trillion and 9.1 trillion respectively, both significantly higher than any year before 2022 (Figure 3). Therefore, the government finds that though the savings in the household sector have increased significantly, household consumption and investment, whether it is stocks, properties, or industrial investment, are all weak, which is, in the policymaker’s view, caused by the lack of confidence in the public. Therefore, the government believes that under the current situation, the most fundamental problem is not to increase debt or fiscal stimulus, but to enhance market confidence.
Source: Bloomberg, CEIC, Wind
We agree with the government’s judgment, but the question is what means and methods could be used to regain confidence in the market. Of course, this is a relatively difficult process that may require continuous exploration and experimentation by policymakers. The trend of the domestic stock market and commodity market in the second half of the year will also be largely affected by the government’s continuous attempts to regain market confidence. Judging from the current situation, the government’s work is still to boost market confidence by holding some conferences and making some declarations, so we think that the effect of these measures is relatively likely to be short-term, so the market also rebound around these government meetings but then soon falling back again.
Therefore, under the current economic and policy background, we believe that investors must first lower their expectations for large-scale stimulus policies, and then they need to be patient, giving policymakers more time to see if they can stimulate investor confidence, and pay attention to what other measures the government will implement.
II. Indicators to measure market confidence.
As a relatively subjective and difficult-to-quantify indicator, investor confidence is relatively difficult to measure. Many investors will use the trend of the capital market, such as the rise and fall of the stock index or the trend of commodity futures, to weather investor confidence. However, we believe that the short-term trend of stocks or commodity futures is often disturbed by short-term and speculative funds, and its trend is often not sustainable. Secondly, the investors we are talking about here refer to investors in the whole society in a broader sense, including business operators in the real economy. Compared with them, stock or commodity futures investors are much smaller, so the short-term trend of stocks and futures is not an effective indicator. Therefore, it is difficult to regard the rise and fall of stocks or futures as an effective indicator of investor confidence.
Relatively speaking, property sales may be a better indicator of confidence. Because the property sales turnover is low, and transaction costs are high, short-term speculation is very difficult. Therefore, property sales are a relatively more effective reflection of changes in confidence in the market. However, at least so far, we still haven’t seen a stable and positive trend in domestic property sales in the market. In fact, since July, the sales are shrinking further (Figure 4).
Source: Bloomberg, CEIC, Wind
The second indicator in our view is non-financial corporate bonds. This is because the government’s issuance of bonds, especially the increase in local government debt, is mostly used to borrow to repay due principal and interest, which does not mean that local governments currently have a high willingness and ability to invest. At present, due to the sluggish credit demand of households, banks have issued a large number of credit lines to SOEs to fill their credit assignment. However, although many SOEs have credit lines and loans, it does not mean that they must have corresponding investment needs. In many cases, they are just to cooperate with banks. Most of these loans are deposited back to the bank again, forming the so-called credit idling. But this also means that the current non-financial corporate bonds can still reflect the real investment needs of companies. Therefore, we can judge changes in investor confidence in the real economy through the increase in bond issuance by non-financial companies (excluding local government funding vehicles) each month. Judging from the statistical data on bond issuance by non-financial companies, the overall corporate willingness to issue bonds has been relatively sluggish so far.
From the above data, we believe that investor confidence in the current market and the real economy is still at a relatively low stage. Therefore, the government still needs to make more efforts to change this situation. For investors in the stock and futures markets, it may not be advisable to be too bullish or bearish on the market. Investors also need to maintain more patience and pay close attention to some of the above-mentioned indicator changes in market confidence.
Source: Bloomberg, CEIC, Wind
III. Talking about the US economy’s resilience.
Market expectations for the risk of a US recession in 2023 have dropped to their lowest point this year. After experiencing multiple sharp interest rate hikes, the Fed’s benchmark interest rate and US mortgage interest rates have hit new highs in this century, and after the crisis broke out in some US banks in March, it is difficult to imagine the market’s consensus expectations for the US economy within a just few months has been transformed into a consensus of non-recession. However, although many institutions and economists who made this prediction recently have talked about the resilience of the US economy, they have not given much reasonable explanation for their reasoning. And we believe that the resilience of the US economy this year is mainly because of the US government’s continuous fiscal deficit expansion. For example, according to statistics, the overall US government deficits in the past 12 months from July 2022 to June 2023 once again reached 2.1 trillion USD, equivalent to 8.5% of US GDP, which was still significantly higher than the average 4% level before Covid.
The changes in the fiscal deficits are also reflected in the issuance of US treasuries, because most of US government debt is treasuries, and municipal bonds are very small proportionally. Similar to the annual increase in Chinese government debt we said above, we saw that the annual increase in US treasury debt has experienced two peaks similar to China. The first wave was during the financial crisis in 2008, and the second wave was after the 2020 pandemic.
Source: Bloomberg, CEIC, Wind
But the difference with China is that the two peaks span a long distance, more than 10 years apart. During this period, the increase in US government debt slowed down significantly during the five years between 2013 and 2017. The second is that the ratio of the increase in US debt to GDP in each year before 2020 was about 4% on average, which is lower than China’s 8%. In addition, since US treasuries are purchased by global investors, and for more than 10 years before 2022, the US treasury yield was very low. Summarizing the above points, it means that the current government finance and debt expansion space of the US is greater than that of China. The current Biden administration is also taking advantage of this, so even though the pandemic in the US has long since ended, the US fiscal has not been withdrawn. However, this does not mean that in the future the US will not encounter similar problems that China currently faces. Because, first of all, as the Fed continues to raise interest rates, the government debt interest expenses will accelerate every year. Secondly, to avoid recession, the US government’s real willingness to reduce the fiscal deficit is low, especially in the face of the general election year in 2024. So on the whole, this means that it may not take long, maybe within 2 years, the increase in the debt interest on US treasury bonds will “eat up” most of the space for the US’s new fiscal deficit (this is the situation China is facing now). Of course, before this, the market can still say that the US economy is full of resilience. After all, as long as the government spends more money on stimulus, US private sector, even in the face of higher interest rates and its lowering leverage, can still maintain resilient consumption.
Fitch recently downgraded the rating of the US Treasury, which reflected that as a rating agency, they have seen a continuous US fiscal deficit expansion to hurt the credit of the US treasury. Although we believe this event has limited impact on short-term US stock market movements, it may also be the first meaningful warning before a real crisis.
We are not too pessimistic about A shares, because the market has reflected pessimistic economic and policy expectations. That said, we do not think that there will be too many stimulus policies that exceed expectations, and more policies will be displayed in ways that encourage investment confidence and increase market risk appetite, so we think there is little room for the market to fall further, but we also see little room for the index to rebound, and the market is likely to maintain the trend of rotating with individual stocks.
Our suggestion for US stocks is to sell near the previous high, and the suggestion for A shares is to buy near the previous low. For commodities, we are relatively more optimistic about crude oil, because the peak consumption season in July-August and the reduction in supply from Saudi Arabia and Russia may cause short-term oil price rises. As fears of a US recession subdued, one of the main factors that had previously weighed on oil prices has also declined markedly recently.
About the Author
1998 – 2004, Chief Representative Assistant of GKN Group in China.
2006, obtained MBA degree from Wisconsin School of Business at University of Wisconsin–Madison.
2006 – 2007, served at the Wisconsin Foundation.
August 2007 – July 2013, served at China International Capital Corporation (CICC) as the leader of the overseas strategy team and A-share strategy team. He is also the main report writer and contributor. Mr. Hou and his team received many honors including the top team for the New Fortune Sell-side Strategy Research in 2008, and the top team for the Asia Money China Strategy Research in Hong Kong in 2009 and 2012, etc.
September 2013 – December 2019, served at Discovering Group and was responsible for the Group’s macro strategy research. During the period, the company has accumulated absolute returns that far exceed the market level.