Key Points:
- Recently, three major events have occurred in domestic and foreign markets that are conducive to the recovery of market sentiment.
- There have been three significant events recently in both domestic and international markets that are favorable for the revival of market sentiment.
- Strengthened Chinese fiscal policy: The Chinese government has increased this year’s budget deficit rate from 3% to 3.8%, leading to an additional issuance of treasury debts worth 1 trillion. Concurrently, the central government has intensified its efforts to replace local government liabilities, including issuing a new quota of over 1 trillion in special refinancing bonds in October.
- Impact of Easing Sino-US Relations and Falling US Bond Yields: The improvement in Sino-US relations and the decrease in long-term US bond yields are likely to benefit the domestic capital market. This may result in a slowdown of foreign capital outflow and, with the US Treasury reducing its bond issuance, the falling US T-bond yields could also be advantageous.
- Chinese domestic Economic Rebound Anticipated in Q4: Thanks to industrial restocking, China’s domestic economy is expected to rebound in the fourth quarter. The end of industrial destocking by Q3’s conclusion and the observed increase in output and investment from manufacturing firms due to active restocking are promising, though the sustainability of this trend remains uncertain.
- US Congress still faces the task of bargaining and voting on the budget for FY24 after new speaker Mike Johnson was elected. The US government may once again face a “shutdown risk” if no agreement is reached before Nov 17. It may have certain adverse impacts on the US economy and stock market in the future. We expect the Treasury Department’s bond issuance to decrease significantly in the future, which will be conducive to a decline in US long-term bond yields.
Hou Zhenhai
Straits Financial (China) Chief Strategist
I. Strengthened Chinese domestic fiscal policy
Firstly, Chinese domestic fiscal policy has intensified its efforts, notably with the government raising this year’s fiscal budget deficit from 3% to 3.8%, thereby increasing the issuance of 1 trillion RMB in treasury debts. Simultaneously, the central government has also escalated its refinancing of local government debts, providing a new quota of over 1 trillion in special refinancing debts and completing its issuance in October, while accelerating the replacement of local government debts. Consequently, since September, there has been a significant increase in the net financing amount of treasury and local government debts in the domestic bond market (Figure 1). In just two months, from September to October, the balance of treasury and local government debts increased by 1.26 trillion and 1.39 trillion respectively, the highest levels since the second half of 2022.
Source: Bloomberg, CEIC, WindWe believe that this part of the new government financing will mainly be used to replace other due liabilities (including hidden debts) of local governments, such as various year-end local government expenditure settlements, including project payments, service procurement, wages and medical insurance settlements. Therefore, we do not believe that this expenditure will greatly stimulate infrastructure and government investment projects, but it will be crucial for improving the cash flow situation of enterprises, especially small and medium-sized enterprises, and avoiding default of local government hidden liabilities due to year-end cash flow shortages. As a result, the market’s tail risk of economic stalling or a large-scale financial default due to end-of-year cash flow concerns has significantly decreased.
II. Impact of Easing Sino-US Relations and Falling US Bond Yields
The second is the impact of the temporary easing of Sino-US relations and the fall in long-term US T-bond yields. Given the recent outbreak of the Palestinian-Israeli conflict and the protracted Russia-Ukraine war, the US government is facing greater diplomatic and financial pressure. Therefore, we believe that the US has no immediate intention of intensifying conflicts with China, and with China’s current focus on resolving the pressure on the domestic economic pressures caused by local government debt and real estate downturn, so both sides are inclined to ease conflicts in the short term. Potential face-to-face talks between the leaders of the two countries in the future may further promote this easing trend. Although in the long run, the overall nature of Sino-US competition will not change, the easing of relations between the two parties in the short term is still beneficial to the domestic capital market. In addition to the improvement in investor sentiment, this also reflects that the speed of foreign capital outflows in the domestic capital market may slow. The substantial net outflow of foreign capital from A-shares since August has been an important driving force for the continued decline of A-shares in this round (Figure 2). Although we do not believe that the temporary relaxation of Sino-US relations will immediately turn foreign capital into a large net inflow again, the situation is similar to the continuous large net selling of foreign capital in September and October may come to an end for the time being, which is important for the short-term stabilization and rebound of A-shares. So, it will be another favorable factor.
Source: Bloomberg, CEIC, Wind
The decrease in US long-term bond yields will also help reduce the selling pressure from foreign investors. Previously, with the US Department of the Treasury significantly increasing its US debt issuance, net financing reached $532.2 billion in October, far exceeding market expectations and the supply of US Treasury bonds from July to September (Figure 3). This concentrated issuance of US debt led to a rapid rise in the yields of US long-term debts, tightening liquidity in the overall financial market. This was particularly challenging for emerging markets, which, in addition to facing rising US long bond yields, also had to contend with an increasing US dollar exchange rate. Consequently, since September, there has been a rapid outflow of global liquidity from emerging market stocks and bonds.
Source: Bloomberg, CEIC, Wind
However, as the US Treasury Department discloses its financing plan before the end of the year, the supply of US debt will slow down significantly in the future, and the net financing of US debt in November and December is expected to fall back below US$200 billion. Moreover, as the spread between the long-term and short-term yields of US Treasury debts has narrowed significantly, the US Treasury Department will be more inclined to issue more short-term T-bills at this level in the future. Therefore, the supply pressure faced by US long-term T-bonds will substantially reduce, aiding in the decline of their interest rates. If the US long-term bond yield falls and weakens the US dollar exchange rate, the pressure from foreign capital outflows on A-shares in the short term will also slow down.
III. Chinese domestic Economic Rebound Anticipated in Q4
Thirdly, the Chinese domestic economy is expected to rebound in Q4 due to industrial restocking. Although we still have not seen a significant improvement in the demand side of the domestic economy, including consumption, real estate and infrastructure investment, the previously pessimistic market sentiment has also suppressed domestic output, leading to active destocking by industrial companies. This trend may have reached its end by the close of the third quarter. Recently we have seen that the output of manufacturing companies has begun to improve. This is reflected in the stabilization and rebound of the inventory level of industrial finished products from a low level and the accelerated growth rate of output and investment of manufacturing companies (Figures 4 and 5).
Source: Bloomberg, CEIC, Wind
Source: Bloomberg, CEIC, Wind
Of course, there are still no signs of significant improvement in infrastructure and real estate investment. Real estate investment is still the most important economic sector dragging down overall economic growth. Therefore, the sustainability of the rebound in investment and output in the manufacturing sector remains to be seen. Nevertheless, this round of industrial output rebound, driven by corporate sector inventory replenishment, will still provide a positive boost to the economy in Q4.
The U.S. government may once again face the test of “shutdown risks” in November.
As former House Speaker Kevin McCarthy was ousted, after a three-week gap and multiple rounds of voting, the US House of Representatives finally elected its new speaker, Republican Congressman Mike Johnson. However, the US Congress still faces a tough task of bargaining and voting on the budget for FY24. As the new speaker Mike Johnson is a conservative Republican, his insistence on reducing the US budget deficit puts him further away from the Democratic Party’s stance than his predecessor McCarthy. Considering that the budget still needs to be approved and signed by the Democratic majority Senate and President Biden himself, any proposal to significantly reduce the deficit will be difficult to finally pass and be signed by the White House. Therefore, there is currently great uncertainty about whether the two parties in the US Congress can pass a budget for the new fiscal year before the end of interim budget expenditures on November 17. If the two parties fail to reach an agreement on a new budget by then, the US government will suspend the operations of “discretionary functional departments of the government”, which is the so-called “government shutdown” again.
Of course, another possibility is that the two parties could again pass a continuing resolution (CR) to sustain fiscal expenditure funding for a future period. However, considering that former Speaker McCarthy was ousted by conservative members of his own party, primarily because he proposed and passed an unconditional 45-day temporary budget expenditure at the end of October, this scenario seems less likely. The new Speaker, Mike Johnson, who is a conservative himself, will certainly not offer an unconditional extension of the temporary fiscal spending bill again. In response, Republican conservatives may demand that the temporary budget spending be extended in exchange for phased reductions in fiscal spending at different times and amounts, a strategy known as a “ladder CR”. The acceptance of this proposal by the Democratic Party and the White House remains highly uncertain. Additionally, due to the recent outbreak of the Palestinian-Israeli conflict, the question of whether the US should increase military aid to Israel and how this expenditure should be linked – either to military aid to Ukraine (as proposed by the Democratic Party) or to increased security expenditures at the US southern border (as proposed by the Republican Party) – is also a current point of contention between the two parties. In short, with less than 10 days remaining, there are many variables as to whether the US Congress can reach an agreement on the budget for the new fiscal year. If the two sides fail to reach an agreement or cause US fiscal expenditures in FY24 to be cut, it will likely have a negative impact on the US economy.
From the perspective of the US Treasury Department, we believe its large-scale issuance of Treasury bonds in October was also a preemptive measure against potential future government shutdowns and the associated uncertainty regarding the Treasury’s financing. However, following the extensive treasury bond issuance and financing in October, the Treasury General Account (TGA) fiscal deposits in the accounts of the US Treasury Department have accumulated to about 800 billion USD. Currently, this amount is sufficient to meet the fiscal expenditure requirements before the year’s end and to provide fiscal funds for the first half of next year, while also leaving room for additional spending. Therefore, this is the main reason why we anticipate that the supply pressure on US long-term bonds will decrease in the future. Additionally, if the US government shuts down or is forced to cut spending, the demand for future bond issuance may be further reduced, which would be more beneficial for the decrease in long-term bond yields.
Source: Bloomberg, CEIC, Wind
China continues its trend of weak recovery in consumption.
Although the overall performance of various domestic economic data since Q2 has been disappointing, we believe that the weak recovery trend of China’s overall consumption has not changed. The term “weak recovery” means that the overall consumption growth rate has dropped significantly compared to the pre-Covid era. For example, domestic consumer retail sales generally maintained an annual growth rate of around 8% before Covid, but this has since fallen to the 4-5% level. This slowdown is partly due to the pandemic’s impact on household incomes and balance sheets, leading to a more cautious attitude towards consumer spending—a situation that will likely persist post-pandemic. Additionally, the overall consumption weakness has been influenced by the decline in the property market. Notably, retail consumption categories closely related to property, such as ‘home appliances’ and ‘construction materials’, have continued to decline this year (Figure 7).
Source: Bloomberg, CEIC, Wind
However, some consumer sectors, like automobiles, have shown exceptional performance. After a slowdown in Q2, the overall domestic automobile consumption growth rate significantly improved in the second half of the year. In September, domestic monthly sales of passenger cars reached 2.48 million units, the highest September sales record in history (Figure 8). According to this trend, domestic automobile sales this year are expected to surpass the previous peak in 2017 and set a new record. Notably, nearly 40% of the current domestic passenger car market shares are from EVs, a marked change from the last peak in 2017.
Source: Bloomberg, CEIC, Wind
The robust sales of domestic cars are partly due to continued price cuts by manufacturers and the extension of subsidy policies like purchase tax reductions. This indicates that, while Chinese households’ desire to buy houses may not have fully recovered, there is still potential for growth in consumption areas that are more affordable and can effectively enhance their quality of life and experiences.
IV. Market Strategy
We continue to hold a neutral view on US stocks. Although the fall in long-term US bond yields is favorable to the recovery and rebound of US stock valuations, the ongoing disputes between the two parties in the US Congress over the fiscal budget and the potential “government shutdown” or spending cuts may still negatively impact the US economy and stock markets in the future. At this juncture, we believe that upside and downside risks of the US stock market are approximately balanced, maintaining our neutral stance. Our further judgment on US stocks will largely depend on how the FY24 budget dispute is resolved by the two parties in the US.
We believe that the overall A-share index may have reached its lowest point this year by the end of October. The potential rebound in A-shares will depend on both internal and external factors. Internally, the focus is on domestic policies, especially the direction of domestic fiscal policies in 2024. The main goal of domestic fiscal policy in 2023 has been repairing the government’s balance sheet post-COVID, such as refinancing local government debt. However, in terms of stimulating economic growth, the overall domestic fiscal policy has been relatively passive. Given the need for repair in the domestic household sector’s balance sheet, whether policymakers will consider increasing fiscal stimulus for economic growth in 2024 is a crucial factor for the future trend of the domestic economy and stock market. Externally, factors include changes in foreign capital’s risk appetite, influenced by Sino-US relations, US treasury yields, and the US dollar exchange rate. A period of relaxation in Sino-US relations and a decline in the US dollar and bond yields could improve foreign capital’s risk appetite, benefiting the stabilization and rebound of the domestic stock market. However, with the US presidential election looming in 2024 and the current frequent geopolitical crises globally, there are still considerable uncertainties.
About the Author
Dr. Hou holds an MBA from the Wisconsin School of Business at the University of Wisconsin–Madison and has a rich history of leading strategic teams. At China International Capital Corporation, he was instrumental in guiding both the overseas and A-share strategy teams, earning several top honors in strategy research. Later, he significantly contributed to macro strategy research at Shanghai Discovering Investment, where he played a pivotal role in achieving exceptional market returns. His expertise is particularly recognized in financial strategy and market analysis within the Chinese market.