investment insights
Chinese and US policies cross paths, on different bearings
Lombard Odier Private Bank
Key takeaways
- The world’s two superpowers’ monetary and fiscal policies are moving in opposite directions
- The People’s Bank of China begins to increase liquidity; the Fed plans tighter financial conditions
- In 2022, China will stimulate its economy as it hosts the Winter Olympics and holds its twice-per-decade Communist Party Congress
- We are underweight US equities and neutral Chinese stocks. We see value in Chinese high yield credit as the systemically-important real estate sector restructures.
In 2021 the US enjoyed solid economic expansion and China experienced a year of slower growth.
As we approach a new year, those trends are poised to reverse. The world’s two superpowers’ monetary and fiscal policies are crossing paths, heading in different directions.
This year, China’s economic expansion slowed as the country tightened borders to fight Covid and restricted support, while a rebounding US economy was driven by accommodative monetary policy and historic levels of federal spending. That is about to change. The US economy is far enough along its recovery path that the US Federal Reserve will roll back its asset purchases. In contrast, China will now target more growth as the Chinese Communist Party prepares for its 20th Congress late in 2022. There it is expected to swear in President Xi Jinping for an unprecedented third term.
Last week the People’s Bank of China reduced the amounts of cash that commercial banks must keep in reserve for the second time this year, adding an estimated USD 188 billion of liquidity to the financial sector. The requirement will cut the ‘reserve requirement ratio,’ or RRR, by 50 basis points, starting 15 December. In addition, the central bank increased its foreign currency RRR by 200 bps to 9%, as part of a move to limit the renminbi’s recent appreciation against the US dollar and investments in foreign-denominated debt (see chart).
China shifts up a gear
Earlier this year, the Chinese authorities worked to cool their economy and continued a shift to increasing domestic demand. They introduced tougher mortgage lending limits and halted credit lines to property developers. The measures acted as a catalyst for the debt defaults of Evergrande in September, removing the implicit guarantee for the property sector, and keeping a lid on demand for new real estate.
With the Winter Olympics in February and the Communist Party’s Congress expected to be held in the second half of 2022, we expect the focus on stimulating growth to translate to annual GDP of 5% and annualised consumer price inflation around 2%. The Communist Party’s recent ‘Central Economic Work Conference,’ part of preparations for next year’s Congress, made a series of commitments pointing to additional support. These included infrastructure investment, changing the focus of housing away from speculation and developing the private sector.
China’s government will continue to manage macroeconomic regulation in line with its longer-term ambition to double per capita income by its 2035 target. More recently, the government set out goals of targeting long-term economic and strategic independence and resilience, rather than boosting short-term growth.
Much of this stimulus may be couched in the language of “common prosperity,” meaning improvements to citizens’ quality of life, wealth equality, financial sector stability, curbs on pollution and, in the light of US restrictions on semi-conductors and Chinese firms, technological independence. Still, China’s ‘common prosperity’ mantra has not yet translated into tangible policies or reforms and, as yet, looks more a shift in mindset than a regulatory reality designed to rebalance the economy.
Covid boost?
Equipped with relatively inefficient vaccines against the pandemic, China will maintain a zero Covid strategy through 2022, adjusted to minimise disruptions to production. The domestically-developed Sinovac, for example, has shown an efficiency of 51% against the coronavirus, according to the World Health Organisation, compared with 95% for Pfizer/BioNTech.
China has not approved distribution of the Pfizer jab, and there is a home-developed vaccine in Phase 3 clinical trials. If both were approved in 2022, we can imagine that China may be in a position to re-open its borders late next year, or in early 2023, offering the economy a further boost. In the shorter-term, the Chinese economy will remain highly sensitive to the evolution of infections in the country, especially in the light of the third-quarter slowdown, which reflected restrictions containing a series of Delta variant outbreaks.
Covid restrictions combined with energy shortages that created manufacturing challenges, third quarter GDP increased 4.9% and growth may register nearer 3% for the last three-months of this year.
US reaches cruising speed
The outlook for America’s 2022 is very different. As we wrote last week, the Fed said that it plans to accelerate the pace at which it cuts monthly asset purchases. It may double the speed of cuts at its 14/15 December meeting, creating space for the central bank to begin raising interest rates with a 25 basis point increase as early as June 2022. We expect the Fed to impose two rate hikes in 2022, with further increases bringing the benchmark rate to around 2.5% in 2024.
With the Fed no longer using ‘transitory’ to describe inflation in the US, we believe that price rises are likely to remain high in 2022, before declining towards the year-end for a core annualised inflation increase of 2.6%. Core PCE (personal consumption expenditures) inflation reached a three-decade high of 4.1% in October, compared with a year earlier. The factors driving inflation this year, including shipping congestion in and at the approach to American ports, are now easing. In addition, we expect oil prices, which in November hit a three-year high at nearly USD 85 per barrel for Brent crude, to continue to decline. On the demand side, consumer backlogs are freeing-up, and the pandemic’s support programmes coming to an end as needs move from goods to services.
Investment opportunities
China’s policies should create a significantly more domestic-focused economy. From a foreign investment perspective, this may increase opportunities, especially for portfolio diversification. Chinese equity markets now offer investors a discount of around 40% on 12-month forward earnings, compared with a US universe such as the S&P500. In the context of improving economic expectations and more balanced risk outlook, this may be interesting for multi-asset portfolios. With this in mind, we are underweight US stocks, and hold a neutral position in Chinese equities versus our strategic benchmark. We remain overweight in Chinese sovereign bonds, which continue to provide a hedge against market volatility.
We do not see a new wave of regulatory threats ahead as the government looks to rebuild growth. Foreign investors in China remain focused on any indications of excessive leverage or tighter regulation.
We see selective value in Chinese high yield. The sector has been under pressure after a series of missed property company payments pushed the default rate to 8%; this is likely to rise next year. Almost 60% of China’s high yield offshore credit is now trading at distressed levels with ‘BB’-rated property bonds averaging yields close to 12%, while single ‘B’ property bonds are yielding more than 30%.
Still, Chinese real estate remains systemically important to the economy. This makes it highly likely that the government will ease conditions for some companies to continue operations, without causing major disruptions to the economy and financial sector. Stronger companies will then be able to refinance their short-term debt, and deleverage their balance sheets. Identifying companies strong enough to survive – or large enough to be considered of systemic importance – is therefore crucial.
Finally, as China’s monetary policy alters, we believe that there is limited room for further renminbi gains against the dollar, leaving it stable through 2022.
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