- Year two of normalization with similar trading range. The biggest normalization of 2023 is that China emerged from COVID. An extended period of seclusion naturally breeds confusion. But with improved communication, as evidenced by high-level exchanges between both sides and increased international traffic, foreign relationship should improve.
At the darkest hours of last October, we were the lone voice for optimism and forecasted that the Shanghai Composite should trade between ~3,000 and 3,500, while the Hang Seng should trade between ~16,000 and 23,000 in the following 12 months. The actual trading range was 2,924 to 3,419 for Shanghai, and 15,945 to 22,700 for Hang Seng. We look for an extension of this trading range in the coming 12 months.
- CNY weakness/China-US yield gap at extremes and set to normalize. As the Fed tightens relentless while the PBOC eases to support the Chinese economy, the China-US yield gap has widened to its largest in history and comparable to the level in early 2006. Such wide and stable yield gap presents a carry trade opportunity for speculators, and weakens foreign confidence and investment return from Chinese assets.
Fortunately, the CNY REER has reached its cyclical lows, and the market is starting to price in four Fed cuts in 2024. As such, the historic weakness of the CNY should trough, while the yield gap should narrow. Such normalization should alleviate the pressure on fund flows and Chinese assets, and spur intermittent market rebounds and rallies.
- PBOC sterilization to wane after strong liquidity growth; fiscal policies coming. The PBOC does not appear to be shortening its balance sheet, with higher foreign assets holdings and steady free reserves. This is not a balance sheet of heavy FX intervention, despite capital outflows. Strong deposit growth, or “excess saving”, is in tandem with China’s surplus in goods trade vs current account.
That said, property malaise will likely take a few years to heal, given the current inventory buildup. As such, deposits balance will unlikely be allocated systemically towards property or stocks, leaving an impression of an economy beset by weakness. In 2023 property statistics worsen further from 2022, with halved land sales, falling property investment and tepid sales growth. but China still manages 5% growth. It is likely to muddle through again in 2024.
As liquidity growth normalizes, fiscal policies will likely take over as a more important stabilizer of growth. Local government debt can be swapped for central government bonds, its maturity can be extended, and interest rate can be cut. For the embattled developers, they need to plan for an extended period with annual sales well under 10 trillion RMB, as the breakneck urbanization pace normalizes and demographic ages. These changes will create headline risks for the market, making any rebound more capricious to trade.
- China finetuning “COVID-Zero”; flames of “Dual Circulation” turning blue. The Chinese authority is finetuning “COVID-0”, at a juncture when negative exports growth for the first time in 29 months and negative retail growth are suggesting receding demand both home and abroad. Yet onshore market rebounded strongly – from a similar level last seen at the onset of COVID in Mar 2020.
China’s export cycle, an intermediate economic cycle running every seven years, has peaked in Feb 2021, and has translated to slowing accumulation of current account surplus compared with GDP. The export cycle correlates closely with China’s stock market cycle via the liquidity created via its export cycle. Thus, a peaking export cycle argues against a “secular bull market” suggested by consensus.
- Economic cycle near turning point, but arduous property recovery likely. The short cycle as measured by the property investment cycle, however, is nearing its turning point, but still needs a catalyst to initiate a new cycle over the course of next twelve months.
There are many similarities between now and early 2014. For instance, both periods saw Fed tightening and Chinese property struggling, and the authority eventually came to the rescue. There are also analogs in the market trajectories in both periods. For instance, the Shanghai Composite struggled in the first few months in 2014.
Meanwhile, the US short economic cycle is receding from its peak, but not yet appropriately reflecting the recessionary risks confronting the US economy. Given the intertwining of the US and Chinese economies, US macro volatility will find its way to Chinese markets and onto the world via exchange rate, commodities, stocks, and bonds.
- Shanghai ~3-3,500, Hang Seng ~16-23,000, with bouts of volatility. Easing into Cyclicals/Growth over Defensive/Value. Our base case is that China will reopen gradually with zigzags, its property sector will recover slowly with policy support, and a 2023 US recession. If any of these three uncertainties is better than expected, such as faster reopening, swift property recovery or no US recession, it will add to our base-case payoff.
China margin cycle is re-expanding and bodes well for the relative performance of cyclicals and growth over defensive and value. Intuitively, if China reopens and property recovers, cyclical demand should improve. And growth, too.
Of course, the risk is China stays a hermit, property continues to ail, and a US recession. Such triple whammies would render a risk scenario similar to what we have been through in 2022 – no need to elaborate further. Even so, the epic volatility in 2022 suggests that we should have seen some of the lowest points in the Shanghai Composite and the Hang Seng Index in the current cycle.
It is time to look forward.