Have Chinese equities bottomed out? Trade war talks, infrastructure spending and boosted production all point to better days ahead
- John Woods says the global production decline appears temporary and China’s own infrastructure spending is picking up. Combined with possible progress in the trade war, this points to a path of recovery for China’s equities
To understand how China’s equity markets could recover, we first need to understand why they fell. Summoning the courage to re-enter the market after an extended decline is not easy. To do so, one needs the clarity that can only come from taking apart and examining the major sell catalysts and determining whether they remain “live”.
Economics, of course, played a big part in the initial sell-off. The two key developments in this area were the slowdown in global industrial production and the failure of China’s economic data (especially credit and monetary data) to respond to or reflect fiscal and monetary stimulus unveiled in July. A closer look at both, however, suggests some encouragement going forward.
For starters, the weakness in global industrial production was not a broad-based slowdown but, rather, centred on discrete one-off factors, such as weather, strikes or manufacturing events. In particular, short-term emissions-related disruptions to the European and Japanese automobile sectors were pronounced, albeit temporary, and are now reversing.
In contrast, global industrial production, excluding autos, has actually been steady and this divergence suggests no broad deterioration in global demand. Once the temporary noise in auto production in Europe and Japan fades, a rebound in global industrial production and growth should become apparent in the next few months.
China’s October fixed-asset investment data, meanwhile, provided some tantalising hints of fiscal spending showing up in infrastructure. For one, the growth rate of infrastructure fixed-asset investment rebounded strongly in October. Potentially significant is that this coincides with a sharp rebound in the amount of both overall and infrastructure investment by state-owned enterprises. Additional supporting evidence came in the form of data on the monthly utilisation hours of construction equipment – which saw the first year-on-year increase since January 2018.
While all this does not make a trend, the sudden and simultaneous appearance of data that all points towards an uptick in investment activity is positive news. Fiscal spending, if directed at shovel-ready infrastructure projects that have already been privately vetted, can be more readily expedited. This is unlike the current round of monetary stimulus, which is being stymied by the need to channel it away from sectors already saddled with excess capacity and towards credit-starved sectors like small and medium-sized enterprises.
Emerging signs of fiscally supported construction activity are significant because it could potentially coincide with the stabilising of two other drivers of the sell-off: US-China trade tensions and downward adjustments in earnings forecasts.
There is reason to be cautiously optimistic about the potential for some degree of reconciliation – or at least accommodation – between China and the United States over their trade dispute, possibly during the G20 summit in Buenos Aires at the end of November.
The best-case scenario is that the US and China manage to work together towards freezing current tariffs, avoiding any further escalation. Nevertheless, it is premature to assume that a resolution – even a partial resolution – is a forgone conclusion. A cautious outlook for the yuan is thus appropriate, at least until we see more concrete evidence of a lasting detente.
Last, but not least, the outperformance of emerging market equities over US markets during the October sell-off reflects in part the amount of bad news already priced into emerging market equity in general, and China in particular. Certainly, China’s equity valuations are looking cheap, with history suggesting that such metrics do not remain at such extended levels for long. Ultimately, a mean reversion is inevitable; it is just a matter of anticipating the inflection point.
Here, it might be worth noting that the timing of a potential bottoming out of the earnings downgrade cycle seems to have slipped under the radar. The last two equity market cycles (2008 and 2015-16) strongly suggest that China’s equity market prices bottom out three to six months ahead of the trough in negative earnings revisions. And, with earnings downgrades potentially lasting another three to four months, signs of market consolidation should not be ignored.
It is perhaps not a coincidence that data from the Institute of International Finance for the first week of November showed inflows of US$5 billion into China equities, the largest weekly total in four years.
Just as there is a downside risk to being too optimistic, there is also a cost to being too negative for too long. We could be just one tweet away from a decisive turn in Chinese equities.
John Woods is chief investment officer for Asia-Pacific at Credit Suisse