After a strong start to 2019, China’s stock market rally has
lost momentum. The Shanghai Composite Index is about 10 per cent down from its mid-April peak following a surge of more than 30 per cent since January. While the unexpected
ratcheting up of US-China trade tensions has weighed heavily on investor sentiment in recent weeks, it has not been the only driver of weakness in Chinese equities.
A closer look at last month’s market indicates investors were already less bullish before the trade
flare-up in early May. The Shanghai benchmark index pulled back more than 5 per cent in the second half of April, despite signs that economic growth momentum was stabilising.
As previous stimulus measures started to gain traction, the Chinese economy expanded faster than expected in the first quarter, at
6.4 per cent, with notable upside surprises in major activity indicators in March. Back then, the market’s focus was on the sustainability of the economic recovery.
With better-than-expected economic data, investors scaled back expectations of additional policy stimulus measures, calling into question whether the nascent growth recovery could last.
The
disappointing set of data for April suggests investor concerns about the economic fundamentals were not unfounded. All major activity indicators came in below market expectations, with surprisingly weak industrial production and retail sales.
It is difficult to get a clear reading of the underlying growth trend, given the volatile monthly data as a result of distortions created by shifting holiday schedules and
cuts in value-added tax rates. Nevertheless, data releases for April point to a more mixed picture, adding to worries about whether growth has bottomed out.
More importantly, China’s economic outlook is clouded by the intensifying trade tensions. The fresh round of
US tariff increases on US$200 billion worth of Chinese goods will probably put pressure on the economy both directly, via weaker exports, and indirectly, through depressed confidence which will in turn weigh on domestic demand.
China’s growth outlook is closely linked to developments in trade negotiations. So far, public comments on the progress of talks suggest structural issues such as intellectual property protection and the removal of existing additional tariffs on Chinese exports remain the main
sticking points. In addition, the urgency to reach a deal has probably declined for both sides in the past few months, given the improved economic and market performance in the US and China, which suggests the odds of a quick resolution are low.
The good news is that Chinese policymakers are likely to shift back to a more accommodative policy stance as the economy faces stiffer headwinds, offering support to both the economy and market sentiment. In fact, there are already signs that the People’s Bank of China is leaning towards an easing bias following the recent escalation of trade friction. The central bank announced a targeted required reserve ratio cut for smaller banks to support liquidity.
Policymakers are likely to take even more monetary and fiscal easing measures to absorb the tariff shock. The positive market reaction following the release of the poor April data does suggest that hopes of further stimulus measures has helped lift investor sentiment.
Still, heightened uncertainty about the outcome of
trade negotiations warrants caution and investors should be prepared for market volatility before the dust settles. If the trade talks do break down, both the market and economy are likely to suffer further.
On the other hand, market confidence should be lifted if a negotiated settlement is reached between the two countries. However, any such boost might be partly offset by the diminished prospect of additional policy stimulus. Once the risk of a full-blown trade war is removed, the Chinese authorities are less likely to take further major easing measures.
This is especially the case given policymakers’ concerns about the overall leverage of the economy and potential overheating in asset markets. Apart from tapering policy support, lingering uncertainty over the future of the US-China trade relationship is likely to remain a weight on the market.
For now, it is hard to predict which direction negotiations will go. But, given the potential economic damage to both sides, it appears to be in everyone’s interest not to further escalate tensions.
Patrik Schowitz is a global multi-asset strategist at JP Morgan Asset Management
This article appeared in the South China Morning Post print edition as: Be ready for more volatility as trade talk uncertainty lingers
