The outlook for China’s economy is poor, but the smart money says there will be further stimulus measures
- Nicholas Spiro says bad news seems to be good news in China’s bond market. Weak economic data has fuelled a government bond rally – with foreign investors betting big on a forthcoming stimulus – even as the stock market suffers
Is bad news good news in China? Ever since the world’s leading central banks resorted to ultra-loose monetary policies to stave off a depression, following the 2008 financial crisis, poor economic data has often been cheered by investors on the grounds that it makes more stimulus likely, instilling confidence in markets and lifting asset prices.
In China, weak economic data has been coming in thick and fast. Last Friday, the country’s statistics bureau announced that retail sales in November grew at their slowest pace in 15 years, with car sales on course for their first annual decline in nearly three decades. Industrial output was also weaker than anticipated, growing at its slowest pace in nearly three years.
The news of an intensifying slowdown in the world’s second-largest economy has rattled markets which, as I have argued previously, are getting a global growth scare because of China and, more recently, the euro zone. The benchmark S&P 500 has slipped to its lowest level since early April despite signs that the United States’ own economy is holding up well.
Yet, in China’s government debt market, bad economic news has helped fuel a blistering rally. The yield on China’s 10-year bond has fallen nearly 65 basis points since mid-January, to 3.36 per cent. The rally has been even fiercer in the money market. The one-month Shanghai Interbank Offered Rate has plummeted 200 basis points since the start of this year, to 2.88 per cent.
With sovereign bonds in other emerging markets suffering heavy losses due to the tightening in financial conditions caused by the hike in US interest rates, foreign investors have poured money into China’s government debt market, further enticed by the country’s entry into global bond indices. According to a report by Morgan Stanley, published on November 25, foreign inflows to China’s sovereign debt market this year are on track to reach US$100 billion, only slightly less than the entire stock of foreign holdings in Brazilian government bonds, the largest overseas position in any emerging market.
Make no mistake, bond investors in China are betting that more forceful stimulus is in the offing.
For equity markets, on the other hand, bad news really is bad news. Chinese stocks have lost a whopping US$2 trillion in value this year, their sharpest fall since 2008, according to data from Bloomberg. The CSI 300 index, which tracks blue chips traded in Shanghai and Shenzhen, is down 28 per cent from its peak in late January, with more than half the decline coming in the second half of the year, when Beijing stepped up the pace of its easing measures. What’s more, consumer stocks, which are less vulnerable to the trade war, have significantly underperformed the broader index since August, showing the extent to which investors doubt the efficacy of stimulus to boost domestic demand.
This marked divergence between stocks and government bonds adds another layer of uncertainty to the outlook for China’s economy next year.
It has often been said that, when it comes to a country’s economic prospects, the bond market is smarter than the stock market. Stock markets are notoriously volatile and China’s is especially turbulent. According to data from Bloomberg, individual investors drive 80 per cent of the trading volume in China’s equity market, accentuating a herd mentality.
The bond market’s expectation of further stimulus is well founded. A more dovish stance from the Federal Reserve could help weaken the dollar next year, giving Beijing greater leeway to ease monetary policy without causing a sharp decline in the yuan. In a report published on December 12, JPMorgan forecast additional easing measures, including further tax cuts and liquidity injections. Yet it also rightly noted that the “magnitude of easing is constrained”, given the continued emphasis on deleveraging.
While China’s stock market may well be overly pessimistic, the bond market appears unduly optimistic. Investors have already priced in a significant amount of easing, calling into question how much further bond yields can fall. China’s interbank rates have been nudging up since September, suggesting that the bar for another major stimulus-led rally is high. Just as importantly, the yield gap between Chinese and American bonds has narrowed excessively, diminishing the appeal of Chinese debt.
While the bond market is more sanguine about the prospects for more aggressive stimulus, the equity market needs to see demonstrable evidence of an economic recovery – and a meaningful de-escalation in trade tensions – to make a sustainable improvement in sentiment. Given the persistent weakness in China’s economy, the disconnect between the two asset classes is likely to persist for some time yet.
Nicholas Spiro is a partner at Lauressa Advisory