Why China’s economic downturn warrants more than a shrug from global investors

Investors may claim they are increasingly concerned about China, but important measures of sentiment suggest otherwise
The failure to reckon with a much sharper than expected slowdown in China is a grave mispricing of risk at a time when global growth is slowing sharply and central banks are preparing to tighten monetary policy

Nicholas Spiro

Published: 2:30pm, 28 Oct, 2021

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Are Chinese risks being assessed and priced accurately? It is a question that has been posed many times as China’s integration into the global economy has deepened over the past two decades.

It is also a major theme that applies to several countries and sectors, and which has become more of a concern since global asset prices became heavily distorted by central banks’ ultra-loose monetary policies.

Since the Covid-19 pandemic erupted, China has been a game of two halves. Last year, it was all about the country’s swift and vigorous recovery, underpinned by Beijing’s successful containment of the virus.

Indeed, one of the reasons many investors initially favoured China was that it was stimulus-shy, allowing it to focus on maintaining financial stability. This benefited the yuan, helping fuel foreign inflows into China’s bond market.

This year, however, China has become a major source of anxiety. The combination of a strong vaccine-driven reopening of the American and European economies, Beijing’s severe regulatory clampdown on the private sector and a much sharper than anticipated slowdown in China has caused a significant deterioration in sentiment towards the world’s second-largest economy.

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In a sign of the degree to which China is perceived much more negatively by international investors, it is now the second-most important “tail risk” in markets after inflation, according to the findings of the latest Bank of America fund manager survey published on October 19.

Yet, quite often what worries markets does not translate into declines in asset prices. The MSCI World Index, a gauge of stocks in advanced economies, is currently trading close to a record high, the average spread on JPMorgan’s Corporate Emerging Market Bond Index (CEMBI) has risen less than 20 basis points in the past three months, while the VIX Index, Wall Street’s “fear gauge”, is only slightly above its historical low.

Global investors may claim they are increasingly concerned about China, but some of the most important measures of sentiment strongly suggest otherwise.

Even one of the asset classes that has been hit the hardest – Chinese equities – is now seen by some investment strategists as an attractive buying opportunity. In a report published on Tuesday, HSBC said the slowdown had already been priced in, resulting in an overly bearish view of China.

While this may be the case as far as beaten-down Chinese stocks are concerned, global markets have shrugged off China’s downturn. This is partly because the most alarming risk to the economy – Beijing’s high-stakes gamble to rein in the excesses of the property sector without triggering a financial crisis – has not caused widespread contagion across asset classes.

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Although markets have proved remarkably resilient to all sorts of pre- and post-pandemic threats, the failure to come to terms with a much sharper than expected downturn in China constitutes a grave mispricing of risk at a time when global growth is slowing sharply and leading central banks are preparing to tighten monetary policy.

First, China’s growth is hugely important to the world economy. Over the past two decades, the country has been the single most important contributor to global growth, accounting for a much bigger share than either the United States or the European Union.

The world has grown accustomed to Chinese annual growth rates in excess of 7 per cent for most of the past 20 years. A steep deceleration is a shock for China, but an even bigger one for the rest of the world.

Second, China’s downturn is mostly policy-induced. While this is a source of comfort to those investors who believe Beijing will soon be forced to take action to stimulate growth, it is also the main reason economic risks in China are being underpriced.

The main threats to the economy – the energy crisis, the pandemic and the property slowdown – are exacerbated by deliberate policy choices that significantly worsen the outlook for growth.

The zero-tolerance approach to the virus, efforts to reduce the country’s dependence on coal and the campaign to curb leverage in the housing market are politically driven decisions that amount to a regime shift in Chinese economic policy, one that markets have yet to grasp.

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Third, while the hawkish tilt by the Federal Reserve has focused attention on the risks of tightening policy in the face of weaker growth, the withdrawal of stimulus by the Fed pales in comparison with the level of retrenchment in China over the past few years, even in the teeth of the trade war and the pandemic.

While the woes of China Evergrande Group have dominated the headlines, it is the new policy framework that gave rise to the developer’s liquidity crisis that should be of greater concern to investors.

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As JPMorgan noted in a report published in August, industrial and regulatory policies in China are no longer supporting macroeconomic ones in order to prioritise structural and financial objectives. This makes it much less likely that Beijing will ease policy significantly, increasing the scope for a sharper slowdown.

There are many examples of asset prices being disconnected from fundamentals. The one that is the most concerning right now is the mispricing of Chinese economic risk in global markets.

Nicholas Spiro is a partner at Lauressa Advisory