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China: The drum beat for policy change gets louder

30 July 2019

GAM Investments’ Rob Mumford highlights the potential attraction of investing in China in light of an increasing likelihood of a significant shift in monetary policy.

The drum beat for a more significant shift in monetary policy in China is getting louder by the minute, driven by the twin effects of lower offshore rates coupled with weak domestic macro data.

Chart 1: Economic data continues to struggle

Source : Bloomberg as at 31/05/2019

Chart 2: Pressuring employment – a primary government KPI

Source : Bloomberg as at 31/05/2019

We see a high probability of near-term interest rate adjustments designed to lower the interest burden to the corporate sector and support credit demand. This is likely to further reinforce the positive credit pulse impact on the market and is typically a tailwind to equity market performance. Credit markets and associated risk measures are also supportive to equity market trends.

Chart 3: China credit pulse – positive delta

Source : Bloomberg as at 31/05/2019

Chart 4: Credit pulse and typical equity market reaction

Source : Bloomberg as at 31/05/2019

The form of this adjustment will almost certainly be the use of monetary tools to further improve liquidity (involving medium term lending facility application and adjustments in financial reserve requirements) coupled with some form of benchmark interest rate shift though this is likely to be more nuanced.

The starting gun for this particular adjustment comes from a state council meeting statement on 26 June, which outlined an intent to lower corporate borrowing rates (and revive credit demand). The final form and timing of the adjustment is likely to be heavily impacted by the Sino-US trade talks which we expect to remain difficult due to political rather than economic factors.

A near-term reserve requirement (RRR) cut, plus other measures to ease liquidity, are high probabilities and mostly likely to take place quickly after clarity from the US Federal Reserve meeting at the end of the month, where a cut of at least 25 basis points is expected. China’s politburo meet in late July to prepare a work report for the second-half of 2019 and we would not be surprised to see both RRR and some form of benchmark interest rate cut soon after with the extent of the cuts and broader interest rate liberalisation being subject to general data releases and the Sino-US engagements.

Chart 5: Shibor elevated again in the post Baoshan Bank bailout era

Source : Bloomberg as at 19/05/2019

Chart 6: Interest rates swaps trending lower

Source : Bloomberg as at 19/05/2019

In our view, the most likely scenario for specific interest rate adjustment is a directive to the banks (for new loans) to lower either their prime rate or benchmark rate for lending 1 year and under, while keeping the 1-5 year and over 5 year benchmark rates which are typically used (and will be encouraged to be used) as a benchmark for mortgage lending unchanged. There is a strong desire to keep the property market from overheating and, with residential housing price rises year to date already running ahead of comfort in a number of regions, this constitutes the main push back to a broader benchmark rate cut.

We have been increasing our focus on potential beneficiaries of this shift in the form of our favoured non-bank financials and higher indebted industrials. The impact on the bank sector is mixed with a potential net margin hit being offset by a prospective rating uplift as some relief is offered to the beleaguered corporate sector. We favour smaller banks where we see some valuation uplift (from very depressed levels) offsetting the potential near-term earnings drag mentioned above.

We also favour select opportunities within the property sector as we see a healthy property market as one of the few stable pillars to the economy’s current growth rate. Select listed companies are executing well and trade at extremely attractive valuations, especially relative to their credit equivalents. The sector is also likely to get a rating boost in the event of more affirmative interest rate action.

Our broader China thesis is positive and chimes with our global emerging view that these equity markets offer premium growth, of an improving quality, at very attractive valuations, in an increasingly ‘ex-growth’ world.

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