China slowdown = Reduce risk

Posted by Cam Hui -
It’s becoming harder and harder to avoid the cold hard facts. China is slowing. The PBOC unexpectedly cut interest rates last week. The central bank began by cutting the benchmark lending rate on overnight, 7-day and 1-month standing lending facility (SLF). The move was followed by another surprising 0.20% cut in its 1-year policy rate, which is more than its usual move of 0.10% cuts.

 

The Citi China Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, peaked in Q1 and it has been falling ever since. The market had hoped for some signs of new direction or signals of stimulus from the Third Plenum, but the communiqué was uninspiring.

 

 

As China’s economy slows, there are signs that it’s starting to take a toll on global risk appetite.

 

 

Market-based signals

It is well-known that official Chinese economic statistics can be manipulated. That’s why I use real-time market data to measure the state of the Chinese economy. The news isn’t good.
Starting with commodities, as China has been a voracious consumer of commodities, commodity prices are weak. Moreover, the cyclically sensitive copper/gold and base metal/gold ratios fell to fresh lows (bottom panel).

 

 

Stock prices are also signaling weakness. The relative performance of MSCI China to the MSCI All-Country World Index (ACWI) and Hong Kong are testing multi-year lows. In addition, the relative performance of the higher beta Chinese small caps has fallen sharply.
 

 

 

Inadequate rebalancing

The initiatives announced from the Third Plenum were disappointing to the markets. The WSJ article headline, “China’s Leaders Point to Economic Threats but Show No Sign of Changing Tack”, tells much of the story. In the face of a weak real estate market and growing local government debt burdens, Beijing chose few course corrections, and an inadequate level of urgency to rebalance growth to the household sector from infrastructure and manufacturing.
 

As the accompanying charts show, exports, as measured by industrial production, spiked to an elevated level in the wake of the COVID Crisis, but growth in the domestic economy, as measured by retail sales, remained below trend.

 

 

In spite of a widespread view that globalization is in retreat, Brad Setser found that China is still highly dependent on exports as its primary growth driver.
 

 

A recent study by Rhodium Group projects that Chinese real domestic consumption growth to be 3–4% over the next 5–10 years. Michael Pettis observed that a 3–4% real growth rate is slightly below the pre-COVID trend rate, which wouldn’t be enough to rebalance the economy. If China were to rebalance its economy by reducing the investment and infrastructure share of GDP growth by 10% over the same period, that amounts to an average growth rate of 1.1–2.1%, which is positively recessionary by Chinese standards.

 

 

Investment implications

Here’s why the deceleration in China growth matters for global investors. China heads one of the three major trade blocs of Asia, Europe and the U.S. Already, the Chinese slowdown is showing up in Europe and European equities.
 

 

My analysis of global equity returns found that the relative returns of U.S. stocks are negatively correlated to Chinese stocks, but relative returns in Europe and EM ex-China are positively correlated. When China sneezes, non-U.S. economies catch colds.
 

 

As a consequence of the slowdown in the Chinese growth outlook and no fixes in sight, I am downgrading my Trend Asset Allocation from bullish to neutral. Investors should regard this shift not as a sell signal, but a take profit signal from a buy signal that went overweight equities in July 2023. We’ve had a good run, it’s time to take some chips off the table.

 

As a reminder, a model portfolio of over or underweighting the S&P 500 using out-of-sample Trend Model signals from 2013 would have seen strong returns with a 60/40 balanced fund-like risk profile.
 

 

In conclusion, the slowdown in China has become unmistakable. The initiative announced in the wake of the Third Plenum has done little to address the problems of a weak real estate market and high local government debt. The effects of the Chinese slowdown are being felt mostly in non-U.S. equity markets. I am therefore downgrading my Trend Asset Allocation Model from bullish to neutral.