Latest on Trade War
Most of proposed 10% tariffs on consumer electronics will be pushed back to 15 December 2019, from the initial 1 September deadline. These should account for roughly half of the targeted $300bn in Chinese exports. The delay will provide modest support to China’s near-term growth.
China’s response is important especially if Beijing returns with stepped-up agricultural imports from the US – an item that is high on Trump’s re-election agenda. Given Trump’s concession, there are increased chances of continued trade talks in September.
Beyond that, our confidence remains low in the two sides’ showing greater flexibility to close the gap on key fundamental issues of market access, forced technology transfers and state subsidies. The limited relief rally in global equities reflects investors’ lingering concerns on trade-war uncertainty. These concerns will continue as tariff deadlines are delayed.
The Economy and Policy Focus
As trade uncertainty and the risk of Trump’s continued tariff/non-tariff decisions remain in the picture, policy responses will be a key market driver. China’s economy remains reasonably resilient but definitely not firm enough for Beijing to be relaxed and refrain from moving policy stimulus to higher gears.
Indeed, after the strong pick up in most domestic demand indicators in June, snapbacks occurred in July from industrial production to retail sales and fixed asset investment.
The industrial sector dipped into deflation with contracting factory gate prices and profit growth. The relapse in domestic demand is a policy alert. Specifically, falling profits in China’s state-owned enterprise-dominated industrial sector should add pressure to policymakers to step up policy accommodation.
In addition, rising headline consumer price index inflation (to 2.8% year-on-year/yoy in July mainly on a surge in pork prices) should not pose a significant inflation threat to policy easing.
By contrast, the underlying weakness in the economy is better reflected in the tame, and still softening, core inflation trend which has declined to 1.6% yoy in July.
China’s new credit expansion was disappointedly modest in July after the surge in the prior month. The People’s Bank of China’s (PBOC) second quarter (2Q/19) monetary policy report fails to lift expectations beyond its usual prudent policy stance with an emphasis on targeted liquidity injections.
The central bank is understandably facing a tough balancing act between preventing re-leveraging risk and providing effective policy stimulus to fight the trade war.
The first constraint is the latest official release of China’s total debt count. Total debt outstanding rose 5.1% points of gross domestic product (GDP) in (1Q/19) to 249% of GDP (or $33trn), indicating rising leverage in the economy again.
The second constraint is a renewed sign of an overheating housing market (average residential property price inflation increased to 11% yoy in July) and there is an increasing need to prevent excess liquidity from flowing into the housing market.
In our view, PBOC’s policy response is credible given its policy constraints. Instead of pouring excessive liquidity into the economy as they did during the global financial crisis (GFC) a decade ago, targeted liquidity injection to support local consumption, infrastructure projects and the private sector should maximise the policy effect – albeit with some lag.
The year-long monetary easing has not brought down effective borrowing cost for firms to desired levels. PBOC’s immediate focus will be on reforming China’s interbank rate system. Corporate prime lending rate can then be more sensitive to lowering short-term interbank rates as a means to lower the funding costs for the real economy.
If push comes to shove, the last resort will be continued cuts in the bank’s reserves requirement ratio (RRR) to release locked liquidity back into the banking system.
Currently at an average of 13.5%, RRR cuts have high flexibility considering that the level was merely at 5%-6% in the early 2000s. For the coming year, we think a measured reduction of 100-200 basis points (bps) represents prudent easing, and RRR reduction is expected to become increasingly targeted to benefit specific financial sectors.
Finally, as argued before (see Asia Macro Strategy – Turning Up the Fiscal Tap, July 11, 2019), China leads in using fiscal stimulus to complement monetary easing. Such flexibility should remain barring a deep economic recession ahead.
Policymakers in other major economies may envy China’s relative policy dynamics, although its current position compares pale to that during GFC when its total debt/GDP ratio was at 150% and fiscal balance was in surplus.
MSCI China’s forward P/E has remained resilient at about 11x (at historical mean level) after the decline in early May on Trump’s new tariff hike on Chinese exports.
The market seems to have priced in reasonable confidence in China’s policy capability to cushion future growth. This is in view of the low forward P/E at 9.8x in early January given heightening trade war uncertainty. We expect Beijing’s continued roll-out of policy support plus protracted trade talks should maintain market valuation at around current levels.
Upside could see multiple expansion to around 12.5x P/E similar to April/early May when news on an imminent trade deal was the focus. On the downside, a market correction of another 10%-15% will knock down forward P/E to below 10x and will begin to make risk and reward attractive.
Chief Asia Investment Strategist