Investor sentiment towards China has softened of late, driven by concerns about inflation, economic overheating and the possibility that tighter monetary conditions could cause a hard landing. Jun Ma, chief economist for Greater China and head of Hong Kong and China strategy at Deutsche Bank, says these pressures are set to ease in the coming months and that the outlook for Chinese equities is positive.
It wasn’t long ago that investors were concerned about rising inflation and the risk of China’s economy overheating. What has changed?
Any risk of overheating has been contained in our view, with a hard landing highly unlikely. We always expected inflation in China to peak mid-year, then fall in the second half of the year, and recent data is increasingly supportive of this view.
Food prices are beginning to ease, with the daily agricultural price food index falling 6% in the past 40 days; property prices are being contained, thereby limiting the upward pressure on residential rental yields; while tough lending practices for local financing vehicles have helped measure credit growth.
We expect the resulting base effects will be very favourable for a decline in year-on-year inflation in the second half of this year and that policy tightening will ease in the coming months.
While China’s economy is set to cool, we still think there is ample opportunity for investors as growth becomes more sustainable than in recent years. We expect MSCI China to re-rate to a normalised forward price-to-earnings multiple of 13 times, up from the current 11.5 times, as macro risks recede in the coming one or two quarters.
So you think inflation in China has peaked?
We think month-on-month inflation has already peaked, yes, while we expect year-on-year inflation to peak in June and then decline significantly from there. We forecast consumer price index (CPI) inflation to reach around 5.8% year-on-year in June, falling to 4% in December on an extremely favourable base effect.
Inflation has clearly been the single most important macro risk for China and has acted as a cap on sentiment, with investors fearful that more aggressive policy tightening would result in a hard landing. The good news is that the key factors driving inflation -- food, oil and property prices -- are either easing or likely to have less of an impact than expected.
Given food prices have contributed to around 70% of the year-on-year CPI movement, its outlook is more significant than any other factors, including labour costs and raw material prices combined. It is therefore significant that the daily agricultural price index has fallen by around 6% in the past 40 days. This is consistent with seasonal effects post Chinese New Year, however the fact that the index is typically more stable in spring than winter or summer means prices will likely fall by around 3% in March-May, as we had predicted earlier.
With everything going on in the Middle East, it is natural to expect some sort of inflationary pressures from rising oil prices, however the effect here is actually quite limited. By our calculations a 20% permanent rise in global oil prices would only lift Chinese CPI by 0.3% as refined oil prices are still subject to control in China. If the average global oil price is in the range of $80 to $130 a barrel the government allows only partial pass through to consumers. If the average global price exceeds $130 a barrel, there is zero pass through. Therefore, even if global oil prices rise to USD120/bbl for the remainder of the year, the effect on Chinese inflation would be negligible.
Property prices are also falling, which will help mitigate upward pressure on rental yields. The average selling price in 35 major cities has declined by around 7.5% between January and the week of 11 March, according to Soufun.com. This, combined with a massive planned injection of public housing supply, will not only keep rental yields under control but also reduce political pressure on the government to introduce further tightening measures.
What does this all mean for monetary policy?
We expect policy tightening to become less aggressive in the coming two quarters as public discontent over inflation recedes. The combination of lower inflation and decelerating gross domestic product (GDP) growth in the second half of the year, which we forecast to fall to 8.5% to 9% from the current 9.8%, would justify a less aggressive policy stance, in our view.
Recent data is supportive. The deceleration in M2 growth [a measure of money supply] is likely close to ending, having fallen sharply from 30% year-on-year in November 2009 to 15.7% in February 2011 and is now below the official year-end target of 16%.
Renminbi loan growth has also slowed sharply, from 33% year-on-year in the fourth quarter of 2009 to 17.7% in February 2011. While we expect this to continue, the fall is likely to be marginal – around 2% for the remainder of the year.
Consequently, we expect reserve rate requirement hikes to become much less frequent, with only two more totalling 100bps this year, versus the 500bps of hikes we saw between January 2010 and March 2011.
This is partly because China’s trade balance continues to narrow, even taking into account the recent spike in commodity prices. For example, the merchandise trade balance fell sharply to a deficit of $1 billion in January/February, down from a monthly average surplus of $12 to $13 billion during the past two years. This implies a reduced need for FX reserve accumulation and therefore sterilisation by the Peoples Bank of China.
Also worth noting is the fall in interbank market rates -- the seven-day repo rate dropped by 2.2% in recent days, down from the January peak of 8%. We even think financing restrictions on property developers and local governments may ease somewhat in the second half of the year as inflation and slower GDP growth allows the central government to extend more flexibility to the financing activities of these sectors.
Overall, we expect two more rate hikes totalling 25bps this year – one in March/April and one in June/July – to take the one-year deposit rate to 3.50%.
So you think it’s a case of slower but better quality growth?
Effectively, yes. The property sector is cooling, infrastructure investment is slowing and the purchasing managers index (a measure of growth for the manufacturing sector) is also declining, suggesting heat is being taken out of the economy.
At the same time, a 100% increase in public housing investment, resilient exports, and healthy consumption of services should pick up the slack and avoid the possibility of there being a hard landing.
We are comfortable with our forecast of year-on-year GDP growth of 8.5% to 9% in the second half of the year and, importantly, expect this growth to be much healthier and sustainable than before.
What does this mean for China’s equity market?
Disinflation and more sustainable GDP growth in the second half of the year should support a re-rating of China’s equity market to its normalised ten-year valuation average. This would see the price-to-earnings multiple on MSCI China rise to 13 times, up from the current 11.5 times, or 10% to 15% index upside in the coming two quarters. We currently forecast a 25% rise from current levels in the next 12 months.
The property, banking, steel, cement and power sectors are our top picks to outperform the index in the coming months, largely because these have already been discounted for the possibility of a hard landing.
During the medium term however, we do not expect a significant re-rating of MSCI China. Inflation will likely become structurally higher and GDP growth lower than their historical averages in the coming years. However, it is important to recognise the benefit of this shift: a more sustainable and resilient Chinese economy.
