The China Story: Slowdown, Not Inflation
Everyone seems to be talking about an inflation pickup, but the greater influence, in our opinion, on investor sentiment with respect to China right now is a growth slowdown.
China’s purchasing managers’ index (PMI)—which shows the prevailing direction of economic trends we believe in the manufacturing and service sectors—has been below 50 for the past two months. Anything below 50 indicates a contraction.
What’s contributing to this? Of course, we have concerns about Evergrande, one of China’s largest real-estate developers, defaulting on its debt. This has occupied the minds of investors in China for some time, and it has far-reaching effects because China’s economy is so big. What happens to China’s growth doesn’t go unnoticed everywhere else.
China has created its own macro-thematic influence of deleveraging its economy and its financial system. What I mean is that this is not occurring by accident; it is occurring with the full awareness and intention of Chinese leadership.
China has a highly investment-led economy, with infrastructure and real estate dominating its growth for many decades. But many have forecast that China cannot and will not pursue that economic model forever. It must eventually transform its economy into one that is more consumption-led in our view because that is what mature economies inevitably become. Importantly, that transition from an investment-led to a consumption-led economy entails a slower growth trajectory.
We have factored a slowing growth outlook into our Chinese assumptions for many years now.
This should not come as a surprise to investors. We, for example, have factored a slowing growth outlook into our China assumptions for many years now, although we did not know exactly when the transition would occur, nor what the growth rates would be.
In any case, it appears that China has become more comfortable with its slowdown occurring in the current environment. China emerged from the pandemic with growth rates that were higher than official targets. As a result, the economy had some space for its leaders to take the measures they are taking now—essentially, slowing growth in a series of regulatory moves that restrict borrowing and investing.
Specifically, China is clamping down on leverage, most recently in the real estate sector. Chinese residential real estate works differently than it does in the United States and some of Europe. Homeowners do not have high leverage; property developers, such as Evergrande, do.
So far, we believe, the situation in China’s real estate sector remains localized; it has not really affected other parts of the Chinese credit market, which is very, very large. Chinese corporate debt is in the midsingle-digit trillions of dollars.
China’s efforts to deal with leverage via its recent series of regulatory moves directly affects just 0.5% of the country’s total credit market.
To break down the absence of spillover, consider that about 90% of China’s total corporate debt is domestic, and it does not appear to have been particularly impacted by recent regulatory moves.
The other 10% is foreign currency debt, which is mostly denominated in U.S. dollars. And of that foreign currency debt, one-tenth is high yield. In other words, U.S.-dollar-denominated high-yield debt appears to be about 1% of the total credit market in China.
Real estate is roughly half of that 1%, so about 0.5% of the total credit market in China. That means China’s efforts to deal with leverage via its recent series of regulatory moves directly appears to affect just 0.5% of the country’s total credit market.
Thus far, China’s efforts have not spilled over into the rest of the high-yield debt market. As evidence, we see a striking bifurcation in the yields of high-yield property debt and other high-yield debt. High-yield property debt is yielding about 30%; the rest of the high-yield debt market is yielding in the low single digits.
China still has the option of stimulating its economy if leadership decides to change course.
That does not mean the situation is simple. We are not sure—and the markets are not sure—just how much of a slowdown in China’s economic growth its leaders will risk before they conclude that they have made a mistake and reverse course. The controllers of a highly centrally planned economy do not have perfect foresight; they probably do not even have foresight that is any better than anyone else’s. It may even be worse than most.
That said, China still has the option of stimulating its economy if leadership decides to change course. Certainly, policymakers can engage in fiscal stimulus, which China did in spades following the 2008 global financial crisis (a move for which it claimed significant reputational kudos). Monetary stimulus is also an option.
As I mentioned, however, this slowdown in growth, we believe is already built into our assumptions for China. We have been estimating equity earnings growth of a bit below 4% for several years. Thus, we do not believe we need to make further downward revisions.
We do not have exposure to Chinese bonds, either sovereign or corporate; we exited a position in sovereign bonds in July. But we still find broad China equity exposure fundamentally attractive and we maintain a long position there.
But to bring it back to the beginning, in an interconnected world, China’s current experience is a nontrivial counterweight to the bigger inflationary picture that we are seeing elsewhere. And I think that’s not a bad thing at all.
Aaron Balsam, CFA, is a senior analyst on William Blair’s Dynamic Allocation Strategies (DAS) team.
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