After significant volatility in the Chinese markets over most of last week, reports that senior Chinese regulators have held a conference call to reassure leaders of investment banks that recent regulations in the private education space would not be applied broadly helped to stem a swift deterioration in investor sentiment.
In our view, this act to reassure markets is key. Investors value a steady operating environment. The sharp hit to private education businesses last week has raised doubts over the role of private capital, in terms of the balance between the profit incentive and social equality, as viewed by China’s policy makers, and whether this equilibrium is subtly shifting.
In the extreme scenario of prolonged investor uncertainty, it could increase risk premiums, depress asset prices, and hurt the ability of Chinese companies to raise funds for growth.
Moreover, international investors mostly prefer a free market-oriented approach towards solving complex problems. In China, while the goal of removing the profit motive in private education centres is to reduce childcare costs, alleviate the wealth gap and ultimately boost the birth rate – a key goal of the government – the tail risk is that removing the profit motive might ironically result in less innovation, lower quality, and higher cost to consumers if poorly implemented.
That said, we believe that China’s long term macro-economic outlook remains sound despite the volatility in Chinese stocks. Past stock routs have not hurt economic growth. Low levels of margin debt in the Chinese stock market will limit contagion to the financial sector.
China’s policymakers have also recently demonstrated that they are sensitive to the growth outlook and will act decisively to support it if required. They have recently begun to inject system liquidity by cutting the reserve requirement ratio for banks, and have more dry powder to shore up growth if needed.
At the quarterly politburo meeting last Friday (30 July 2021), China’s policymakers assessed that the economic outlook for China was decidedly cautious, and emphasized that recovery remained “unbalanced” and “not yet stable” while the external environment has become more complicated and challenging, with the global pandemic still evolving.
We believe the Chinese government plans to quicken the implementation of fiscal policy and maintain prudent monetary policy while providing targeted support for SMEs.
This supportive policy approach bodes well for China’s growth outlook, as the government at the same time seeks to aggressively address challenges related to excesses and weaknesses in various markets and sectors, an aging workforce, and tensions with the United States.
In addressing these challenges, the broad direction of China’s policies has been fairly sound and consistent. For example, in the fast-growing technology sector, where network and scale effects often accrue overwhelming market power to the leading players, regulations against monopolistic practices and to protect consumers are sensible.
China’s efforts in this area are not dissimilar to the US and European Union’s antitrust efforts to keep Google, Facebook, Amazon and other tech giants in check. The key difference is that under the China model, we can see results in months instead of years of litigation.
China is also taking a well thought out approach in addressing tensions with the US in the arenas of capital markets and technology. The recent market attention on the tighter requirements for overseas listings for Chinese companies in the aftermath of China’s punitive actions on Didi Chuxing created a common misperception that these were a knee-jerk reaction to Didi’s US IPO.
The reality is that these rules formed part of a set of capital market regulations approved at a top-level government meeting last year which also focused to a large extent on domestic capital market infrastructure development.
This speaks to China’s structured approach to capital market development governed by clear rules and regulations, including clarity around data security and cross border data flow, and to alleviate long-term funding risks for overseas-listed Chinese firms.
Regulatory uncertainty, however, is likely to weigh on investor sentiment over the near to medium term.
Within the Chinese equity universe, we have a relative preference for the onshore A-shares market, which yields less exposure to the sectors receiving regulatory scrutiny.
We are cautious that Chinese stocks listed in the US (also known as ADRs), especially those in sensitive technology and data-intensive sectors, could see further volatility as both US and Chinese regulatory pressures continue to loom large.
As for the Chinese technology sector, we believe its long-term prospects remain sound, but it is premature to call a bottom for the sector considering the latest move by the government to set up a special task force to regulate the internet sector and the risk of further earnings uncertainty.
In contrast, we favor sectors that are key to Beijing’s long term strategic goals as highlighted in its 14th Five-Year Plan, such as AI, 5G, renewables, infrastructure, and new energy vehicles as they are slated to receive increased government support.
The semiconductor and telecom sectors will also benefit from Beijing’s support of 5G technologies and strong demand for chips. The outlook for the domestic consumption sector is also buoyant as China prioritises the expansion of the middle class.
For global markets, the key takeaway from the Federal Open Market Committee’s July meeting last week was that the tapering of its quantitative easing program is likely months away. While the taper announcement ahead could trigger some degree of volatility, we expect only a gradual reduction in the monthly pace of asset purchases, which should continue to be largely supportive of risk asset prices.
At its meeting, as widely anticipated, the US Federal Reserve maintained the overnight fed funds rate at 0.0-0.25% and made no changes to the quantum of its purchases of US Treasury and agency mortgage-backed securities.
The notable point in the July FOMC statement is the acknowledgement that “the economy has made progress toward” the Fed’s goals of maximum employment and the 2% inflation target since the bond purchase program was enacted last December. This constituted an upgrade in its assessment of the state of the US economy, and the market has interpreted that this effectively makes all the upcoming FOMC meetings “live” for the announcements to taper its bond purchases.
The details of the tapering (timeline, pace, composition) remain topics for discussion in the upcoming meetings. Chairman Jerome Powell noted during the press conference that the July meeting was “the first really…deep dive” amongst the committee but no decisions were made that could enable any guidance from him after this month’s meeting.
Chairman Powell also reiterated his views on two key topics for the Fed, namely 1) the elevated inflation currently in the US as being transitory, and 2) the labour market remains “some way away” from the “substantial further progress” that the Fed would like to see towards its maximum employment goal.
The initial market reaction to the statement was muted. S&P500 held steady on Wednesday, slipping 0.82 point or less than 0.1% while the tech-heavy NASDAQ rose 102 points or 0.7%. The 10- year US Treasury yield rose to 1.259% at the end of Wednesday, up 2.4 basis points from Tuesday’s close of 1.235% but the uptick was not sustained. The 10-year yield slipped back to below 1.24% on Friday. US equities ended the week slightly down as well, with the S&P and NASDAQ closing the week at 0.4% and 1.1% lower, respectively.
We continue to closely monitor the Covid-19 situation and its impact on the global growth outlook.
The number of Covid-19 cases globally continues to rise due to the spread of the more transmissible Delta variant. In the US, the 7-day moving average for new confirmed cases has picked up from ~13,000 at the end of June to ~79,000 last Friday. In the closely monitored example of the UK which suffered from the Delta variant earlier, the 7-day average has moved from ~19,000 at end- June to a peak of ~48,000 by the 3rd week of July and inflected recently down to ~27,000 as at last Friday. Globally, the 7-day moving average of new confirmed cases has risen from ~370,000 to ~590,000 over the month of July.
This is currently some way below the worst witnessed in January this year where new cases averaged ~740,000 at the worst point of the outbreak in the US and Europe, and the ~820,000 figure in April this year at the worst point of India’s outbreak.
Notably, the rates of hospitalizations in the UK and US this month are far below that seen during the worst points around January. In January, peak hospitalization in the UK and US were ~420 and ~350 per million people, respectively, and that statistic is just under 100 per million in the latest data. The same trend is observed for case fatality rates.
This is supportive of our continued base case that the vaccines are helping to break the link between infection and the catastrophic impact of the Covid-19 virus.
Moreover, the good news is that there is continued progress in vaccination rates globally. The share of population that has received at least one vaccine dose in the European Union has risen to ~59% as at end-July, edging past the US’ ~57%. Globally, the vaccination rate (of at least one vaccine dose) has risen by 4 percentage points from ~24% at the end of June to ~28% at the end of July.
In our view, we maintain an overall overweight position in equities with a preference for US equities.
While we believe inflationary pressures are likely to begin easing from current high levels in 2022, the strong price trends over the next few months should keep cyclical sectors, such as commodities, energy, material and real estate, relatively supported over a 3-6 month horizon.
Due to concerns over the Delta variant and the growth outlook, we see selective opportunities in solidly run companies with strong balance sheets and health earnings profiles in re-opening related sectors, such as airlines, hospitality and restaurants, given the recent correction which appears overdone in some pockets. For instance, the S&P Airline index has fallen back to levels seen between November 2020 and January 2021 at the height of the outbreak in the US.
In fixed income, we remain overweight in Emerging Market High Yield bonds, where valuations still look relatively attractive and should offer a buffer against the adverse impact of rising rates compared to other fixed income segments.
We stay underweight in both Developed Market and Emerging Market Investment Grade bonds, where historically rich valuations leave little buffer against rising rates.
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