Newsletter commentary Sep 2023

In September, the market retraced many of the gains seen after the positive policy announcements in August, with trading volume reaching extremely low levels, briefly dropping below 600 billion RMB. Clearly, the market remains quite pessimistic and exhibits the following characteristics structurally: the dividend index performed well, rising nearly 3 per cent, while the Shanghai and Shenzhen 300 index fell by 2 per cent. The CSI 500 index declined by 0.85%, while the performance of the CSI 1000 and CSI 2000 indices was not significant. In addition, previously crowded industry indices underperformed. The weakness in the Shanghai and Shenzhen 300 index may be related to the continuous outflow of northbound capital, as this capital tends to prefer large-cap companies relative to the overall market.

The market's pessimism has not changed our positive view on the economy and the market. We believe that positive factors are continuously accumulating. The same objective facts can evoke different emotions and lead to different interpretations. It is objective that the Chinese economy faces challenges, and a decline in overall expectations reflects this comprehensively. Stock prices are a main indicator in this regard.

The recent continuous sell-off by northbound capital is a substantial manifestation of this sentiment. However, we believe that they may be mistaken, just like how they, along with other institutional investors (which may include all market participants), created a significant bubble in blue-chip stocks at the end of 2020 and early 2021, in parallel, they might be digging a big hole now.

Compared to other countries, the COVID-19 pandemic did not create a significantly larger economic hole for us over the past three years. However, what stands out is the significant changes in our economic structure within a short period of time. The reliability of China's supply chain for most of the time has led to a substantial increase in the proportion of industrial production.

Overall, in 2023, the economy showed rapid improvement in February and March, raising market expectations. However, as compensatory consumption behaviour subsided and temporary stimulus policies implemented during the pandemic expired, the economy experienced a noticeable decline in April and May. From June onwards, a slow recovery began. The initial rapid rebound of the economy at the beginning of the year has likely concluded, and the expectation of a strong momentum to overcome the scars of the pandemic may not be feasible without significant direct fiscal stimulus akin to the American approach.

At the same time, the normalization of global supply chains and destocking processes have made exports more challenging. Although the actual physical export volume may be better than the apparent data suggests, maintaining a healthy trade share, it is still difficult due to the combination of factors. Moreover, the anticipation of a turning point in the real estate sector and the gradual adjustment of real estate policies may not have a significant reversal effect. plus, the exposure of local government debt and some financial risks adds to the pessimistic reasons that are being accumulated.

As the policy tone began to shift in July, signalling a change in direction. At that time, the market started to question the relevance of further economic stimulus. Currently, there has been a relaxation of restrictions on property purchases, which is beneficial for improving the real estate market. The easing of restrictions on home purchases and loans will help alleviate the demand squeeze caused by purchase and loan restrictions.

While the real estate sector's role as a key driver of the economy has diminished after more than 20 years of robust growth, with new construction areas almost halving compared to 2019, and sales declining by 30-40%, the phase of real estate's fastest impact on the economy through leading indicators has passed. The subsequent phase involves a decrease in incremental growth and a decline in ongoing construction projects. Additionally, there may be a substitution effect between second-hand and new housing. However, the demand for housing upgrades will keep the development volume at its current level for many years. If further policies likely large-scale public rental housing is implemented, it will provide additional support to the overall real estate market.

Since August, fiscal policies have become more proactive. A new round of fiscal easing primarily focuses on tax reduction measures aimed at supporting the real economy, increasing household income and consumption, supporting tech and new-emerging industries, bolstering the capital market, stabilizing foreign investment and foreign trade, as well as addressing financial risks. In addition, there has been an acceleration in the issuance and utilization of local government bonds, as well as an expedited pace of fiscal expenditures. The speed of recent fiscal expenditures has noticeably increased.

In terms of monetary policy, there has been a continued easing stance. In September, the reserve requirement ratio (RRR) was lowered by 0.25% following the previous cut in March. In June and August, the rates for reverse repurchase agreements (repo) and medium-term lending facility (MLF) were both reduced by 10 basis points (BP) and 15 BP, respectively. Banks also lowered deposit rates on two occasions. The loan prime rate (LPR) was lowered twice in June and August, each time by 10 BP. In June, the 5-year LPR was reduced by 10 BP. Moreover, there have been relaxations in property loan restrictions, including reductions in down payment ratios for first and second property, lowered mortgage rates for second property, and eased criteria for first-property eligibility. In September, mortgage rates for existing first-property loans were lowered.

Regarding exchange rates, the macro-prudential adjustment coefficient for cross-border financing was increased in July to prevent excessive fluctuations in the exchange rate. In September, a meeting on foreign exchange self-discipline mechanisms was held to guard against exchange rate overshooting. The renminbi (RMB) had a relatively weak performance in June and July, but since August, it has shown relative strength amid a new round of appreciation in the U.S. dollar index.

Moving to capital market policies, a balanced approach has been taken. In addition to both tax reductions and fee reductions, measures have been implemented to restrict major shareholders from reducing their holdings, encourage dividend payouts, promote share buybacks, and limit financing. Since September, there has been a significant decrease in financing activities. These policies have largely altered the incentive mechanisms in the capital market, and if consistently upheld, they are expected to enhance investment functionality and make financing more effective. We have high expectations for the long-term effects of these measures.

At this point, doubts about whether economic development should remain the central focus may be dispelled, as the ability to introduce effective policies is likely to improve along with the stabilization and positive trajectory of economic data. Recent data on industrial enterprise profits and the Purchasing Managers' Index (PMI) have shown a positive momentum in economic recovery. Despite the challenges in the real estate sector, the economy has been gradually recovering without significant fiscal stimulus, which is a normal process. The future of the Chinese economy will be characterized by diversity and excitement, rather than a sudden surge forward.

As the recent sustained reduction in foreign capital holdings cannot be ignored. Over the past 40 trading days, foreign investors have been net sellers, with an average daily outflow of around 5 billion RMB. In a market with low trading volume and a lack of incremental funds, continuous selling by foreign investors can have a significant short-term impact. However, it's worth noting that this year, the net inflow of funds from northbound investors has reached nearly 100 billion RMB, while southbound investors have seen a net inflow of over 200 billion RMB. The short-term capital flow does influence the market, and foreign investors are indeed important participants in the Chinese stock market. However, their understanding of Chinese stock investments is also evolving, just like domestic investors.

Over the past 30 years, China's capital market has been evolving, and investors have been evolving along with it. On one hand, it is one of the most dynamic and innovative markets, but on the other hand, it is also highly volatile. It is difficult to make easy money in this market, but it is also a market that cannot be ignored. China's stock market represents a significant portion of emerging markets, accounting for 30% of the total.

What we want to emphasize is that the current difficulties are not solely related to the Chinese economy. Instead, they are associated with the period from 2019 to the end of 2020 and the beginning of 2021. During this time, the Chinese capital market experienced unsustainable high returns as institutional investors championed value investments from a low starting point in 2018. furthermore, with limited space for lending business, banks actively sought wealth management and increased product sales. Plus, the industry saw excessive speculation in sectors such as new energy, innovative pharmaceuticals, and the electrification and intelligence of automobiles.

Unfortunately, the indices tracked by foreign investors experienced significant adjustments in 2017 and 2020, and the timing of these adjustments was not ideal. This increased the difficulty of foreign investment in China and further fuelled the bubbles at the time. Just as greed prevailed during the period of high valuations, the current fear is essentially the same but based on low valuations. It is not comprehensive to attribute all these factors solely to the Chinese economy.

Looking forward at the longer term, the external environment we face will also have many variables in terms of its impact on us. We tend to believe that there is a high probability of opportunities for improvement. Many current international events reflect the changing dynamics of the world. The balance of power has shifted in various ways. For example, the recent significant rise of the US dollar has not led to major crises in developing countries. On the contrary, many developed countries are facing challenges and constraints due to their economic issues and limited resources.

In the past period, compared to some countries' exaggerated fiscal stimulus, our conservative approach in economic strategy may have felt disappointing. However, there is no free lunch in the world. The US economy has consistently outperformed expectations this year, initially breaking expectations of a recession and benefiting the stock market. However, this narrative has gradually shifted to concerns that US inflation may not return to the 2% target. Even with a strong economy, investors are still worried about the long-term impact of inflation on interest rates. If economic theory holds, restrictive interest rates will eventually limit the economy, and whether structural inflation can offset the growth opportunities brought by manufacturing reshoring remains to be seen.

If fiscal policy becomes unsustainable in the future, coupled with persistently low inflation, it would be the worst combination. However, during extraordinary times, the creditworthiness of the US dollar can still be exploited.

However, the Chinese economy has gradually undergone a process of self-reflection and re-evaluation amidst the recent period of painful confusion. The era of relying heavily on real estate as a key driver of economic growth, characterized by excessive expansion, is fading away. The future lies in high-quality development, with the capital market at its core, fostering innovation and wealth management to achieve shared prosperity. This shift represents a significant transformation in the economic landscape.

The focus on high-quality development indicates a shift towards a more sustainable and balanced growth model, where innovation, entrepreneurship, and the efficient allocation of resources play pivotal roles. By promoting the capital market and encouraging the development of innovative industries and wealth management, China aims to foster an environment that nurtures shared prosperity and creates opportunities for all.

This transition signifies a departure from the previous growth pattern and highlights the commitment to long-term stability and sustainable development. It is a crucial step towards achieving a more resilient and inclusive economy.

During times of real change, production capacity is the true reflection of productivity, rather than the monetized prices. Prices often experience disorderly fluctuations. For example, during a pandemic, the ability to manufacture masks and vaccines reflects actual capacity, not the amount of nominal currency held. The productivity of the Chinese economy will ultimately be reflected in prices.