· China headlines in recent weeks have significantly increased the volatility in global markets.
· The impact on China’s real economy from equity market volatility should be modest.
· On the credit front, we view the risk of a 'sudden stop' in China as remote.
· The stability of the RMB and capital outflows are our biggest concerns.
· We continue to expect a 'bumpy deceleration', and the near-term growth outlook remains unclear.
· Worries about growth and deflationary pressures are likely to continue ...
· … until policy actions or better macro data provide catalysts to the contrary.
1. Market Overview
It was a relatively quiet day yesterday with a public holiday in the UK, although another sharp rebound in oil prices failed to help improved sentiment and the S&P500 fell 0.8%. The weakness in global equity markets continued overnight, with most Asian bourses lower, although Asia currencies held up, supported by the news that the PBoC is to impose a reserve requirement on financial institutions trading in FX forwards. According to Bloomberg, the changes, aimed at curbing currency speculation, will take effect on October 15 and will mandate a deposit of 20% of sales to be held at zero interest and frozen for a year.
In terms of data, China’s official August manufacturing PMI was in line with market expectations at 49.7, and the breakdown of the sub-components showed that August growth was likely to have been weak. We continue to expect more support for policy banks, such as RRR cuts and additional liquidity support, aimed at boosting infrastructure investment. For the rest of this week, key data releases include the ISM manufacturing report today, the ISM non-manufacturing report on Thursday and the employment report on Friday for the US (see US Week Ahead for more details); the Euro area PMI today, the ECB meeting on Thursday and Euro area Q2 GDP on Friday for Europe (see European Economics Daily for more details); and the July monthly employment statistics in Japan (see Japan Focus of the Week for details).
2. The implications of recent market moves
China news has dominated headlines in recent weeks and led to a significant increase in volatility in global markets, as investors digest the impact of the A-share sell-off and the weakening of the RMB. Concerns about China credit risk have resurfaced, with particular focus on the foreign debt incurred by Chinese entities. All this occurred against a backdrop of slower growth. The weaker than expected July and August activity data, together with alternative indicators of activity suggesting a sharper slowdown, led our China economists to mark down our GDP forecasts for 2016, 2017 and 2018 to 6.4%, 6.1% and 5.8% respectively, from 6.7%, 6.5% and 6.2% previously, while keeping our 2015 forecast unchanged at 6.8% (see “China’s bumpy deceleration continues, pulling region along for the ride”, Asia Economics Analyst, August 31, 2015). In this piece, we look into the impact of the recent equity, credit and FX moves, and highlight the key risks to watch out for.
3. Equity sell-off should have relatively small macro impact
The Shanghai composite index has corrected by 38% since reaching its peak in mid-June, and is near levels we saw at the beginning of the year. The market remains volatile, with headlines dominated by potential government intervention and the ability of the government to support the market. Despite such moves, our China economists have argued that the impact on the real economy should be modest. We think the equity market’s 'wealth effects' on consumption are overstated, although other channels could be affected, including big-ticket consumer durable purchases and capital expenditures, due to heightened uncertainty and 'wait-and-see' effects. Our model suggests that the downside risk posed by recent equity volatility could be worth roughly 1pp to IP over the next half-year, or around 70bp based on our Current Activity Indicator (see “China: Less wealthy and less confident, but the equity market impact on growth still looks contained”, August 17, 2015).
The other concern surrounding China's domestic equity market has been the very large expansion of margin financing during the first half of 2015. As of the beginning of June, the balance of margin financing outstanding was RMB2.2trn, and our China equity strategists estimated an additional RMB1trn - RMB1.5trn of 'hidden' leverage from other types of borrowing (e.g., consumer loans and trust products). In aggregate, they added up to approximately 5% of GDP at the time. We argued that the financial sector has sufficient strength to ensure that systemic risks are contained, and we continue to believe that is the case (see “Greece, China and Grey Swans”, Top of Mind, July 9, 2015). The latest data have shown that the margin balance has halved from the peak amount to RMB1.1trn, and we believe there has also been a significant reduction in 'hidden' leverage. Our equity strategists estimate that the level of 'steady state' margin financing is roughly RMB1trn, equivalent to around 2% of market capitalisation, a level that is typical in the US.
4. Credit under the spotlight, but risk of 'sudden stop' is remote
Another concern raised by investors is whether the recent growth slowdown and market impact have been a result of deleveraging, and reflect credit issues coming to the forefront. We see little evidence to support this: the most recent data show credit growth accelerating, most likely a result of the policy easing from earlier this year. The year-on-year increase in the stock of Total Social Financing outstanding was 13.1% in July 2015, the fastest pace of increase since February this year. We view the risk of a 'sudden stop' in China as remote. We estimate that around 60% of the country’s credit is supplied by the banking sector, over 20% by the bond market (and over two-thirds of the bond market is owned by domestic banks), and that around 15% comes from other shadow banking activities and 5% from the offshore market. This suggests that the bulk of the credit is supplied by the banking sector. Since the biggest banks have the central government as their largest shareholder, and the banking sector reported NPL levels at 1.5%, with solid capital ratios, we are not witnessing excessive stresses on the banking sector.
From an external debt perspective, the recent 3% devaluation should not have a meaningful impact. From a broader macro perspective, we see no major vulnerability, as we have estimated that the level of external debt in China remains relatively low, at around 8.5% of GDP at the end of last year. Moreover, a large part of the external debt appears to be trade-related, and around 70% of China’s external debts are bank borrowings. This is supported by our analysis of the external debt profiles of the top 125 listed Chinese companies, where we found that less than 25% of total debts are foreign debts, and our scenario analysis indicates that the impact from further CNY depreciation on credit profiles is relatively small (see “How does a weaker RMB impact China credit”, Global Markets Daily, August 17, 2015).
5. Stability of the RMB and capital outflows are our biggest concerns
The unexpected adjustment to the RMB fixing mechanism on August 11 and the 3% depreciation came as a surprise to markets, and the impact continues to reverberate. The worry is that there will be further devaluation ahead, and our China economists have estimated that the pace of FX outflow could have been very rapid, possibly between US$150bn and US$200bn since the announcement. And, as Robin Brookes pointed out, although our analysis suggests that the RMB is around 'fair value', this does not preclude the possibility of further weakness in the short term (see FX Views: Is the RMB overvalued?, August 28, 2015). To the extent that large FX outflows reinforce the market perception of further devaluation risk, and hence sell-off pressure, there is a clear possibility that an adverse feedback loop could become entrenched.
A slowing Chinese economy and the risk of further CNY weakness will transmit across the EM complex, through slowing export growth, the pressures on FX devaluation and lower commodity prices (see “China transmission runs through EM”, Global Economics Weekly, August 27, 2015). Although, as noted by Fiona Lake, we do think Asia’s fundamentals are in a stronger position now than they were in the mid-1990s, the risks are that we could see significant portfolio outflows which could weaken Asia’s external balances (see “Asia’s fundamentals better than prior to the Asia Financial Crisis, but currency weakness still likely”, Global Markets Daily, August 25, 2015).
6. Will need to see better China data for markets to stabilise
We continue to expect a 'bumpy deceleration' for China, and the near-term growth outlook remains unclear. August industrial and investment activities will be affected by the restrictions to industrial activity during the World Athletic Championships and the WWII commemoration, and the explosion in the port city Tianjin is likely to have negative effects on foreign trade. This suggests that August activity growth data are likely to be weak, as should September's. That said, we do expect policy stimulus, primarily through fiscal policy, to support growth in the latter part of the year.
However, as highlighted by our GOAL team, investors may well assume the worst and hope for the best and, from this perspective, persistent fears about growth and deflationary pressures are likely to continue until policy actions or better macro data provide catalysts to the contrary (see GOAL Flash: China & Commodity Commotion; our views across the asset classes, August 25, 2015). Therefore, policymaker actions to stabilise the RMB and capital outflows, as well as signs of stability in activity levels, will be the key issues to watch out for.
7. Tactical Trading Views
The following trading ideas from the Global Markets Group reflect shorter-term views, which may differ from the longer-term ‘structural’ positions included in our ‘Top Trades’ list further below.
On Rates:
1. Stay short 10-year US Treasuries and long 10-year Bunds, opened on 17 Jul 2015 at a spread of 153bp, with a target of 190bp and a stop loss of 130bp, currently trading at 140bp.
8. Recommended Top Trades for 2015
Longer-term structural views are expressed in our Top Trade recommendations. These are typically managed with a wide stop, and assessed on the basis of whether the fundamentals continue to support the medium-term investment theme.
1. Stay long EUR/$ downside via 1-year 1.00/0.95 put spread (originally at 1.20/1.15 with a premium of 70bp EUR at initiation), expiring on 20 Nov 2015, opened at a spot EUR/$ of 1.253 on 20 Nov 2014, currently at 1.128.
2. Close constant maturity 10-year US Treasury 3.00-3.50% ‘cap-spread’, funded by selling a corresponding 2.24-1.75% ‘floor spread’ , opened on 20 Nov 2014, for a potential return of 0%.
3. Close long Dec-2015 Eurostoxx 50 3150/3450 ‘bull’ call spread on 19 Feb 2015, opened at 101.5 on 20 Nov 2014, for a potential payout of c1.8-to-1.
4. Close long risk on the 5-year CDX HY 23 junior mezzanine tranche (the 15-25% portion of the loss distribution) on 6 Apr 2015, opened at 495bp on 20 Nov 2014, for a potential unlevered gain of 5.2%.
5. Close long basket of EM crude oil importers stock markets, implemented via equal part of TWSE and NIFTY indices (XU030 closed as of 1 Apr 2015), opened at 100 on 20 Nov 2014, for a potential loss of 8%.
6. Close short CHF/SEK on 15 Jan 2015, opened at 7.70 on 20 Nov 2014, for a potential loss of 16.5% including carry.
7. Close short Dec-15 LME Copper futures and long Dec-15 LME Nickel futures on 23 March 2015, for a potential gain of 0.3% on the relative value trade.
8. Close long USD against a basket of HUF and ZAR on 21 Jan 2015, opened at 100 on 20 Nov 2014, for a potential gain of 8% including carry.
9. Stay long USD against a basket of ZAR and KRW (on a spot basis), opened at 100 on 3 Feb 2015, with a target of 115 (extended from 110) and a stop on a close below 97.5 (raised from 95), currently at 111.6.
