1. Chinese policymakers have stepped up the pace of easing in recent weeks, with interest rates continuing lower. The 7-day repo rate -- the key short-term policy interest rate -- has fallen nearly 300bp in just two months. Lower rates are typical following periods of rapid debt accumulation in most countries, as policymakers try to maintain growth by easing high debt service costs. With repo rates near our year-end forecast of 2.25% and the curve steepening through our target of 30bp, we see the best opportunities now further out the curve. Policymakers' focus may also have shifted in this direction, given their desire to ensure a successful launch of new municipal securities in coming weeks.
2. Heightened focus on supporting economic activity--reinforced at the most recent Politburo meeting--is clearly appropriate. Q1 growth was dismal, the worst since the global financial crisis. Official data implied only a 2-3% real GDP growth pace on a quarter-over-quarter basis after subtracting a large contribution from the financial sector's fervent activity, and industrial output was especially weak in March.
3. Lower rates are unlikely to be sufficient by themselves to push Chinese growth back up towards the official target of "around 7%". Measures to stabilize housing activity--recent data suggests that progress is being made in this area, although we saw a false start late in 2014--and especially to boost fiscal outlays will be key. On the latter point, local governments have been a key source of growth in China in recent years, generating significant revenue from land sales and borrowing heavily via off-balance sheet funding vehicles. With these revenue sources under threat--the former from a softer property market and the latter from regulatory intervention to bring greater accountability and transparency--and the anticorruption campaign providing strong incentives for local officials to be conservative, spending has slowed significantly.
4. Clients we visited recently in London, Singapore, Seoul, and Tokyo were extremely curious about the Chinese equity boom--even after the selloff of the past few days, A shares have rallied over 70% in 6 months--and what it means for the economy and other asset markets. We see a stronger equity market as a helpful, albeit modest, support for activity in the near term, and perhaps more importantly as a vehicle for reducing the reliance of the economy on debt financing. Our equity strategists remain overweight, though they see the best opportunities in offshore listings such as select H-shares and China ADRs. Views differ considerably depending on where clients sit, with sentiment bullish within greater China and generally more skeptical outside it.
5. Skepticism has certainly been the theme in southern Asian asset markets in recent weeks. Weakness in equities and some currencies (notably the Thai baht) began before the selloff in core bond markets--based on client conversations, this seems to reflect concerns about the progress of structural reforms, weaker-than-expected growth outcomes, and possibly some rotation towards China-related assets. Governments in south and southeast Asia are confronting diverse challenges, including pressure to deliver on high reform expectations and/or domestic political challenges. Though some political leaders in the region have openly called for monetary easing, central bankers remain concerned about various domestic (inflation or credit growth) or external (current account) imbalances despite progress since the "taper tantrum", particularly given expectations for the onset of Fed rate hikes later this year.
6. Indeed, a key concern raised in client meetings--particularly within Asia--continues to be the potential impact of Fed rate hikes on regional asset markets and currencies. For policymakers dealing with "lowflation" concerns, weaker currencies are more likely to be an acceptable or even desirable outcome of Fed tightening (for example in Japan, Korea, and Thailand--arguably China too, though policymakers there seem more focused on maintaining stability versus the dollar to support their longer-term policy goal of renminbi internationalization). For countries such as Indonesia (and to a lesser extent India) that run current account deficits, or for rate-sensitive financial centers such as HK and Singapore, a gradual Fed liftoff will be especially important.
7. From an investment perspective, we see the biggest opportunity for further policy rate cuts in China (where we expect a benchmark rate cut of 50bp), Korea, and Thailand. Further cuts are also a possibility in India (where the market is already pricing one) and Indonesia (given a disappointing Q1 growth report), though our base case in both countries is for policy to stay on hold. Our Japan economics team expects the Bank of Japan to step up monetary easing to maintain the credibility of the 2% inflation target; however, this now appears likely to happen later in the year (October is our forecast) given the BOJ recently revised its expected timeframe for achieving the target back to mid-2016. While the BOJ's adjustment appears to have been digested relatively well by markets (at least compared to recent European and US bond market moves), any signs of a more significant rethink in the policy approach might not be --though we emphasize this is a medium term risk, not a concern for the coming 12-18 months.