Asia

Dear Client, Next week I will be presenting our 2021 outlook on China at our last webcasts of the year "China 2021 Key Views: Shifting Gears In The New Decade".  The webcasts will take place next Wednesday, December 16 at 10:00AM EST (English) and at 9:00 AM Beijing/HK/Taipei time, 12:00 PM Australian Eastern time (Mandarin). In addition, our final weekly publication for 2020 will be on Wednesday, December 16, 2020. Best regards, Jing Sima, China Strategist   Highlights Chinese policymakers have shifted their focus from supporting economic growth at all costs to risk management. The trend will likely gather speed in 2021. A deceleration in credit growth next year is almost a certainty. While policymakers will be data dependent and the slowdown will be managed, our baseline scenario suggests a decline of approximately three percentage points in credit impulse in 2021. Chinese stocks could still trend higher in Q1, but prices will falter as the market starts to price in a tighter policy environment and slower profit growth in 2H21. We recommend a tactical neutral stance in both the onshore and offshore markets.  We continue to favor Chinese government bonds on a cyclical basis, while gyrations in the onshore corporate bond market will endure for at least the next six months. Feature China’s economic growth momentum has strengthened in recent months, but the nation’s policy stance has also turned more hawkish. As set out in the 14th Five-Year Plan, 2021 will mark the beginning of a new era in which policymakers will switch gears from building a "moderately prosperous society" to becoming a "great modern socialist nation.” The pivot means China’s top officials may tolerate slower economic growth, implement tougher financial and industry regulations, and accelerate structural reforms by allowing more bankruptcies and industry consolidations. As we pointed out in our November 4, 2020 Strategy Report,1 external challenges combined with a stronger domestic leadership will allow China to initiate more meaningful reforms in the next decade than in the past ten years. The reforms will strengthen our structural view on China’s economy and financial assets, but this restructuring will create headwinds for growth in the short to medium term.  Therefore, investors should maintain low expectations for Chinese growth and financial asset prices. In 2021, credit growth will decelerate, regulations will be tightened and the “old economy” will moderate in the second half of the year.  We will discuss four main themes in our outlook for 2021. Key Theme #1: Macro Policy: Turning More Hawkish Government officials recently stepped up mention of financial risk containment in their public announcements, along with tightened industry regulations. Many market commentators are downplaying the risk of a tighter policy in 2021, citing China’s fragile recovery and a weak global economy. However, the current environment resembles the policy backdrop in late 2016/early 2017 when President Xi Jinping began his financial deleveraging campaign. Our policy framework suggests that China currently faces fewer constraints than in 2016/2017. Thus, the odds are high that the leaders will turn their tough rhetoric into action in the next six to twelve months.   Importantly, despite low year-over-year GDP growth, the pace of China’s domestic economic recovery has been faster than in 2016 (Chart 1). The PMIs in both the manufacturing and service sectors have been above the 50 percent boom-bust threshold for nine consecutive months (Chart 2). The laggards in the economy - manufacturing investment and household consumption - have been consistently improving (Chart 3). Bond yields have climbed sharply, but given that corporate bond issuance only accounts for 10% of total social financing, the economic impact from rising corporate bond yields has been more than offset by the large number of government bonds issued (Chart 4). Moreover, the recovery in China’s export sector and current account balance has fared surprisingly well this year, propelled by the global demand for medical supplies and stay-at-home electronic goods (Chart 5). Portfolio inflows also have been strong, fueling a rapid appreciation in the RMB.  Chart 1Current Economic Recovery In Better Shape Than In 2016 Current Economic Recovery In Better Shape Than In 2016 Current Economic Recovery In Better Shape Than In 2016 Chart 2PMI Remains Strong PMI Remains Strong PMI Remains Strong Chart 3The Laggards Are Catching Up The Laggards Are Catching Up The Laggards Are Catching Up Chart 4Large Fiscal Stimulus More Than Offset Tighter Monetary Stance Large Fiscal Stimulus More Than Offset Tighter Monetary Stance Large Fiscal Stimulus More Than Offset Tighter Monetary Stance Chart 5Exports Surged Exports Surged Exports Surged Chart 6Chinese Business Cycle Upswing Still Has Steam Chinese Business Cycle Upswing Still Has Steam Chinese Business Cycle Upswing Still Has Steam Looking forward, China’s economic recovery should continue for at least another two quarters due to this year’s credit expansion. Economic activities usually lag the turning points in credit growth by six to nine months (Chart 6). Moreover, headline economic data in 1H21 should be impressive, given the deep slump in domestic output during the same period in 2020. The strengthening economic data will provide China’s leadership with a long-awaited opportunity to focus on risk management. Chart 7A Mild Deflation Will Not Stop Policymakers From Reining In Stimulus A Mild Deflation Will Not Stop Policymakers From Reining In Stimulus A Mild Deflation Will Not Stop Policymakers From Reining In Stimulus Furthermore, the ongoing deflation in the ex-factory prices should not stop the authorities from scaling back policy support. It is worth noting that Xi’s administration doubled down on squeezing shadow banking activity in early 2017 when the CPI was decelerating; the PPI turned positive only due to a low base factor from deep contractions in 2016 (Chart 7). In this vein, as long as the deceleration in both the CPI and PPI does not drastically worsen, we think that policymakers will see less need to reflate the economy. China’s external environment will be less challenging in 2021 than in 2016/2017. Geopolitical tensions are set to ease, at least temporarily, with US President-elect Joe Biden taking office in January. This contrasts with 2016/2017 when President Xi began his financial deleveraging campaign despite increasing strain from then newly-elected President Donald Trump. In hindsight, Xi’s intention may have been to solidify China’s financial sector in preparation for a trade war with the US. The same logic can be applied to our view for next year: Xi will accelerate structure reforms to mitigate risk in the domestic economy before the Biden administration turns its focus to China. We do not think the Communist Party’s 100th anniversary next year will prevent Xi from adopting a hawkish policy bias either. Xi plowed ahead with tightening financial regulations in 2017 even as the ruling Communist Party Committee (CPC) was preparing for a generational leadership reshuffle. In the past two years, the escalation in US-China tensions has strengthened Xi’s power in the CPC and Chinese society. The recent large number of changes in provincial CPC leaders should help Xi to further consolidate his centralized power over local governments. All signs indicate that both the domestic and external landscapes should provide Xi with even more room to undertake reforms in 2021 compared with 2017. Key Theme #2: Stimulus: Deceleration Ahead A deceleration in both credit growth and fiscal support in 2021 is almost a certainty in light of the more hawkish tone by Chinese policymakers. Chart 8 shows that between 2017 and 2019, policymakers came close to stabilizing the macro leverage ratio, but the progress was more than reversed this year due to the pandemic. If policymakers are to allow the increase in the 2021 debt-to-GDP ratio to be within the range of the past four years, then credit may expand at a rate slightly above nominal GDP growth in 2021 (assuming nominal output growth at around 10-11% next year). This scenario, which is our baseline view, is in line with recent statements from the PBoC, which calls for aligning credit growth with nominal GDP in 2021.  Our calculation suggests that credit impulse will reach around 29% of next year’s GDP, about 2 to 3 percentage points lower than in 2020 (Chart 9). Chart 8Financial Deleveraging Efforts Erased By COVID-19 Financial Deleveraging Efforts Erased By COVID-19 Financial Deleveraging Efforts Erased By COVID-19 Chart 9Credit Growth Will Decelerate In 2021 Credit Growth Will Decelerate In 2021 Credit Growth Will Decelerate In 2021 Even if the PBoC keeps its official policy rate (i.e. the 7-day interbank repo rate) steady, tightening regulations and repricing credit risk will lead to higher funding costs and a lower appetite for borrowing (Chart 10). Banking regulators have made it clear that some of the one-off easing measures from this year, such as the extension of loan payments (through March 2021) and the delay of macro-prudential assessments (through end-2021), will end next year. Financial institutions will need to slow the pace of their asset balance sheet to comply with these regulations. The regulatory pressures will lead to de facto deleveraging. On the fiscal front, we expect the large budget deficit to remain intact next year. Targeted stimulus through subsidies and tax cuts to support household consumption and small businesses will likely continue. Government spending in the new economy sectors such as semiconductor and tech-related infrastructure will even accelerate. However, the new-economy infrastructure investment is estimated to only account for about 1% of China’s total capital formation, having limited impact on the overall economy.2 Chart 10Higher Funding Costs Will Discourage Corporate Borrowing Higher Funding Costs Will Discourage Corporate Borrowing Higher Funding Costs Will Discourage Corporate Borrowing Chart 11Fiscal Boost For Infrastructure Will Scale Back 2021 Key Views: Shifting Gears In The New Decade 2021 Key Views: Shifting Gears In The New Decade The proceeds from the large number of the local government special purpose bonds (SPBs) this year will continue to provide tailwinds for infrastructure investment into Q1 2021. However, as the laggards in the economic recovery catch up and government tax revenue improves next year, 2021 quotas for government general and SPBs are likely to be scaled back, reining in expenditure growth in the traditional infrastructure sector (Chart 11).   Finally, investors should watch for signs of further hawkishness from China’s leaders at the Central Economic Work Conference this December and the National People’s Congress next March.  While we expect policymakers to be data dependent and keep a controlled deceleration in credit and economic growth, risks of a policy overkill cannot be ruled out. A more bearish scenario would be if policymakers decide to fully revert the pace of debt accumulation to the average rate in 2017-2019. In this case, credit impulse in 2021 could fall by more than 5 percentage points compared with 2020 (Scenario 2 in Chart 9 on Page 6). Key Theme #3: Chinese Equities: Position For A Peak In Prices This year’s cyclical (6- to 12 months) call to overweight Chinese stocks within a global portfolio has panned out. In the next 12 months, the risks in Chinese stocks relative to global benchmarks are to the downside; Chinese stocks are vulnerable to setbacks in policy support next year, in both absolute and relative terms. We are closing the following trades: Long MSCI China Index/Short MSCI All Country World Index, for a 1.5% profit; Long MSCI China A Onshore Index/Short MSCI All Country World Index, for a 5.6% profit; Long MSCI China Ex-TMT/Short MSCI Global EX-TMT, for a 0.7% loss; Long Investable Materials/Short broad investable market, for a 5.6% profit; and Long Onshore Materials/Short broad A-Share market, for a 9.3% profit. Chart 12Onshore Equity Market Investors Will Start To Price In Slower Profit Growth In 2H21 Onshore Equity Market Investors Will Start To Price In Slower Profit Growth In 2H21 Onshore Equity Market Investors Will Start To Price In Slower Profit Growth In 2H21 In absolute terms, Chinese onshore stocks on an aggregate level could still inch higher in the next quarter, supported by an improving business and profit cycle (Chart 12). However, in Q2 the market may start to price in slower economic and profit growth in 2H21, erasing the gains from the first quarter.  The resilient performance in Chinese stocks against a tightening policy backdrop in 2017 is not likely to repeat itself next year. Current valuations in both China’s onshore and offshore equity markets are higher than at the end of 2016; the price-to-forward earnings ratios in both markets this year have breached the peak levels achieved in 2017 (Chart 13A and 13B). Recovering earnings in the next year will help to digest the currently elevated valuations, i.e. the market has already priced in a substantial post-pandemic profit recovery and investors’ focus will soon switch to a more pessimistic outlook for corporate earnings in 2H21.  Chart 13AInvestable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Investable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Investable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Chart 13BA-Shares Are Less Expensive, But Valuations Still Elevated A-Shares Are Less Expensive, But Valuations Still Elevated A-Shares Are Less Expensive, But Valuations Still Elevated Additionally, a property market boom in 2017 boosted the stock performance of real estate developers and related sectors in the supply chain (Chart 14). Policies have already turned much more restrictive in the past month, and deleveraging pressures faced by property developers may weigh on both the sector’s profit growth and stock performance in the next six to twelve months.3 The investable market may not be insulated from tighter domestic policies either. Recent anti-trust regulations in China could create headwinds for mega-cap technology stocks in the near term. Global investors will demand a higher risk premium for China’s tech sector than in the past, as the rich valuations of tech stocks pose more downside risks in a less friendly policy environment (Chart 15).  Chart 14Housing Boom In 2017 Also Helped Sustain A Bull Market Back Then Housing Boom In 2017 Also Helped Sustain A Bull Market Back Then Housing Boom In 2017 Also Helped Sustain A Bull Market Back Then Chart 15Valuations In Chinese Tech Stocks Are Elevated Valuations In Chinese Tech Stocks Are Elevated Valuations In Chinese Tech Stocks Are Elevated Chart 16A Policy Overkill Will Significantly Raise Prob Of A Earnings Contraction In 12 Months A Policy Overkill Will Significantly Raise Prob Of A Earnings Contraction In 12 Months A Policy Overkill Will Significantly Raise Prob Of A Earnings Contraction In 12 Months Furthermore, if we presume a policy overkill with more aggressive deleveraging and a further appreciation in the RMB in 2021, our model shows a significant increase in the probability of a profit growth contraction in the next 12 months (Chart 16). In this scenario, selloffs in Chinese stock prices may start in Q1, a risk that cannot be ruled out. In relative terms, Chinese stocks will likely underperform global equities. It is doubtful that the impressive outperformance in Chinese investable stocks throughout 2017 will be repeated in 2021. Chinese equities have benefited from the successful containment of China’s COVID-19 situation in the past year (Chart 17). As breakthroughs in vaccines make the pandemic less threatening to the global economy, Chinese risk assets relative to global ones will become less appealing. Global cyclical stocks, particularly European and Japanese equities, should benefit from improvements in business activities and relatively low valuations (Chart 18). Chart 17Chinese Equities Have Benefited From A Better Control Of COVID-19 This Year... Chinese Equities Have Benefited From A Better Control Of COVID-19 This Year... Chinese Equities Have Benefited From A Better Control Of COVID-19 This Year... Chart 18...But Vaccines Will Give A Boost To Other Markets Next Year ...But Vaccines Will Give A Boost To Other Markets Next Year ...But Vaccines Will Give A Boost To Other Markets Next Year Importantly, despite strong inflows this year from foreign investors to China’s bond market, foreign portfolio flows into China’s onshore equity market have been less than one-third of that in 2019 (Chart 19). Looking ahead, global investors will be less keen to support Chinese stocks, based on the expectation of tighter onshore liquidity conditions and less buoyant economic growth.   Chart 19Foreign Investors Have Not Been So Keen On Chinese Risky Assets This Year Foreign Investors Have Not Been So Keen On Chinese Risky Assets This Year Foreign Investors Have Not Been So Keen On Chinese Risky Assets This Year Everything considered, we anticipate that Chinese A-shares and investable stocks will start descending in Q2 in absolute terms. Their performance relative to global equities will also peak. We recommend a neutral stance on both bourses in the next three months to minimize the downside risks.  Key Theme #4: Chinese Bonds: Favor Onshore Government Over Corporate Bonds We continue to recommend a cyclical long position in Chinese government bonds within a global fixed-income portfolio. However, we are closing our long Chinese onshore corporate bond trade for now, for a 17% gain (Chart 20). The large interest rate differential between yields in Chinese bonds versus those in other major developed nations should remain intact into the new year. The yield on the short-duration government notes will continue to trend higher in 1H21, based on the prospect of tighter monetary policy. The yield on long-dated bonds will also escalate as the outlook for the economy continues to improve. We are pricing in a 70BPs increase in the 1-year government bond yield and a 40BPs rise in the yield of the 10-year bond from their current levels (Chart 21).   Chart 20Handsome Returns On Chinese Government Bonds Handsome Returns On Chinese Government Bonds Handsome Returns On Chinese Government Bonds Chart 21Our Projections On Government Bond Yield Hikes Next Year Our Projections On Government Bond Yield Hikes Next Year Our Projections On Government Bond Yield Hikes Next Year Chart 22RMB Appreciation Will Continue In 2021, But At A Slower Pace Than This Year RMB Appreciation Will Continue In 2021, But At A Slower Pace Than This Year RMB Appreciation Will Continue In 2021, But At A Slower Pace Than This Year The ongoing appreciation in the RMB will also make Chinese government bonds attractive to global investors. The speed of the gain in the RMB against the US dollar may slow in 2021, but the economic fundamentals do not yet suggest that this trend will reverse. Relative growth and interest rates between China and the US will probably narrow and the geopolitical tailwinds affecting the RMB following the Biden win in the US election will subside in the new year (Chart 22). However, China's strong export sector should still support a record high trade surplus and provide a floor to the Chinese currency against the USD. Chinese onshore corporate bonds have undergone a major shakeout in the domestic corporate bond market in the past month. A slew of state-owned enterprise (SOE) bond defaults has pushed up the yields on the lower-rated corporate bond by nearly 40BPs in one month. In our view, the recent panic selloff in the onshore corporate bond market is overdone and domestic corporate bonds are starting to look attractive on a cyclical basis. Bloomberg data shows that the value of defaulted bonds in the first three quarters of this year is in fact much lower than in the past two years: it dropped to 85Bn RMB from 142Bn RMB defaults in 2019 and the default of 122Bn RMB in 2018. Bondholders have been spooked by the fact that the Chinese local government and top financial regulators allow defaults by state-backed firms. The policy change to shift risk to the markets should result in a continuation of risk-off sentiment among investors, inducing selling pressure in the domestic corporate bond market in the near term. However, on a cyclical basis, such selloffs could present good buying opportunities. While we expect China’s onshore corporate bond defaults to be higher in 2021, the default rate remains below the global average (Chart 23). As we pointed out in our previous report, since 2017 Chinese onshore corporate bonds have been priced with a significantly higher risk premium than their global peers, which in our view is overdone (Chart 24). Chart 23Chinese Corporate Bond Default Rate Lower Than Global Average... Chinese Corporate Bond Default Rate Lower Than Global Average... Chinese Corporate Bond Default Rate Lower Than Global Average... Chart 24...And Much Lower Than Their Risk Premiums Imply ...And Much Lower Than Their Risk Premiums Imply ...And Much Lower Than Their Risk Premiums Imply Chart 25Chinese Corporate Bonds Can Bring Better Returns Once The Peak Intensity In Policy Tightening Passes Chinese Corporate Bonds Can Bring Better Returns Once The Peak Intensity In Policy Tightening Passes Chinese Corporate Bonds Can Bring Better Returns Once The Peak Intensity In Policy Tightening Passes In addition, Chart 25 shows that the total returns on Chinese onshore corporate bonds briefly declined in 2017 when the government’s financial de-risking efforts intensified. It sequentially rebounded in 2018, suggesting a turnaround in investors’ sentiment after the first cleanup wave in the corporate sector.  As such, while we do not favor Chinese onshore corporate bonds in the next six months, on a 12-month horizon, conditions could become more favorable to initiate a long position. Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Please see China Investment Strategy Report "The 14th Five-Year Plan: Meaningful Transformations Ahead," dated November 4, 2020, available at cis.bcaresearch.com 2Please see China Investment Strategy Special Report "Chinese Economic Stimulus: How Much For Infrastructure And The Property Market?" dated March 25, 2020, available at cis.bcaresearch.com 3Please see China Investment Strategy Special Report "China: The Implications Of Deleveraging By Property Developers," dated October 21, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

The strength in China’s post-pandemic policy support likely peaked in October. Interbank rates have normalized to their pre-pandemic levels and bond yields have risen sharply since May. The renewed emphasis on financial de-risking is evident in China’s recent anti-trust regulations against domestic leading online retail and lending providers, rising corporate bond defaults and readouts from recent PBoC meetings. In the near term, US President-elect Joe Biden will focus on reviving the economy and this may restore some balance to the Sino-US trade relationship. Additionally, China’s economic recovery is on track. The odds are rising that next year the Chinese leadership will accelerate structural reforms and the de-risking campaign, which began in 2017 but was delayed due to the US-China trade war and the COVID pandemic. These policy actions will improve China’s productivity growth and industrial competitiveness in the medium to long term, but they will create short-term headwinds to the economic recovery and the stock market’s performance. The uptrend in China’s business cycle will likely be maintained for another two quarters, propelled by the momentum from this year's massive stimulus. Historically, turning points in China’s business activities lag credit cycles by six to nine months. Given that China’s policy support apexed in Q4 this year, a peak in the country’s business cycle will probably be reached by mid-2021. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com     Below is a set of market relevant charts along with our observations: Monetary policy has tightened, but fiscal spending by local governments should pick up in the next two quarters to support the ongoing business cycle expansion into H1 2021. Fiscal spending has been constrained due to shortfalls in revenues this year, despite record sales of special-purpose bonds.1 Government expenditures will gain strength as local governments’ tax revenues start to improve and the proceeds from bond sales are distributed. Chart 1Credit Impulse Has Peaked... Credit Impulse Has Peaked... Credit Impulse Has Peaked... Chart 3Business Cycle Expansion To Continue In 1H21 Business Cycle Expansion To Continue In 1H21 Business Cycle Expansion To Continue In 1H21 Chart 2...But Fiscal Spending Should Pick Up ...But Fiscal Spending Should Pick Up ...But Fiscal Spending Should Pick Up Part of the buildup in this year’s industrial inventory is due to the solid recovery in domestic demand and proactive restocking by manufacturers. However, the pace of inventory pileup this year has been the highest since 2014, while infrastructure investment and industrial output growth have barely recovered to pre-pandemic levels. The rapid expansion in industrial inventory may be the result of cheap credit and commodity prices and could lead to a period of destocking and slower imports of raw materials in Q1 2021.   Chart 4Industrial Inventory Has Run Ahead Of Economic Recovery... Industrial Inventory Has Run Ahead Of Economic Recovery... Industrial Inventory Has Run Ahead Of Economic Recovery... Chart 5...Propelled By Solid Recovery And Cheap Credit ...Propelled By Solid Recovery And Cheap Credit ...Propelled By Solid Recovery And Cheap Credit   Core CPI has reached its weakest level in more than a decade, while the PPI remains in negative territory. A delayed recovery in the household consumption and services sector has been disinflationary to core CPI along with the PPI’s consumer goods price subcomponent.2 Historically, when the growth rate in the PPI outpaces that in the CPI, industrial output and profits tend to improve even if the PPI is in contraction. However, a deflationary PPI is the result of depressed demand for both industrial products and household goods. Hence, neither the widening gap between the PPI and CPI nor the improvement in industrial profits can be sustained on the back of falling consumer prices.  Credit impulse tends to lead an increase in both the PPI and CPI by six to nine months.  Improving service sector activities and rebounding energy and commodity prices will also be reflationary to both the CPI and the PPI. Meanwhile, the peaking credit impulse coupled with tighter domestic monetary policy and a rapidly rising RMB will limit the upside in both the consumer and producer price indexes.  Chart 6Rising Deflation Risks Rising Deflation Risks Rising Deflation Risks Chart 7PPI Has Been Dragged Down By Its Consumer Goods Price Component PPI Has Been Dragged Down By Its Consumer Goods Price Component PPI Has Been Dragged Down By Its Consumer Goods Price Component Chart 8Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Chart 9While The Economic Recovery Should Support Prices... While The Economic Recovery Should Support Prices... While The Economic Recovery Should Support Prices... Chart 10...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year ...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year ...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year   Retail sales growth further strengthened in October. However, despite a sharp rebound in auto sales, other consumption segments, such as catering, tourism and consumer durable goods, remain sluggish. Household disposable income and employment have improved from troughs earlier this year, but both continue to lag behind the recovery in the industrial sector. The sluggish household sector has prompted Chinese leaders to take actions. In a State Council executive meeting on November 18, Primer Li Keqiang pledged to promote the consumption of home appliances, catering, and automobiles.3 Stocks of consumer goods and automakers rallied following the pro-consumption stimulus announcement. We continue to favor consumer discretionary stocks in both onshore and offshore markets. Even though the valuations in both sectors are elevated compared with the broad market, their earnings outlook also shows a notable improvement. In the next 6 months, targeted pro-consumption stimulus policies should further boost investors’ sentiment as well as profits in these sectors. Chart 11The Ex-Auto Retail Sales Remain Sluggish The Ex-Auto Retail Sales Remain Sluggish The Ex-Auto Retail Sales Remain Sluggish Chart 12Improving Household Income And Employment Will Support Consumption Improving Household Income And Employment Will Support Consumption Improving Household Income And Employment Will Support Consumption Chart 13Policy Support Will Continue Boosting Auto Sales... Policy Support Will Continue Boosting Auto Sales... Policy Support Will Continue Boosting Auto Sales... Chart 14...And Promote NEV Sales ...And Promote NEV Sales ...And Promote NEV Sales Chart 15Auto Sector's Outperformance Should Continue Auto Sector's Outperformance Should Continue Auto Sector's Outperformance Should Continue Chart 16Consumer Discretionary Sector Will Also Benefit From More Policy Support Consumer Discretionary Sector Will Also Benefit From More Policy Support Consumer Discretionary Sector Will Also Benefit From More Policy Support   Chart 17Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over In the past four weeks, the high-frequency data show that momentum in housing demand in second- and third-tier cities has quickly abated. Moreover, bank lending to property developers has rolled over, reflecting tighter financing regulations and pressure to deleverage in the property sector.   Growth has flattened in medium- and long-term consumer loans while the propensity for home purchase has ticked up slightly. This divergence may be a sign that demand for real estate has not softened, but that home buyers are waiting for more discounts from property developers. As such, the rebound in floor space started in October should be short-lived as property developers’ profit margins continue to narrow and their financing remains constrained. We expect aggregate home sales growth to decelerate slightly in 1H21 from the past six months. However, real estate developers need to complete their existing projects, which will support construction activities into H1 next year. Chart 18Home Buyers May Be Expecting More Home Price Discounts Ahead Home Buyers May Be Expecting More Home Price Discounts Ahead Home Buyers May Be Expecting More Home Price Discounts Ahead Chart 19Financing Constrains Will Limit Investments In New Building Projects Financing Constrains Will Limit Investments In New Building Projects Financing Constrains Will Limit Investments In New Building Projects   This year’s strong outperformance in China’s offshore equity prices has been driven by the TMT sector’s stocks (Information Technology, Media & Entertainment, and Internet & Direct Marketing Retail). Since October, however, Chinese stocks excluding the TMT sector have also started to outperform the global benchmarks. Moreover, domestic cyclicals, which do not feature some of China’s leading tech companies such as Alibaba and Tencent, have outpaced onshore defensive stocks. These developments indicate that as the upswing in China’s business cycle continues to strengthen, the outperformance in China’s ex-TMT stocks will likely be sustained into early 2021. Within cyclical sectors, we continue to favor the materials and consumer discretionary sectors aimed at policy dividends and a rebound in commodity prices. Chart 20China's Ex-TMT Stocks Starting To Outperform Global China's Ex-TMT Stocks Starting To Outperform Global China's Ex-TMT Stocks Starting To Outperform Global Chart 21Domestic Cyclicals Are Now Breaking Out Relative To Defensives Domestic Cyclicals Are Now Breaking Out Relative To Defensives Domestic Cyclicals Are Now Breaking Out Relative To Defensives Chart 22Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Chart 23Rebounding Commodity Prices Will Bode Well For Material Stocks Rebounding Commodity Prices Will Bode Well For Material Stocks Rebounding Commodity Prices Will Bode Well For Material Stocks   Recent bond payment defaults by several SOEs have led to a spike in onshore corporate bond yields. Nonetheless, the ripple effect on China’s financial markets has been limited outside of the corporate bond market; onshore stocks were little changed by news of the defaults. Moreover, the PBoC’s recent liquidity injections helped to stabilize the interbank rate. Historically, corporate bond defaults and rising bond yields have not had an imminent negative impact on China’s domestic stock market performance; none of the defaults in 2015, 2016 or 2019 led to selloffs in the equity market. However, during a business cycle upswing and following a large-scale stimulus, increasing corporate defaults typically mark the onset of tightening in financial regulations and the monetary cycle. We expect the upswing in the business cycle to begin losing momentum as the tightening policy cycle gains further traction in 2021.  Prices in the forward-looking equity market will likely peak sooner on the expectation that the rate of economic and corporate earnings growth will slow in 2H21.  Chart 24Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Chart 25Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Chart 26But So Far Negative Impacts On The Stock Market Are Limited But So Far Negative Impacts On The Stock Market Are Limited But So Far Negative Impacts On The Stock Market Are Limited   Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Footnotes 1Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 2Headline PPI is comprised of producer and consumer goods. The weights of producer and consumer goods are roughly 75% and 25%, respectively. As for producer goods by industry, the weight of the manufacturing sector is around 50%, followed by 20% for the raw material sector; the mining sector accounts for only around 5%.   3Pro-auto consumption plans include: providing subsidies to encourage urban car owners to replace older and higher-emission models with newer environmentally friendly ones; encouraging automobile sales and upgrades in rural areas; and promoting New Energy Vehicle (NEV) sales. The plan will also loosen some existing restrictions on auto sales and increase the permits for vehicle license plates. Cyclical Investment Stance Equity Sector Recommendations

Highlights The upcoming anti-trust regulation for platform companies is a positive development for the entire Chinese economy in the long run. That said, government regulations could create headwinds for Chinese mega-cap new economy stocks in near term because these are overbought and richly valued. Corporate defaults, if allowed by the authorities to take place, will be negative for mainland equity and corporate bond markets and the economy in the medium term. However, this is an important part of structural reforms and will benefit the economy in the long run. As a trade, we recommend going long global value stocks / short Chinese value stocks. Feature Chart 1Chinese Onshore Corporate Bond Yields Have Spiked China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications In recent weeks, there have been several developments in China warranting careful assessment. These include: The publication of the draft Antitrust Guidelines for the Platform Economy (“Platform Guidelines”) which, if adopted, will serve as antitrust regulation for the largest listed Chinese companies: Alibaba, Tencent, and Meituan. Investors might wonder whether this regulation will dent the bull market in these companies’ share prices. Defaults in onshore bond payments by a few companies (mainly SOEs) and rising corporate bond yields (Chart 1). The pertinent questions in this case are as follows: Does it imply that the authorities are ready to allow bankruptcies and defaults? Will rising corporate bond yields dampen credit growth next year and weigh on China’s business cycle? We examine and provide our take on these issues below. Antitrust Regulation The antitrust regulations proposed in the draft Platform Guidelines aim to protect the interests of smaller platform companies (competitors) as well as users (merchants) and customers. The large incumbents – listed companies such as Alibaba, Tencent and Meituan – will experience regulatory curbs. The idea is that the largest platform companies control an outsized share of the market. For instance, Alipay and Tenpay account for 55.5% and 39% of mobile payments, respectively (Chart 2, top panel). In turn, mobile payment transactions have increased 40-fold in the past seven years (Chart 2, bottom panel). Further, it is estimated that Alibaba accounts for 55% of online retail sales in 2019. Official data shows that online sales of goods currently account for 24% of total retail sales (Chart 3). Chart 2Alipay’s And Tenpay’s Market Shares In Expanding Mobile Payments China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications Chart 3China: Online Retail Sales Penetration China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications     These platform companies have the capability of engaging in monopolistic or oligopolistic behavior that would harm consumers, such as over-pricing their services and limiting customer choice. Therefore, from an economy-wide perspective, anti-trust regulation makes sense. From a macro perspective, it is impossible to estimate the impact of the regulations on the profitability of these large companies. Instead, we offer a framework for understanding the impact of anti-trust restrictions on share prices of large incumbent monopolies and oligopolies, based on historical data from the US. Our colleagues from BCA Global Asset Allocation and Geopolitical Strategy published a Special Report in 2019 on the impact of anti-monopoly suits on share prices of large US companies.1     They concluded that in the cases where courts issued remedies other than a full break up, the effect on the stock price was mixed. Whereas when the courts dictated dissolutions of companies, the stock price underperformed following the decision. We borrowed the following charts from that report: Chart 4 illustrates that Alcoa and Microsoft’s relative performance versus the equity benchmark was initially negative following the court decision stipulating a remedy other than breakup. However, their performance recovered over time. Chart 5 demonstrates that share prices of Standard Oil, American Tobacco, and AT&T have meaningfully underperformed the overall market following the dissolution decision by the court. Chart 4Performance Of US Individual Stocks After Anti-Trust Decision “Remedy Other Than Dissolution” China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications Chart 5Performance Of US Individual Stocks After Anti-Trust Decision “Dissolution / Break Up” China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications     In this light, it is relevant that the Platform Guidelines will regulate China’s large platform companies but does not call for breakups or other stringent measures. Hence, if the experience of US companies is of any guide, the negative impact of these regulations on the share prices of Chinese large platform companies will be fleeting. On the whole, this antitrust regulation will prove to be positive for China’s economy in the long run. It will protect the interests of consumers, allow for more competition, and safeguard the interests of small and medium enterprises (SMEs) using these platforms. The regulation will foster the development of SMEs in various industries throughout the country. As a result, productivity gains will spill over from platform companies to the rest of the economy. This could help preclude a further slowdown in the nation’s potential growth rate (Chart 6). At the same time, by preserving economies of scale, these platform companies can share efficiency gains with consumers via lower prices, while continuing to innovate and maintain their technological edge. The key risk to China’s growth stocks is their overbought conditions and valuations. As Chart 7 shows, the equal-weighted US FAANGM stock index as well as Tencent’s stock price have risen by about 23- and 18-fold, respectively, since January 2010. This is equivalent to the Nasdaq 100 index’s rally during the 1990-2000 bull market. We do not show Alibaba because it was IPO-ed in 2014. Chart 6To Continue Its Ascendancy China Needs To Prevent A Major Deceleration In Productivity Growth China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications Chart 7FAANGM Stocks Have Rallied As Much As The Nasdaq 100 In The 1990s China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications   We do not mean that China’s mega-cap platform companies represent a bubble that is about to burst. We simply do not know. The point is that their share prices have risen a great deal and a period of indigestion is likely to follow given headwinds from anti-trust regulation as well as regulation on Ant Financial from the China Banking and Insurance Regulatory Commission. Bottom Line: We view the upcoming anti-trust regulation for platform companies as a positive development for the entire Chinese economy in the long run. That said, government regulations pose a risk for Chinese mega-cap new economy stocks in the near term because these are overbought and richly valued. Corporate Defaults And Monetary Conditions Chart 8China's Corporate Debt Continues To Rise China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications We have the following observations concerning several onshore corporate bond market defaults: It is noteworthy that these defaults are occurring in the context of China’s current robust economy amid abundant credit flows. It is particularly significant that these defaults are taking place in industries that are currently booming, such as commodities, semiconductors, and the automotive sector. We attribute these defaults to the following: (1) The debt accumulated by some Chinese companies is so large (Chart 8) that even a robust business cycle recovery is not sufficient to enable them to service the debt. (2) Authorities are reluctant to use the financial resources of strong entities to bail out the weakest ones. Thereby, they are ready to allow bankruptcies to improve capital allocation and financial discipline. Besides, it is preferred to do so during a business cycle upswing as opposed to a downtrend. If this policy of permitting bankruptcies is tolerated by the authorities, it will move China closer to a market mechanism of credit allocation and, thereby, enhance the nation’s long-run productivity. Chart 9Higher Corporate Bond Yields Entail Less Corporate Bond Issuance China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications The onshore corporate bond market has been complacent about credit risks and the repricing of credit risk is natural. Yet, higher corporate bond yields will have ramifications for the credit cycle. Specifically, the top panel of Chart 9 illustrates that rising corporate bond yields (shown inverted) will lead to a decline in corporate bond issuance. This is worrying as corporate bond issuance has accounted for 11% of total social financing excluding government bonds in the past 12 months (Chart 9, bottom panel). In brief, repricing of corporate credit risk will lead to higher borrowing costs and dampen credit flows to enterprises. The PBoC been tightening interbank liquidity and hiking the de-facto policy rate since May, which has caused the currency to appreciate rapidly. As a result, monetary conditions – which combine the real effective exchange rate and real interest rates – have tightened considerably. Chart 10 illustrates that the large drop in the Monetary Conditions Index (reflecting tightening monetary conditions) is sending a warning to the Chinese A-share price index. The latter is dominated by old economy stocks that are more sensitive to monetary conditions (because they have more debt) than new economy companies. Chart 10Tightening Monetary Conditions Are A Risk To A-Share Prices China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications Bottom Line: China’s growth momentum is strong and the economy will remain robust in H1 2021. However, the peak in stimulus in Q4 2020 heralds a business cycle slowdown in H2 2021. Corporate defaults, if allowed by the authorities to take place, will be negative for mainland markets and the economy in the medium term. However, this is an important part of structural reforms that will benefit the economy in the long run. Investment Conclusions Chart 11Growth Versus Value Stocks: More Downside? China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications We have a low conviction level on the outlook of Chinese investable growth versus value stocks. Odds are that global growth versus global value relative share prices will at least drop to their 200-day moving average before bottoming out (Chart 11, top panel). It would make sense to extrapolate this global view to China’s investable stocks but there are nuances that should be taken into account (Chart 11, bottom panel). In particular, the business cycle in China is much more advanced than it is in the rest of the world. Plus, monetary policy is tightening and borrowing costs are rising in China while monetary policy will stay very accommodative in the rest of the world. As a trade, we recommend going long global value stocks / short Chinese value stocks (Chart 12). The motive is that China’s recovery is more advanced and its monetary/credit and fiscal policies are tightening. In the rest of the world, the business cycle recovery is in early stages and monetary policy will remain very easy for a long time. Interestingly, Chinese investable bank, property, materials, and industrial share prices have not yet entered a bull market (Chart 13). This is a sign of the underlying structural weakness of these companies and sectors. Chart 12Go Long Global Value / Short Chinese Value Stocks China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications Chart 13Chinese Cyclical Stocks Have Not Entered A Bull Market China: A Hint Of Structural Reforms And Their Implications China: A Hint Of Structural Reforms And Their Implications   As to EM equity portfolios, we continue recommending overweighting Chinese stocks but we will be looking to downgrade it sometime in H1 2021. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Isabelle Dimyadi Research Associate Isabelled@bcaresearch.com     Footnotes 1 Please see Global Asset Allocation and Geopolitical Strategy Special Report "Surviving A Breakup: The Investor’s Guide To Monopoly-Busting In America," dated March 20, 2019, available at gps.bcaresearch.com