Chinese Growth: What Went Wrong?

At 7.4%, China’s annual GDP growth rate in the past quarter matched some of the lowest growth numbers in China’s recent history. According to our China strategists, the slowdown is due to a combination of both global and domestic factors.

Chinese Growth, What Went Wrong?

From a global point of view, post-crisis demand destruction has clearly taken a heavy toll on Chinese growth. Deleveraging pressure among American households was a major headwind for exporters. In addition, external demand destruction has exaggerated the overcapacity problem and depressed manufacturing-related capital spending activity, leading to a broad-based growth downturn.

While weakness in global demand is a universal problem, Chinese growth has suffered particularly badly from its excessively tight monetary conditions. Amid fears of lending bubbles and liquidity overflow, the Chinese authorities aggressively tightened credit and liquidity. High borrowing costs have dampened aggregate demand, compounding difficulties for debtors to honor their obligations and amplifying risks in the financial system. Meanwhile, the Chinese currency has also appreciated significantly over the past several years, adding pressure to an already tight monetary environment.

All of this has become a major detriment for corporate profits and business activity. Taken together, high borrowing costs and an expensive RMB have choked off margins, leading to tremendous difficulties in some low-margin export-oriented sectors.

In short, global headwinds and self-imposed policy restraints have been the main reasons behind China’s growth problems in recent years. By the same token, improvement in the global outlook and prospects for some policy loosening, even marginally, should be good news. In the past several weeks, China’s policy settings have clearly shifted toward growth boosting. Meanwhile, we expect continued improvement in global demand, especially from developed economies. This should help the Chinese economy stabilize and strengthen in the coming quarters.

U.S. Consumer Spending: A Positive Surprise!

U.S. retail sales in March popped higher, while February revisions were positive.

U.S. Consumer Spending

After hibernating this winter, U.S. consumers appear to be opening their wallets again. March retail sales data were strong across the board – the only exceptions were spending on gasoline and electronics, which contracted month-over-month.

Fundamentals for consumer spending remain solid: the consumer deleveraging cycle is very mature, policy uncertainty has finally subsided, business confidence is improving, and the wealth effect is still positive, despite equity market volatility in recent weeks. Most importantly, job prospects are gradually improving and this is beginning to be reflected in overall consumer confidence, a pre-condition for more vigorous spending.

Overall, we expect the U.S. economy is on track for 3% growth or better over the next year.

Brazilian Banks: Not Out Of The Woods Yet

The carnage in Brazilian assets over the past three years has not spared the country’s banks. According to our EM strategists, bank stocks in Brazil have not yet priced in the economy’s most likely path toward recession and the ensuing negative effect on their profits, via a worsening of credit quality.

There are several reasons why we expect banks’ credit portfolios to deteriorate considerably:

  • Ongoing monetary tightening suggests that growth is about to relapse anew, which threatens to toss the economy into recession by the end of this year.
  • Borrowing among companies and households (domestic and foreign) has risen from 40% to 90% of GDP in 10 years.

Brazilian Banks Not Out Of The Wood Yet

  • Household debt servicing costs are elevated, taking up 22% of disposable income. The recent rate hikes and flagging income growth will only further depress households’ ability to service debt.
  • With respect to the corporate sector, even though businesses are not particularly leveraged, a recession will depress revenues and a rise in corporate defaults is likely.
  • Furthermore, the foreign debt rollover rate among Brazilian companies has dropped below 100%, a sign that foreign lenders are getting wary of their credit exposure to Brazilian debtors. We expect the rollover rate to drop further as foreign lenders seek to limit/curtail their exposure to Brazil. Given that Brazil runs a current account deficit of 3.7% of GDP, a lack of new foreign capital will put pressure on debtors’ finances and force them to delever. The outcome of deleveraging will be a further slump in the economy, resulting in additional credit quality aggravation.

Bottom Line: A marked deterioration in banks’ credit portfolios poses the largest threat to Brazilian banks. We continue to recommend that investors underweight Brazilian banks versus their EM peers.

Is A Bubble Forming In U.S. Equities?

According to our U.S. Investment Strategy service, bubble concerns are premature.

Bubble in US Equities

Today’s valuations do not resemble the excesses that were inescapably apparent in the 1999-2000 equity bubble. Back then, large-cap tech stocks, achieved valuations that dwarfed disregarded old-economy small-caps. Even old-economy mega-caps went along for the ride, trading at levels that hobbled their performance for several years afterwards.

Equities are surely somewhat frothy and consumer tech businesses (with dubious long-run profitability outlooks) are commanding stupendous valuations, but today’s landscape does not compare to 1999. There are always story stocks that capture the market’s imagination and trade at triple-digit multiples, but the S&P 500 as a whole is trading at 15.6 times calendar year 2014 earnings – 62% of its December 31, 1999 multiple, or 60% below its peak.

The bottom line is that although vigilance is warranted (indeed, a correction may be in the offing), there is room for the bull market to run.

What To Do With Chinese Stocks?

The shift in policy stance should help the economy and the Chinese stock market to stabilize.

What To Do With Chinese Stocks

Chinese stocks, both in the domestic and the investable markets, have remained stuck in a broad trading range that has been in place since 2012. The two indexes have become increasingly correlated, and both have failed several attempts to break out, but it is encouraging that the markets have always been able to find strong support at the bottom end of the trading range, despite mounting macro concerns.

The trading pattern of Chinese stocks appears consistent with the broad macro situation: the upside in growth is capped by the authorities’ credit tightening efforts, and the downside is limited by some mini stimulus programs to prevent a deflationary downward spiral. In this vein, we expect the shift in policy stance should help both the economy and stock prices.

Structurally, our China Investment Strategy service maintains the view that Chinese equities have been dramatically de-rated in the past several years, and the current valuation level has largely reflected deep macro concerns among investors. But the reform programs announced late last year will help the economy’s long term outlook and increase the structural appeal of Chinese equities.