Flash Comment China holiday wrap-up: sentiment improving

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1 Investment Research General Market Conditions 9 August 2016 Flash Comment China holiday wrap-up: sentiment improving Below is a brief summary of developments in China over the summer Chinese offshore stocks have performed well in recent weeks, reaching their highest level since equities started to plummet in early January (chart 1). Decent Chinese data and more global monetary easing is underpinning stocks. The onshore market has underperformed offshore stocks but is closing in on the highs in July. Industrial profits rose 5.1% y/y in June the fourth monthly rise following two years of declines. We continue to recommend an overweight in Chinese equities as valuations are fairly cheap and the macro environment has improved. Chart 1: Chinese equity sentiment improving FX reserves for July were broadly flat both in actual terms and when adjusted for currency. This suggests that the PBoC allowed the CNY to weaken in July without any significant intervention. This was a bit surprising to us following reports that the PBoC had intervened at the end of the month to halt the deprecation of the CNY in late June and early July. CNY has strengthened slightly since mid-july following a month of renewed depreciation (chart 2). We continue to look for CNY to weaken on a structural basis in the coming years due to a fragile macro environment and gradual rate increases by the Fed. Chinese bond yields have sunk to a multi-year low (chart 3). The 10-year bond yield is now below 2.8%, the lowest level since The decline in global yields and expectation of increased demand for wealth management products (WMP) are the main drivers. New rules for WMP curb investment in equities and limit it to bonds and money market products. Iron ore prices have continued to rally. It is likely fuelled by stronger Chinese demand as indicated by Chinese imports of iron ore that have risen by close to 10% on average so far this year compared to last year (see chart 5). The construction recovery and infrastructure spending are likely to be the main driver of this. PMIs for July released on 1 August were mixed but generally better than we expected. The private Caixin PMI manufacturing was very strong with the new orders index rising to 51.2, its strongest level in two years. The official NBS PMI manufacturing index painted a softer picture though, falling slightly. The truth is probably somewhere in between. Our favourite measure takes the average of the two on a standardised basis. This measure improved and continued to trend higher in July. However, we believe we are close to a peak on this measure and that PMIs will moderate a bit during H2. China's central bank indicated last Friday that further cuts to interest rates and the reserve requirement ratio are unlikely for now. The PBoC said it would add too much liquidity to the financial system and lead to expectations of yuan depreciation. Chart 2: CNY has gained again lately following renewed weakness Chart 3: Chinese bond yields sink to multi-year low (continued overleaf) Chief Analyst Allan von Mehren alvo@danskebank.dk Important disclosures and certifications are contained from page 3 of this report. anskeresearch.com

2 In the second-quarter policy implementation report it said it would use multiple tools to maintain reasonable growth in credit. It added that it would promote interest-rate liberalisation, work on structural reforms and increase the yuan s two-way flexibility while keeping it basically stable at an equilibrium level. The report underlined that China is increasingly looking to fiscal policy to fine-tune growth to reach the 6.5-7% growth target for However, we expect monetary policy easing to resume in 2017 as the tailwind from construction will likely fade due to lower growth in home sales. Inflation data points to further easing of deflationary pressures. China CPI for July came in as expected at 1.8% y/y, slightly down from 1.9% in June. However, this was purely a reflection of lower food price inflation. CPI ex food rose to 1.4% y/y from 1.2% y/y pointing to easing disinflationary pressures. This was still far from China's 3% target, though. Chinese PPI inflation rose to -1.7% y/y (consensus -2.0% y/y) and thus continues to surprise to the upside. PPI has increased m/m for four out of the past five months and is escaping deflationary territory. However, this is more a reflection of higher commodity prices than that overcapacity has been reduced. The correlation between industrial commodity prices and PPI is very high. Overall the Chinese inflation data points to easing deflationary pressures - but there is still plenty of room to ease policy if needed. Chart 4: Our PMI composite moved up again in July after a brief set-back Chart 5: Iron ore prices keep rising Export growth (CNY) for July was close to expectations at 2.9% y/y (consensus 2.3% y/y). Imports were weaker than expected at -5.7% y/y (consensus -1.1% y/y). However, we do not focus much on Chinese trade data as it is extremely volatile and often distorted due to problems with over/under invoicing. Judging from other data (PMI) exports have improved moderately. That imports should be falling more than 5% is hard to square with clear indications from a range of data that growth picked up moderately in H1. For an overview of our key China views see next page. Chart 6: Iron ore imports have picked up pointing to stronger demand Chart 7: PPI deflation is easing as commodity prices rise 2 9 August anskeresearch.com

3 Our key China macro views in short: 1. China is in a moderate cyclical recovery driven by a lift to construction and fiscal stimulus. 2. We expect PMI manufacturing (composite of Caixin and NBS) to peak soon and moderate slightly for the rest of The construction recovery should support commodity markets for the rest of the year. 3. Fiscal policy is currently favoured as a tool by policy makers. Monetary easing is on hold due to concerns over the risk of housing bubbles and rising debt. 4. We expect growth of 6.7% in 2016 and 6.6% in Structurally, Chinese growth is slowing as recognised by the government s lower growth target for of around 6.5% (down from close to 10% in from ). 6. China is in transition, shifting to a new normal. Growth is increasingly driven by the service sector, private consumption and investment in high tech sectors, while the old heavy industry sectors such as steel, coal and cement are in structural decline. Infrastructure continues to play a key role but will fade over time. 7. China s main challenge is rapidly rising debt centred in the corporate sector. We don t expect a financial crisis within the next 1-2 years but the threat is real on a 4-6 year horizon. 8. China has many other challenges: cutting capacity in old sectors, controlling big imbalances in the housing market, an ageing population, pollution and high inequality. 9. At 25% of average US living standards China still has substantial catch-up potential in the coming decades. At a nominal growth rate of around 8.5% over the next five years, China would add USD5.5 trn to its current GDP of USD11 trn (2015). This is equivalent to adding an economy twice the size of the UK. 10. Supply side reform and industrial restructuring will continue to be a key focus alongside a high priority given to innovation and technology. While China is facing many challenges, the policy makers are right in our view in focusing on supply side reform, technology, innovation and entrepreneurship. However, implementation is crucial. 11. China is still competitive and continues to gain export market share globally. 12. China is more innovative than its reputation, taking global market share in high tech sectors. 13. Financial liberalisation and an opening of the capital account will continue. However, the pace will fluctuate, taking financial stability issues into consideration. 14. The CNY is set to weaken further over the coming years. We look for USD/CNY to rise to M. 15. We look for a further increase in Chinese stocks on a 3-6 month horizon as the macro environment is more stable and global policy easing supports EM assets. 3 9 August anskeresearch.com

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