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China is Slowing, but Don’t be Alarmed

29 September 2017

Adrian Zuercher, Head APAC Asset Allocation, UBS Hong Kong; Hu Yifan, Regional CIO and Chief China Economist, UBS Hong Kong; Hyde Chen, Analyst, UBS Hong Kong

China remains the most important economy in Asia, so getting the view perspective on this market is critical. After Q1 2017 growth beat expectations on almost all fronts, we think momentum has peaked and moderation is underway. We still remain positive from a tactical point of view.

First-quarter Growth Sets a High Bar and a Solid Base

China’s Q1 2017 macroeconomic data beat expectations nearly across the board. Real GDP growth for Q1 2017 accelerated to 6.9% y/y from the 2016 average of 6.7%, but the real standout was the 11.8% rebound in nominal growth, which was fueled by a revival in commodity prices passing through to producer prices. Nominal growth is highly correlated with corporate earnings growth, so the region’s equity markets have rallied accordingly. The surge in fixed asset investment (up 9.2% y/y vs. 8.1% y/y in 2016), thanks to the 23.5% y/y rise in government-backed infrastructure investment, the largest increase since Q3 2014, was the major driver of this result. Strong housing sales and a rebound in exports (up 8.2% this year from –6.2% last year) were additional factors.

This solid base of growth should provide a good deal of support for the full-year GDP figure, even as momentum slows in the second half of the year.

Moderation is Already Underway

Real economic activity softened in April; weaker trade data reflected softer external demand, as the deceleration in industrial production and fixed asset investment moderated on the domestic front. These data trends remain in line with our view that economic growth momentum has peaked and a gradual deceleration is underway. Recent data did surprise on construction and investment, which should be resilient over the next few months. Afterwards, we expect the property sector to cool more noticeably as more restrictive measures are introduced and credit continues to tighten. Likewise, infrastructure investment should moderate due to rising financing costs and the stricter supervision of government debt. We have constructed indicators to get a better understanding of the potential magnitude of the likely imminent deceleration. Our analysis indicates that China’s economic growth has hit an inflection point, but the slowdown should be shallower than was the case in previous episodes. We expect GDP growth of around 6.5% in the second half of 2017, down from 6.9% in Q1 2017.

Best of Reflation is Behind Us, but not Completely Over

We believe nominal growth peaked in the first quarter of 2017 and should sequentially slow alongside producer price inflation. This suggests that the best of the reflation trade is behind us. However, we still see scope for a 2%–3% acceleration in nominal GDP growth this year with producer prices stabilizing around mid-single-digit rates. Broader services growth and higher crude oil prices over the next few months should help stem the recent decline.

How China manages to restrain non-standard credit growth and tighten local government financing remains the main risk to our outlook. These risks should be mitigated by the fact that economic and financial stability will likely remain the Chinese government’s top priority ahead of the 19th National Party Congress in the last quarter of the year. Already, we have noticed a decisive softening of its tone on regulatory tightening in recent days.

China Still Our Tactical Pick

Despite our forecast for a gradual deceleration in growth over the remainder of 2017, we remain overweight on China in our intra-equity tactical strategy for four reasons:

  1. Chinese authorities have the flexibility, the capacity and the policy tools to support the economy and meet the country’s 6.5% growth target, even if domestic or global financial market risks escalate
  2. Liquidity remains ample in the economy. This is defined by growth in M1, which is in excess of nominal GDP growth. Also, elevated household savings (around 40% of disposable income) and our forecast for easing real interest rates should boost domestic demand
  3. Valuations of offshore Chinese equities look reasonable — they are trading on a 25% P/E discount to global markets and below historical average relative valuations. In addition, the breadth of earnings revisions for offshore Chinese and Asian ex-Japan equities is strong, even when compared to global earnings revisions
  4. Positive PPI inflation is associated with improving return-on-equity ratios in Hong Kong-listed Chinese corporations, as well as those in Korea, India, Australia, Indonesia, Thailand, and Taiwan. China remains an internationally under-owned equity market, so it should benefit from an inclusion of A-share equities into MSCI indices. MSCI may announce the addition of onshore Chinese equities into its indices at the next review meeting in the coming few weeks.