China: rate cuts amid economic weakness

Key takeaways:

• China released weaker-than-expected industrial production and retail sales data and the PBoC delivered earlier-than-expected rate cuts today.

• Chinese equities were down today due to rising concerns over China’s macro weakness. CNY depreciated to a 9-month low due to rate cuts.

• On Chinese equities, we think the market has possibly priced in the short-term challenges. We retain our constructive longer-term views on stimulus and low valuations. 

What happened?

Following yesterday’s market close, Fitch Ratings announced it was downgrading long-term (i.e., longer than one year) U.S. government debt from AAA to AA+. The announcement to downgrade U.S. Treasuries comes two months after the ratings agency had previously stated that U.S. debt was being closely watched given the protracted debt ceiling negotiations between the Biden Administration and U.S. Congress.

Within Fitch’s statement, the rating agency highlighted several drivers behind its downgrade decision and its expectation that the U.S. governments fiscal health will deteriorate over the next three years. Chief amongst them was the “steady deterioration in standards of governance” as protracted negotiations around the debt ceiling and “cliff-edge” resolution talks have become more frequent in recent years.  
The overall growing levels of debt were also flagged as a concern, fuelled predominately by a combination of economic shocks, tax cuts and new spending initiatives. Fitch forecasts that the U.S. debt-to-GDP ratio will reach 118% by 2025.

Broader economic factors have also played a role in Fitch's downgrade decision with the Federal Reserve’s aggressive monetary policy, both in raising the Fed Funds Rate and reducing the size of its balance sheet. Such actions have further tightened financial conditions within the U.S. economy.  
Combined with the apparent erosion in governance, there appears to have been a lack of progress made in medium-term challenges related to both Social Security and the funding of Medicare. The increased cost of debt servicing, and unfavourable demographics has placed further pressure on future costs. Fitch noted that the tax cuts that were implemented in 2017 are set to expire in 2025, but the current political landscape will most likely mean that such cuts will be made permanent, further widening out deficit projections. 

How did markets react?

China’s equity indices were generally down due to the weak macro data. Hong Kong’s Hang Seng Index was down 1.0% and the Hang Seng Tech Index was down 0.7% today. The Shanghai Composite Index was down 0.1%, while the Shenzhen Component was down 0.7%. CNY depreciated 0.34% against USD to 7.283 as of 6pm Hong Kong Time today due to the rate cuts – its lowest level in 9 months. 

What does it mean for investors?

With the weak macro conditions, we expect further housing policy easing measures (in lower tier cities) in the coming weeks, such as loosening the definition of first home mortgage and home purchase restrictions, and lower downpayment requirements, as well as additional fiscal support to boost infrastructure and targeted tax cuts for high-end manufacturing. 
Meanwhile, the more difficult task for policymakers remains to restore confidence among home buyers and consumers to support a recovery in household consumption of goods and to encourage private entrepreneurs to increase their investment activity to boost employment and household incomes. 
So far, China's economic recovery has been uneven and largely driven by strong demand for services - mainly travel, leisure, accommodation and restaurants. While it is difficult to imagine a significant change in this pattern during the current summer season - the first without travel and contact restrictions in three years - a return to "normality" in the autumn could lead to a more balanced development in the coming quarters, which is likely to increase the multiplier effect of the support measures implemented so far and those expected to be implemented in the future. Such a scenario could underpin rising demand for goods, leading to an increase in manufacturing output, and an improvement in earnings growth for Chinese companies - possibly finally setting the stage for a stabilisation of investor confidence in Chinese equities.

This could also be supported by a possible reduction in stamp duty on stock transactions. Although the China Securities Regulatory Commission has yet to issue an official statement on the matter, such a move could support market sentiment, as Chinese equity markets are sensitive to policy changes that affect market liquidity.  
Chinese equities traded down much more throughout the day and stabilized later on. In aggregate, today we got quite a lot of news, but the price action suggests that the market has possibly priced in the short-term challenges and has taken away from today’s policy action that the Chinese government is keen to address investor sentiment by (1) lowering rates earlier than expected, (2) pausing the display of youth unemployment and (3) contemplating to drop stamp duty on stock trading. We retain our slightly more constructive views in longer term due to the likely more aggressive stimulus measures and the low valuations. 

The CIO Memo above is available to download. Please refer to the Important Information at the end of the memo for disclosures and risk warnings.

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