China: The economy that came in from the cold

Sean Darby is chief global equity strategist at Jefferies
Sean Darby is chief global equity strategist at Jefferies

After an economic recovery in 2016 that consensus ignored, investors were anxious that China would tip into recession in 2017 as monetary and fiscal policy was tightened. Halfway through the year and the temperature gauge does not appear to have changed that much. The capital account is improving while monetary conditions remain loose. Perhaps, the best news is not necessarily the trade data but the fact that export pricing has revived.

2017 was always going to be a much harder proposition simply because of base effect. Furthermore, the central bank would need to tighten policy to deal with the higher inflation rate. Fixed asset investment has remained steady. The fact that export pricing in the major North Asian economies is not deteriorating also means that there is little need for competitive devaluations. Chinese exports should not be under too much pressure.

Around one third of China’s total credit is contributed by the shadow banking system. Since the beginning of the year there has been increasing regulatory oversight of shadow credit financing in an attempt to deleverage the economy. One major concern is that credit generated by the formal banking system would be impacted but recent data show that medium-term bank lending to non-financials is still firm.

While the central bank has kept repo rates under a tight leash, the long end of the yield curve has moved up. More importantly, the interest rate differential between China and the US has returned to its historical spread. However, there is still some room for short rates to move up to their historical mean. In this respect, capital outflows ought to be less of an issue. Indeed, the underlying balance of payments seems to be improving.

Overall, current economic activity remains strong. However, the concern that going into the second half, the economy may suffer from high base effects as the activity level in the second half of 2016 was rather strong.

Equity investors need to watch two things. First, there is a modest correlation between China monetary conditions and the performance of the CSI 300 index. Second, there is also a modest positive relationship between Chinese banks and the US long-end of the yield curve. Investors should reduce big underweight on China large cap financials.

Sean Darby is chief global equity strategist at Jefferies