When reality touches ground?

Mar 09, 2020

Liquidity drives improvements to sentiments in China, while virus drives panic as it spreads globally.

  • We think that there are “Three Phases” of trading during a major macro event shock; phase I - “panic selling after an event outbreak”, phase II - “improving of sentiment” and phase III - “expectation meets reality”
  • Presently, A share is entering phase II - “improving of sentiment”, while the US stock market is closing the end of phase I. Investors should pay close attention to whether and when phase III would appear.
  • Only a few macro events could severely impact the global markets in phase III and they are events that will commonly lead to a global economic recession. Therefore, whether this epidemic will lead to a global recession is the key in determining future investments this year.
  • The most impacted sectors during this epidemic are global supply chain as well as the household leverage ratios and small firms in China. We think that they may have fundamental structural issues and risk exposures.
  • The A share’s short term outperformances are largely due to over-liquidity in the domestic capital markets as money ceases to enter real economy due to the suspension in jobs and consumption. While stimulus policy expectations will be verified around the central government’s “two sessions” held in April, A share may have more pressure then. Domestic trading commodities will also outperform global commodities, and future prices outperform physical spot prices due to the same liquidity effect.
  • The Fed began to inject liquidities into the market through repo market again last week. If the Fed continues liquidity injection as it did in Q4 last year, we think the US market will gradually enter into “improving of sentiment” phase, but its room of rebound could be smaller than that of A share, as the virus outbreak may continue overseas and major foreign central banks are short of effective tools for further loosening. Relatively, the US could still outperform European and Japanese stock markets.
  • We think crude oil is the most vulnerable commodity in a global epidemic outbreak, while gold’s “safety haven” feature will shine again after liquidity problem was alleviated by the Fed’s renewed liquidity injection.

Hou Zhenhai 
Straits Financial (China) Chief Strategist

In our last month’s commentary, we proposed three possible scenarios for the development of the COVID-19 epidemic in China. At present, the actual situation in China is basically in line with the more optimistic scenario, which means that an inflection point for the epidemic situation has occurred in mid-February, and the number of new infections outside Hubei province will mostly disappear by the end of March. This suggests that the epidemic in China has been under effective control. But it's still worrisome because overseas infection cases, especially in Japan, South Korea, Europe and Iran have shown a pattern of wide-spread which will cause an impact to the global economy, its trade and supply chains, as well as further reduction in consumption. Therefore, we still think there are more downward risks for China and the global economy.

Chinese domestic capital market saw strong performances during the past month. The major stock indices not only recovered from the losses after the Spring Festival, we also saw huge trading volumes in the stock market. In February, the trading volume of A-share increased by 65% over the same month last year, and 40% month on month over January. As mentioned in our last article, during this period of competition between “fundamentals” and “liquidities”, the stock market has clearly emerged as the short-term winner over the real economy. But how long will this stock market strength last? When will the stock market return to levels of the real economy again? Let’s elaborate further:

I. In major macro event driven markets, the trading will go through “Three Phases”.

We believe that during a major macro event like this epidemic global outbreak, markets will normally go through “Three Phases” (as shown in Chart 1). Phase I is "Panic selling after an event outbreak". During this phase, risk assets usually fall very fast, while safety assets such as treasury bonds and gold gain due to “fly to safety” asset reallocation, but this period generally lasts only for a short time, sometimes even only a few trading days. Phase II is "Improving of Sentiments", which usually happens after the government and central banks try to appease the markets by stimulus and monetary loosening. Subsequently, optimistic policy expectations and liquidity easing will promote the rebound of risk assets, but the level of rebound will depend on the strength of these policies, especially the monetary policies, and have little to do with the overall real economic fundamentals at that moment. Safety asset prices will cease to outperform in this period, but also not likely to drop as they also benefit from the liquidity improvement in the market. 

But it is the Phase III when “expectation meets reality” that we must pay close attention to, in some cases, this period will have the largest impact on the market. But not all of them. For those events that did not have much long term economic impacts, such as “9.11” in 2001, and the SARS outbreak in China in 2003, the long term market impacts were also minimal. While some other events, such as the Subprime mortgage crisis which started in late 2006 in the US was totally different. While the initial negative impact on the market disappeared soon after the Fed cut interest rates, the US stock indices made a record high in 2007. However, the market came back to reality and suffered severe sell-off in the middle of 2008, which corresponded to what we mentioned in Phase III.

While we believe that many macro shocks will not have a great impact over time because they do not change the trend of medium and long-term economic fundamentals, it is important to pick out those macro events with long-term impacts, and such macro events are often referred as “crisis leading to economic recessions”. Therefore, whether the COVID-19 outbreak will eventually lead to a global recession crisis will be a key for our market participants to decide how they should trade in the future.

Picture 1

II. Will COVID-19 lead to a global recession?

To answer this question, let’s identify which sectors will suffer the largest impact during the outbreak and whether there are any underlying structural problems in those sectors?

We believe that the major sectors impacted by the epidemic are mostly global trade and supply chain as well as small firms and households in China. We also think there are certain structural weakness in them.

1. Small firms in China are already facing multiple challenges even before the virus outbreak; such as high rental costs, high financing costs and low profit margin. Their cash flow situations are also worsened by the current epidemic. Furthermore, these small firms are not able to benefit from the government's stimulus and liquidity loosening directly. In the past 10 years, they have always been victims of the resulting high housing prices, rents and inflation pressures from liquidity loosening, while the beneficiaries of the stimulus are mostly big enterprises and SOEs, because the latter enjoys the advantage of cheap funding that makes small firms even harder to compete against. Though there are some arguments that this may help to consolidate Chinese industrial and services sectors, but the real underlying problem is that small firms provide most job opportunities in the country. A fast decline in number of small firms will lead to a significant drop in China’s household income growth, especially for those in the middle to lower income class.

2. Chinese households began its fast leveraging cycle since 2008. At present, their leverage ratio (showed as household debts over household disposal incomes) is close to or even higher than that of developed countries in Europe and America (Chart 2). Moreover, China's real interest rate is significantly higher than developed countries, so the proportion of interest expenses over their incomes borne by Chinese households are also much higher. Though the present COVID-19 impact might be short term, it will impact household disposable income and considering their high debt burden, their consumption and leverage ability will be greatly compromised. Therefore, we are not that optimistic about the theory of "retaliatory price rebound" after the end of the epidemic. Compared to 2008 and 2016, the number of households that are close to the leverage limits in China has increased significantly. Therefore, we think the loosening of credit and interest rate cuts this time will not have the same re-leverage effects to the Chinese households as before.

Picture 2

3. During the past 10 years, the extent of globalization have deepened, as a result, today the world’s economy relies on global supply chains like never before. Now as the COVID-19 outbreak shows a wide-spread over the world’s most populous and industrialized regions, the economic losses will be much more severe than the epidemics contained in one country or region. We are particularly concerned about regions such as Europe, with big cities which are densely populated and a large number of immigrants. Furthermore, Europe maintains a free and open political system, thus, government lack the ability to enforce control to limit people’s movements and interactions. In addition to the lack of border control among EU countries, Europe is also the intersection to Middle East, Asia, Africa and other parts of the world. Thus, these conditions allow the virus to spread freely. If the virus outbreak becomes global, which is more likely to happen now, along with the economic impacts caused by China's epidemic prevention measures, we foresee a great increase of probability for a global economic recession this year.

Although the peak of the epidemic in China should be over, it is still difficult to have optimistic expectations about the global economic situation this year. The coming developments of the epidemic in Europe and the resumption of work in China are two key indicators to observe the level of global economic downside risks. In observing the level of China's resumption of work, we believe that the power generation data is still the most reliable indicator. We compared the coal consumption data of power generated from 6 major Chinese power generation groups, and took the Spring Festival as the benchmark point every year. The data shows that although the power generation situation in China has begun to improve, it is presently still at around 70% compared to the same period in normal year (Chart 3). So it indicates that China has lost about 35% of its normal economic activity in the past month, equivalent to 2.5% of its total annual economic output. Even if we exclude the impact of a global virus outbreak in the future, it may still take about one month for this level to return to normal. Even with some stimulus and loosening, the loss of China's overall economic activities in 2020 will still be close to 2 percentage points. Before the epidemic outbreak, IMF predicted that the global economic growth rate would be 3.3% in 2020. We believe the global economic growth rate would reduce to near zero if the epidemic becomes a global pandemic in the next two months.

Picture 3

III. Trading strategies now

We believe that the China market has basically entered the above-mentioned Phase II of “Improving of Sentiment”. The core drivers of trading during this period are improvement of liquidity in the financial markets and anticipation of policy stimulus. In our opinion, these two factors will still be supportive to Chinese domestic stocks and other risk assets in the future. Firstly, to many people’s surprise, we observed that the risk appetite and capital inflow to domestic A share market from retail investors have improved significantly after the Spring Festival. This can be seen from the following indicators: the trading volume and stock volatility have increased as compared to the period before the outbreak; outstanding balance of A-share margin accounts has reached its highest since 2017 (Chart 4). However, since the Spring Festival, the HK through-train northbound funds have been on a net selling of A shares as a whole, so this does not support the assumption where global inflows have bought and pushed up the A-shares. We believe that the biggest reason behind this is due to extended suspension of work and consumptions, resulting in idle money from private companies and households pouring into the domestic capital markets, esp. the A-share market, which remains open as usual. Thus, this lead to a "cold economy, hot stock market" outcome. The recent trend of interbank lending rate can also reflect this phenomenon; although PBoC lowered the MLF rate after the Spring Festival, the current 1-year MLF rate of 3.15% is still significantly higher than the level of 2.75% in 2016. However, we see a rapid decline in domestic interbank interest rates after the Spring Festival. Presently, the 7-days interbank lending rate has fallen to 2.31%, dropping below the lowest level in 2016 (Chart 5). This fast widening spread shows that a large amount of liquidity is still concentrated in financial institutions and capital markets, but not the real economy. 

Therefore, even the domestic commodity market, which is supposed to be more closely matched with the real economy, also showed a similar pattern where futures trading prices are much stronger than physical spot prices. When crude oil in global markets fell sharply due to the weakening of demand expectation, domestically driven commodities such as rebar, still remain strong driven by incremental liquidity even with a historically high inventory. Of course, with the resumption of work and gradual recovery of consumption activities in the future, some liquidity may flow back to the real economy. However, as the real economy may take a longer time to recover, the short term over-liquidity in the domestic capital markets may continue to persist.

Picture 4

Picture 5

Meanwhile, another factor supporting the Chinese domestic capital markets is the anticipation of policy stimulus. So the market must pay close attention to the possible stimulus policies announced around the so-called central government "two sessions" held in Beijing in April. In this regard, we believe that there will be a stimulus plan, but its scale may be lower than the current market expectations. From policymaker’s current perspective, the central government is still reluctant in using overall liquidity easing as their major policy tools, instead they intend to adopt more industry specific supportive measures including financing and fiscal subsidies. By observing the financing data including loans and bonds we will be able to determine the strength of such stimulus. Among these, the increase of outstanding local government bonds and policy bank bonds are closely related to the growth of infrastructure investments in the future. However, during the first two months of this year, we can see that there were no significant incremental issuance in those two segments (Chart 6). Therefore, we remain cautious about the rebound of overall infrastructure growth. Of course, the market will continue to anticipate more stimulus in the near term. The "expectation meets reality" phase may not occur until the end of April or even May. Therefore, we believe that A-share is still expected to remain in fall resistance in the near future, while the "two sessions" in April may become an event to attest the current stimulus expectations, where A-share may have some risk of adjustment then.

Picture 6
Switching our views to the overseas market, with the anticipated rate cut by the Fed, we believe that the US stock market is also close to the end of Phase I of panic selling, as compared with A-share, the room for sentiment improvement in US stock is smaller. That's because the Fed has already cut rates 3 times and expanded its balance sheet last year. Moreover, given the Democratic Party's control of the House of Representatives and an election year in 2020, it's difficult for President Trump to launch a larger fiscal stimulus package. Therefore, the market’s confidence level on an American loosening and stimulus policy is significantly lower than that of China.

In addition, the U.S. stock market is subject to two other factors, the presidential election and liquidity in the US financial market. If Bernie Sanders is the likely winner for the candidate, the market will be pressured accordingly. The liquidity problem of the American financial market was actually revealed before in September last year, and subsequently eased after the Fed injected liquidity into financial markets through its open market repo operations (Chart 7). Looking at the Fed's balance sheet, the Fed injected a total of $255.6 billion of liquidity into the market through repo arrangements from last September to December which helped to boost the US stocks. Since then, in early January, the Fed began to withdraw liquidity from the market, and by the end of February, it had pulled out about $110 billion of liquidity. However, the U.S. stock market plummeted again last week and liquidity shortage took place, there again, the Fed injected more than 50 billion dollars of liquidity into the market through the open market repo operation. Therefore, we expect that if the Fed continues to inject liquidity, after the short-term market panic has passed, the US stocks may find some relief on liquidity shortage.

Picture 7

However, we think that there are more downside risks in European and Japanese stock markets. Firstly, the outbreak risk in Europe and Japan are relatively higher, for the ECB and BOJ, who have never stop their QE, they will have little room and market confidence to maneuver. Furthermore, their rates have been negative all over the curve for a long time, so in the face of the current new economic risks, there are not much room for new policies and it won’t be as effective. Therefore, we believe that in the same "improving of sentiment" phase, the rebound of A-share should be greater than that of US stock, while the European and Japanese stock markets could be among the weakest.

In general, for Chinese domestic commodities, we think it will have a weaker trend as compared to the stock market. Although the liquidity easing supports financial markets, commodities will face a test whether real demand can meet with the current optimistic domestic expectations during the coming month. Our view is that the weak demand situation can hardly be turned around during the first half this year. Considering most of the commodities still have high inventories, their price level will continue to face pressure. In the overseas market, we believe that crude oil demand will suffer the most during this global epidemic outbreak, so crude oil continue to be the most vulnerable commodity in the near future. While gold faces the risk of a liquidity crunch during a global sell-off, which the Fed’s renewed injection of liquidity into the market should help to lower that impact. Therefore, gold still strives to be the “safety haven”.

About the Author

1998 – 2004, Chief Representative Assistant of GKN Group in China.

2006, obtained MBA degree from Wisconsin School of Business at University of Wisconsin–Madison.

2006 – 2007, served at the Wisconsin Foundation.

August 2007 – July 2013, served at China International Capital Corporation (CICC) as the leader of the overseas strategy team and A-share strategy team. He is also the main report writer and contributor. Mr. Hou and his team received many honors including the top team for the New Fortune Sell-side Strategy Research in 2008, and the top team for the Asia Money China Strategy Research in Hong Kong in 2009 and 2012, etc.

September 2013 – December 2019, served at Discovering Group and was responsible for the Group’s macro strategy research. During the period, the company has accumulated absolute returns that far exceed the market level.

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