China Monitor: Despite Protests, Reopening/Reflation Scenario Intact

Summary

• We examine policy, politics, and markets in this bi-weekly China Monitor.
• We review four scenarios for China’s zero-Covid strategy. The medium-term reopening scenario remains intact, in our view. This points to a rocky trajectory towards herd immunity and a reflation/reopening rally in China risk assets.
• Chinese markets had a strong November, mostly due to reduction of shorts or underweights.
• The CGB curve will be steep next year, as PBOC anchors the front end while long yields react to the better economy and inflation expectations rise.
• Strategy: We stay neutral CNH for now, and we like to express our positive China view through being long equities, in particular Hang Seng.

Fluid Zero-Covid Situation, But Medium-Term Re-Opening Still Intact

The zero-Covid (ZC) situation in China is fluid, but how should markets react? I can think of four broad scenarios to guide our thinking:

• Scenario #1: The government doubles down on ZC, increasing lockdowns: negative for market as growth expectations are squashed.

• Scenario #2: Public unrest increases as the government loses control of the streets: very negative for the market, as we enter an unknown political dimension.
• Scenario #3: The government pretends not to give in to public demands for re-opening; however, in practice the recently relaxed ZC measures stay: somewhat positive for the market as the economy bottoms out and herd immunity ensues.
• Scenario #4: The government accelerates the re-opening in response to public demands: this would be an admission of defeat from President Xi, but it would be bullish for the market. India in 2021 is an example of this scenario. Prime Minister Modi lifted the Covid lockdowns on 30 May, and from June onwards there was a 20% rally in Sensex (from 52,000 to 61,000; Chart 1).

In recent days, Chinese markets traded lower on a combination of scenario #2 and #1.

But in reality, we are in scenario #3, in our view. The Chinese press keeps reminding everyone of China’s ZC strategy, but simultaneously there is no real action to bring strict lockdowns back. The decision has been taken to re-open after the winter. This is a rocky road to herd immunity and a reflation/reopening rally.

More Property Support in Recent Weeks

Somewhat in the background to the protests and the ZC debate has been the support the government has announced for the property sector.

The government appears to have pulled out all the stops to support the sector. Two weeks ago, the central bank and the banking regulator released a new package of 16 measures to unclog bank lending to developers, complete stalled construction projects, and merge developers. Also, major banks announced $160bn would be pumped into the ailing sector. I expect more property-boosting regulation to follow, as it has become clear the central government has prioritised rescuing the property sector.

In summary, the policies of the ‘three red lines’ and ‘two concentrations’ are now on hold. Announced in 2020, these policies had been responsible for the severe slowdown in the sector. Temporarily ending them is the most meaningful step Chinese policymakers could have taken if the goal is to provide a near-term boost to property.

Yield Curve Should Remain Steep Going Into Next Year

In recent weeks, China’s yield curve has bear-steepened as the market has become more optimistic for the economic outlook. On Friday, the PBOC cut the RRR rate by 25bp, as was widely expected after the State Council had hinted earlier at an upcoming easing. While the cut injects CNY500bn of liquidity into the money market, it is more like a redistribution of liquidity along the maturity profile rather than a net addition. The liquidity unlocked by this cut will replace the (short-term) MLF funding that is maturing.

The RRR cut will anchor the front end of the yield curve. As we head into 2023, the curve will have a steepening bias (Chart 2). The long end yields will reflect a bottoming out of the economy and focus on the potential for rising inflation expectations next year.

November Saw Strong China Markets on Reduction of Shorts

During November, a price rebound was visible in all China asset classes (except CGBs). Table 1 summarizes the market moves. The flows driving the bounce were mostly profit-taking on shorts and reducing underweights. As we head into the new year and investors become more convinced of an eventual reopening, we expect overweights to drive the rally forward.

China Strategy Remains: Long Equities, and Neutral CNH

The best strategy to reflect our preferred ZC scenario (i.e., scenario #3) is to be long equities. As such, we entered a long Hang Seng position two weeks ago.

As for CNH, we are neutral now. CNH is likely to appreciate in a reopening scenario. However, reopening would also result in rising imports and a contraction in the trade balance, which would hamper any rally.

Bert Gochet is a strategist at Macro Hive, specialising in Emerging Markets strategy. Between 2009 and 2017, he was co-head of global EM strategy with a focus on fixed income and currencies at JP Morgan.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)