Bad news is good news for A-shares

（中文摘要：在當前宏觀經濟因素下，增加流動性將促使中國資產價格繼續攀升。在今明兩年，有數個因素將使 A 股進一步向上，包括吸引的估值、結構性改革加快、商品價格下跌、以及有利增長的貨幣政策。即使經濟面臨挑戰，相信中國股市仍有不少投資機會。）

 

Even as China’s economy has faltered, growing at its slowest pace in more than five years, the stock market has surged. Further gains in A-shares are expected this year. This sounds puzzling as bad news for the economy should bode ill for company earnings and, hence, stock prices. The irony is that weak economic momentum has increased the risk of deflation in China which, in turn, has put pressure on Beijing to keep a policy-easing bias while it is trying to balance economic growth with structural reforms. The resultant liquidity implications are positive for the stock market.

 

While China’s 2014 GDP growth only missed the official target marginally, its CPI inflation (which averaged less than 2% in 2014) undershot Beijing’s target of 3.5% significantly. China’s PPI has been stuck in deflation for almost three years now. The property market correction, if not managed properly, could convert CPI disinflation into outright deflation by inflicting a systemic shock. Those who think all this sounds bad for Chinese assets should probably think again.

 

 

The key to China’s market outlook is the threat of deflation and its policy implications. The size of the “output gap”, or the difference between actual and potential output growth, determines the rate of inflation. A positive output gap (i.e. actual growth higher than potential growth) generally leads to rising inflation, while a negative output gap leads to falling inflation or even deflation.

 

China’s potential growth rate is estimated to have fallen from more than 10% a year between 2003 and 2010 to 8.5% between 2011 and 2013, according to the IMF. However, its inflation rate has fallen even faster, implying a negative output gap in recent years.

 

In my view, China’s declining growth rate is the result of a policy choice by Beijing, which is focusing on structural reforms rather than chasing growth quantity. Intensifying reforms under President Xi Jinping have forced GDP growth down to 7.0%-7.5% a year recently, widening the negative output gap and raising the risk of deflation.

 

The output gap is widening because both domestic and external demand are weak. One could argue that commodity price weakness had also exerted significant deflationary pressure on China. This is only half right because weak Chinese demand has had a negative feedback effect on commodity prices (especially oil), with China being the world’s largest oil importer and one of the largest commodity users.

 

 

The policy implication would be for monetary easing to close the output gap and boost inflation back to normal levels consistent with potential growth. China is still a long way from zero interest rates. Beijing has the firepower to address the mounting deflation risk. So far it has refused to engage in significant easing as it is wary of throwing more good money after bad. But this also makes it hard to break the disinflationary/deflationary trends decisively.

 

The inflation outlook depends on whether China’s output gap narrows or widens. Beijing cannot affect the potential growth rate in the short-term, but it can set a GDP growth target that influences market expectations and actual output. There has been market speculation on what target rate Beijing would set for 2015 GDP growth.

 

If it cuts the growth target to 7.0% or less, as some observers speculate, growth expectations would fall and that creates a self-fulfilling prophesy that would not help close the output gap and fight deflation. Setting a growth target range of 7.0%-7.5% seems a better choice, as that would allow Beijing some policy flexibility to manoeuvre while having 7.0% as the bottom line for the balance between growth and reform.

 

Since monetary policy affects the economy with long and variable time lags, the People’s Bank of China will have to keep a policy-easing bias for longer to ensure there is no “growth mistake”. What would prompt it to ease more aggressively? Not inflation because there is none; nor a credit event in the system since Beijing still has a selective “implicit guarantee” policy in place to contain any systemic fallout. It will not be growth either, as slow growth is a policy choice. A possible trigger would be a sharp deterioration in the labour market, which would affect the Communist Party’s power base.

 

 

The liquidity implications of this macroeconomic backdrop bode well for Chinese asset prices. When bad news for the economy is good news for the market, the asset price recovery should have a long way to run in China. There are a number of factors will push up A-shares further this year, and perhaps next. They include: attractive valuations, accelerating structural reforms, lower commodity prices and pro-growth monetary policy.

 

Positive momentum in Chinese equities will come mainly from onshore investors reallocating their investment to stocks, reinforced by increased participation from international investors joining Shanghai-Hong Kong (and later the Shenzhen-Hong Kong) Stock Connect. This year presents ongoing challenges for China but it will also present opportunities for investors in Chinese stocks.   Happy investing in the Year of the Ram.