Don't Chase the Long China Trade

After underperforming for three years and losing more than 50% of its value, Chinese indices have been mostly uninvestable. After staying closed for so long during COVID, and seeing its property market crater, investors lost faith in the system, no matter how cheap the valuation was. 

Investors are so used to seeing China through their old lens, one where the PBOC would constantly stimulate its way by out-boosting GDP growth via infrastructure investment, that they fail to miss what the new China is all about.

Most western sell-side banks assume China will come back and do a bazooka stimulus in Q4 2024 to make up for the underperformance. China had tried to do a few stimulus measures in the last few years, but each time after they printed money, the markets fizzled out and it lost all its outperformance at the cost of its currency. 

Last week, the politburo made some strong comments that they are focused on supporting the housing market and even allowing banks to tap into emergency funds if need be, and also lowered down payments on homes across cities to stimulate growth. This got the market excited and the indices rallied 30%-plus in a matter of a few days, calling all the shorts out. Given the massive underweight in China across hedge funds, there was a scramble to close positions out lest it be the start of a new bull market. But for the past year, it’s been more words than real action.

This week, as China came back from its holidays, the market was disappointed not to hear any tangible numbers or credible policies. The rally has now lost more than half of its gains in one day as indices have overcome their nosebleed levels. China's is an economy that is so indebted that the amount of money needed today to kick start its domestic recovery is much larger than what it was a decade ago. 

In the 2015 stimulus cycle, China’s credit impulse peaked at 13.5 trillion yuan, equivalent to over 15% of GDP. Today, its economy is about twice as large so it would need at least double that to around 27 trillion yuan! Now, if one were to look back at the credit impulse recently, it hardly moved above 5 trillion yuan. Each time China announced some stimulus, the rate of change of the percentage of GDP was lower and lower. After the credit impulse peaked at a massive 25% of GDP in 2009, subsequent peaks have reached 15%, 15%, 10% and just 3%. So, the impact has been less each time.

As much as everyone is excited about China's stimulus, it is important to put the numbers and policies in perspective. A lot of the Chinese savings are tied up in real estate, savings and gold. The average youth unemployment is quite high, and President Xi Jinping has said time and again that their focus is on domestic consumption, national security, etc. It does not care about inflating its stock market bubble as, unlike America, the consumers’ wealth is not tied up in capital markets. It is exposed to property and gold.

China will need to do a whole lot more if it really wants to get its GDP back to old highs. Perhaps a mix of some very aggressive fiscal and monetary policy, as the latter alone will not be enough. We are told that they may announce some new measures on Sunday. The proof will be in the pudding. 

China really does not have the flexibility to print or do more QE as its currency is devaluing in line with the yen. Its hands are tied, as it cannot risk more capital outflows. The markets expect the Fed to cut rates by 200 BPS over the next year, but given how robust the U.S. economy is, the Fed may not be able to cut rates that quickly. 

If that is the case, then the PBOC will have to wait a lot longer for the dollar to devalue, which means the rest of the world may just get exhausted chasing the long China trade as shorts have seen this week alone. Commodities like copper and oil beg to differ in terms of real Chinese demand, as they did not follow suit last week. Time shall tell who is right, but physical commodity markets never lie.

At the time of publication, Bengali had no positions in any securities mentioned.