Morgan Stanley IM: China - Smoke and Mirrors

Bottom Line

The shift in China’s policymakers’ tone has been dramatic, but actions so far represent only a modest step in the direction of what will ultimately be required. Chinese stocks are likely still under owned by local and global investors but their superficially low multiples do not represent a compelling reason to go overweight China until policy measures sufficient to solve its debt deflation problems are implemented – fade the stock rally.

Since the PBOC announced a rate cut and other stimulus on Sept 24^th, two questions on investors’ minds have been: 1) will they do RMB 2, 5, or 10 trillion of fiscal stimulus? And, 2) chase or fade the rally in Chinese stocks? To answer these questions, it is important first to diagnose the underlying problem and to identify the proper solution.

The Problem

China is suffering from debt deflation, the result of a debt-fueled fixed investment bubble. The original sin was setting excessive GDP growth targets (6-8% in the 2010s and 5% today) that were aimed at transforming China into a first world economy, without regard for its underlying capacity (China’s labor force and population are declining). To meet growth targets, massive investment funded by debt has been directed at the property, manufacturing, and infrastructure sectors: investment averaged 43% of China’s GDP over the past decade (versus 32-36% at the peak of Japan and Korea’s investment bubbles in the 1980s and 1990s). The result is overcapacity and one of the world’s largest debt loads at more than 300% of GDP – see Display 1.

The property market has been in contraction for three years (home sales and starts down 50-70%). Investment in infrastructure and the “New Three” industries¹ helped to offset this, but are coming under pressure: local governments have fewer resources to invest in infrastructure and New Three capacity in China is already more than twice global demand. Households, under pressure from job losses, wage cuts and the hit to their wealth from property price declines have curtailed spending. Bank lending has been steadily decelerating due to lending officers’ caution and a lack of demand from overindebted households, corporates and local governments. The net result is the Chinese economy has been in deflation for seven out of the past eight quarters.

Here you can find the complete article

^{Risk Considerations}

^{The views and opinions and/or analysis expressed are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time without notice due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively “the Firm”), and may not be reflected in all the strategies and products that the Firm offers.}

^{Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors or the investment team. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific strategy or product the Firm offers. Future results may differ significantly depending on factors such as changes in securities or financial markets or general economic conditions.}

^{This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and the Firm has not sought to independently verify information taken from public and third-party sources.}

^{This material is a general communication, which is not impartial and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.}