Stay short iron ore. Why? Nomura explains:
Beijing’s recent regulatory blitz on several sectors, including off-campus tutoring and internet platforms, has garnered investor attention. However, markets may have become so focused on the regulatory storm that they ignore the elephant in the room: Beijing’scurbs on the property sector, which makes up one-quarter of China’s economy and half of the global construction business.
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In coming months, we expect China’s GDP growth to drop significantly, driven by the latest wave of Covid-19 (the delta variant), slowing exports, property tightening and the campaign to reduce carbon emissions. The property sector may once again be at centre stage, testing the nerves of both China’s government and global investors. Markets should be prepared for what could be a much worse-than-expected growth slowdown, more loan and bond defaults, and potential stock market turmoil.
In a sense, this could be China’s Volcker moment, considering Beijing’s unprecedented determination to tighten property sector policy and tame property prices. During the late1970s, former Fed Chairman Paul Volcker made a radical move to contain inflation and, while the US economy experienced a substantial recession in 1980-82, he set the table for the long economic expansions of the 1980s and 1990s. At least at this moment, Beijing seems willing to sacrifice some growth stability for achieving these long-term targets, namely less dependence on foreign high-tech goods, achieving a higher birth rate and reducing wealth inequality.
Seasoned investors may regard the above view as an exaggeration, as they have become accustomed to the ups and downs of Beijing’s property sector policies, but things are likely to change and past behaviour cannot always be extrapolated into the future. We believe this time it’s different, as Beijing has attached national strategic importance to reining in property bubbles, directly intervening in the credit supply for the property sector, and has left little scope to dial back these curbs.
Since 2018 Beijing has faced three key property sector-related challenges: US-China tensions, the rapid decline in birth rates, and worsening wealth inequality. Beijing’sdetermination to roll out unprecedented property curbs is closely associated with its desire to address these challenges. Beijing has recently compromised the K-12 off-campus tutoring sector to lighten the burden on middle-class households and is now taking steps to move the largest mountain – high home prices – and these property curbs are set to have a much more significant impact on China’s economy and financial markets.
What’s the end game? The long-term outlook for China’s property sector is still uncertain, as Beijing has not yet developed a comprehensive, long-term plan for the sector, and as these ongoing curbs may not deliver exactly what top leaders expect.
Beijing appears to be finally determined to expand the property tax system from some trial programs in Shanghai and Chongqing to the whole of China for two reasons. First, homeownership is one of the major root causes of wealth inequality in China and Beijing has vowed to achieve “common prosperity”. Second, the ongoing property curbs should broadly reduce local government land sales revenues and Beijing needs to find are placement.
Public housing is unlikely to be the white knight for stabilizing growth in the near term, as Beijing does not yet have a mature and comprehensive plan on public housing. We are unsure what the eventual impact of the public housing program will be but believe market forces will recede to some extent in coming years on the provision of urban housing for Chinese households.
If you are an investor in miners, I recommend you read the entire note. Nomura is arguing, in effect, that this is the end of China’s commodity-intensive growth period. This will have almost as large a deleterious impact on base metals like nickel and copper.
I don’t know if Nomura will be proven right about Beijing’s determination to weather lower growth this time. What I can say is that all of the signals I see today are very much consistent with this analysis.
Part of the reason that iron ore has bounced out of its crash in the last week is more stimulus:
PBOC Governor Yi Gang earlier this week pledged to boost credit support to the economy and improve efforts to bring down real lending rates for businesses. In a front-page commentary in the China Securities Journal Friday, analysts said there could be an increase to credit supply soon and another reduction in the RRR following July’s surprise cut.
Zhou Hao, senior emerging market economist at Commerzbank AG in Singapore, said the PBOC’s comments have fueled speculation of a RRR cut as early as Friday. Lu Ting, chief China economist at Nomura Holdings Inc., sees more than 70% chance of a RRR cut in the next two months.
“With the rising risk of a growth slowdown and the lack of flexibility in some key existing tightening measures, we believe the probability of a RRR cut is on the rise in the near term,” Lu said in a note Friday.
…Lu said any cut in the RRR will likely be targeted that injects less than 500 billion yuan of liquidity, given the effective RRR for small banks is already quite low at 5.5%.
Separately, the Ministry of Finance said in a statement Friday it will accelerate fiscal spending and moderately speed up local government bond sales, providing additional support to the economy in the second half of the year.
RRR cuts are largely irrelevant to growth, especially when so targeted. The MOF material is more bullish but, even here, we have seen policymakers try this repeatedly since May and fail. Nomura is on the money here as well:
The void left by the property sector is just too large to be filled
A review of China’s major economic indicators suggests that its economic recovery in Q2from Q1 this year was broadly based across major demand-side factors. Specifically,annualized 2y-o-2y growth in exports, retail sales, property construction investment,manufacturing investment and infrastructure investment rose to 14.4%, 4.6%, 9.8%, 4.6%and 3.7% in Q2 (Figure 19), respectively, from 13.4%, 4.1%, 8.3%, -1.5% and 3.0% in Q1.However, as we expect the delta variant, slowing exports, property tightening and the campaign to reduce carbon emissions to result in a notable slowdown in H2, manufacturing and infrastructure investment have become the main potential offsets tothe upcoming slowdown in H2.
Manufacturing investment may remain solid but will still likely face headwinds
As one of the key elements of the dual circulation strategy, Beijing aims to divert more funding away from the property sector and into high-end manufacturing, and this is also a major reason why the expected sharp downturn in the property sector appears inevitable. We have seen increasing evidence showing more funding is being diverted into the manufacturing sector. According to the PBoC, growth in outstanding medium- and long-term bank loans to the manufacturing sector reached 41.6% y-o-y at end-June 2021, 16.9pp above the pace at end-June 2020, which marked the fourth consecutive month of an above 40% pace. By contrast, growth in outstanding bank loans to the property sector had already dropped to 9.5% y-o-y at end-June, its slowest pace since Q4 2004, when the PBoC first released the series.
However, the void left by the property sector is just too large to be filled. Despite the rapid expansion in recent months, the share of outstanding medium- and long-term bank loans to the manufacturing sector in total outstanding medium- and long-term bank loans and outstanding overall bank loans remained quite low at 3.2% and 4.8%, respectively, at end-February 2021 (latest data available). By contrast, the share of outstanding bank loans to the property sector in outstanding overall bank loans remained elevated at 28.4% at end-March and 28.0% at end-June 2021 (latest data available). Therefore, it is unlikely manufacturing investment will be able to fill the void left by the cooling property sector in are latively short period.
Amid rising raw material prices, annualized 2y-o-2y growth in industrial profits surged to20.6% in H1 this year, which should be positive for manufacturing investment. However, the surge in industrial profit growth was mainly concentrated in upstream sectors, including mining/processing of ferrous and non-ferrous metals and related raw materials, as well as the manufacture of chemical products, while profit growth in downstream industries and small businesses has been somewhat squeezed. The mixed impact from rising raw material prices on upstream and downstream sectors may limit the potential upside in manufacturing investment.
Second, as we expect exports to weaken notably in H2, slowing exports bodes poorly for manufacturing investment, especially in the export-oriented manufacturing sector. Lastly,US-China relations remain quite uncertain. The US government has continued to implement bans and other restrictions on the export of high-tech products (especially chips) to China amid trade tensions. Manufacturers may remain cautious about their investment plans.
The upside for infrastructure investment appeared limited
The funding of infrastructure investment is derived mainly from three sources: fiscal expenditure, government bond issuance and local government revenues from land sales. With slower-than-usual fiscal expenditure and government bond issuance, annualized 2y-o-2y growth in infrastructure investment remained mediocre over the first seven months of this year at 2.7%, mainly supported by still-strong local government revenue from land sales (with annualized 2y-o-2y growth of 12.8% over the same period). As we expect Beijing to fully tap the remaining RMB4.3trn of its net bond financing quota for the final five months of this year and fiscal expenditure to speed up in coming months to counter the expected slowdown, infrastructure investment may increase in coming months. However, as we expect property market conditions to worsen notably, a likely slump in local government revenue from land sales suggests the potential upside for infrastructure investment is likely to be limited. In fact, the sharp slowdown in volume sales of capital durable goods in recent months, including excavators (Figure 20) and heavy-duty trucks, also bodes poorly for infrastructure investment in H2.
The pressure will mount on Chinese authorities as this campaign moves forward. They have established a framework to see off rentier pressure in the “common prosperity” doctrine, another signal that they are serious this time. So is this:
China kicked off a two-month campaign to crack down on commercial platforms and social media accounts that post finance-related information that’s deemed harmful to its economy.
The initiative will focus on rectifying violations including those that “maliciously” bad-mouth China’s financial markets and falsely interpret domestic policies and economic data, the Cyberspace Administration of China said in a statement late Friday. Those who republish foreign media reports or commentaries that falsely interpret domestic financial topics “without taking a stance or making a judgment” will also be targeted, it added.
The move is aimed at cultivating a “benign” online environment for public opinion that can facilitate “sustainable and healthy development” of China’s economy and its society, according to the statement. It followed a draft proposal issued earlier Friday by the cyberspace regulator to regulate algorithms that technology firms use to recommend videos and other content.
Only time will tell if policymakers can take the heat. For now, Beijing is not for the turning and the big further downside for metals is obvious. Remember that property consumes 45% of all Chinese steel and it is nearly 70% with infrastructure added.
There is MUCH MORE in the Nomura report. If you only read one this year, make it this one.
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