Will Delta shock China?

Goldman with the note. Slowly but surely they’re all falling in behind the MB view of China:

China has been back in focus over the past month with a notable pickup in policy and market volatility. Ongoing regulatory pressures—reflecting a broadening of efforts beyond financial risk reduction to include concerns over anticompetitive behavior, data security, and social inequality—came to a head with a crackdown on the after-school tutoring sector that sharply reduced the scope for private companies to operate, along with their equity values. While authorities had previously signaled concern about this space, the severity of the action was unexpected and has prompted many investors to reassess regulatory risk, particularly for offshore-listed equities (Exhibit 1). Separately, the property sector continues to be under strain given the ongoing debt servicing pressures on Evergrande, one of the country’s largest property developers (Exhibit 2). Government bond yields have also moved lower, with the 10-year CGB yield down about 25bp in the past month. As we warned previously, the various sector-level regulatory tightenings don’t look too threatening to growth in isolation, but collectively they could be material.

Several downside risks exist for China’s second-half growth outlook, some long-anticipated and some new. First, the latest high-frequency growth data suggest deceleration, with the three July PMIs released so far (both official PMIs and the Markit manufacturing PMI) all lower, though still north of 50. The “new export orders” index of the official manufacturing PMI slid to 47.7, a post-lockdown low, seemingly validating prior concerns about H2 deceleration in export growth. Second, Covid risks have increased materially, with a daily total of nearly 100 cases across 14 of China’s provinces on August 1 following a recent outbreak traced to Nanjing airport, prompting multiple local and regional control measures (our Effective Lockdown Index has already returned to its tightest level since February). While China’s track record suggests the outbreak will likely be brought under control in coming weeks, the question is at what economic cost. Third, policymakers still appear reluctant to implement significant macro policy easing, with Friday’s Politburo meeting maintaining a broadly neutral tone—with a tight stance on property policies and a hint that fiscal support could be more backloaded than we had assumed. To the extent policymakers are concerned about growth, our sense is that their focus is on year-over-year figures, in which case the bar for Q3 is still relatively low (we currently forecast real GDP growth of just over 6% yoy in Q3, but expect growth to fall to 4.6% yoy in Q4).

The near-term growth outlook has dimmed for several other economies in the Asia-Pacific region. Last week’s Q2 GDP data was underwhelming for northeast Asia, with Korea, Taiwan, and Hong Kong all reporting deceleration (and the latter two a quarter-on-quarter contraction). More recently, the spread of the “delta” coronavirus variant, combined with Asia’s low-tolerance Covid approach, has led to significantly tighter restrictions in most countries (Exhibits 3 and 4). In much of Southeast Asia the“delta”wave has been the biggest yet, with Malaysia, Thailand, and Vietnam currently reporting record new case levels. But even in economies with relatively fewer infections  such as Australia and South Korea, restrictions have tightened materially. Early last month we cut our Q3 growth forecasts in anticipation of these effects, particularly in Southeast Asia; we now expect Australia’s economy to contract in Q3as lockdowns extend into August. We still expect the region and world to have recovered significantly furtherby early- to mid-2022, but with softer growth in the near term and modestly stronger growth in Q4/early 2022 than we had been forecasting prior to the “delta”wave.

The broad inflation picture continues to look subdued across most of Asia-Pacific.After a sharp acceleration since late 2020, almost all regional economies reported small declines in year-over-year CPI inflation in June (Exhibit 5). From here, we expect fairly stable headline inflation in year-over-year terms as crude prices were relatively flattish for most of H2 2020, and our commodity team sees a relatively modest further increase to$80/bbl in Q4, though they have noted supply-driven spikes are a risk. Core inflation has been moving higher but remains below 2% almost everywhere in the region on both a six-month annualized and one-year basis. The biggest exception is India, where core and headline inflation are both in the 6-7% range. We expect the RBI—which meets this week—to continue a multi-stage process of policy normalization in coming months but to keep the repo rate target unchanged until 2022.

Monetary policy around the region is a tale of two priorities—financial stability, and everything else. From a traditional “Taylor rule” perspective there is little reason to hike rates in most economies, as those with high inflation (India and to a lesser extent the Philippines) are still operating well below potential output. Global conditions are also very permissive at the moment, with the latest Fed meeting suggesting a QE taper isnot imminent (our US team continues to expect a December announcement), and global bond yields at multi-month lows in many countries e.g. sub-1.2% for the 10-year USTreasury. So the only regional central banks likely to hike this year are those for whom financial stability concerns about household debt and/or housing prices outweigh these dovish factors. The Bank of Korea and more recently the Reserve Bank of New Zealand have placed themselves in this camp—the RBNZ recently proposed further macroprudential tightening, and we expect both to lift rates in August.6. The race between the virus and vaccines will continue into 2022. The good news is that the pace of vaccination has picked up across the region, though it remains decidedly slower in south and southeast Asia than elsewhere (Exhibit 6 simplifies the picture by averaging some sub-regions). The bad news is that the more infectious delta variant implies a higher bar for “herd immunity”—likely 85% or above. Adjusting for vaccine efficacy, the largest countries likely to reach this threshold in 2021 are those that have experienced particularly extensive outbreaks (Exhibit 7). In most economies, policymakers will likely stay on guard well into the first half of next year.

Despite recent volatility, our market views remain broadly unchanged. Our Asia equity strategists moderated their stance on offshore-listed China equities but remain overweight China A shares, Taiwan, Korea, and India. Wider credit spreads look attractive, but we continue to prefer higher-quality high yield until there are clearer signs of a resolution to current China property stresses. In rates, we remain bullish on CNYbonds, and are most bearish in Korea given likely BOK tightening in coming months. We remain constructive on EM Asia FX over a 6-12 month horizon, but with modest targets.

China’s current account remains strong but the flow picture is more mixed given market volatility, and policymakers had already signaled discomfort with more appreciation. We continue to expect KRW outperformance and THB underperformance among lowyielders, with INR outperforming IDR and PHP among high yielders. Good luck to all ourclients in the markets, and in finding a few quieter days to watch the last events of the Tokyo Olympics.

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