In early 2016, many investors were surprised at the economic recovery that was occurring in China, a recovery that supported a global rally in cyclicals and global equity markets. In the late-2015/early-2016 period, concerns about a deflationary bust due to China yuan devaluation, weakening European economic data, and U.S. political uncertainty overshadowed markets. This risk-off sentiment quickly rotated to a strong risk-on environment where emerging market equities led a global recovery in equities, with many cyclical sectors outperforming. So how did investors miss the reacceleration that occurred in parts of the economy during that period? And how does this period compare to what we are seeing on the ground today in China?
The lesson learned from the economic recovery of 2016 was that policy responses in China have become stealthier and more targeted than they were during prior economic cycles. Consequently, it has become increasingly important to understand where policy is focused to position our portfolios to benefit from these tailwinds. During 2015 and 2016, two of the key focuses for the government were infrastructure (public private partnerships) and housing (shantytown redevelopment), both of which may have been initially underestimated by investors. These programs added fuel to the cyclical recovery, and along with other smaller stealth stimulus programs, contributed to the stabilization in global growth we enjoyed during 2016 and 2017.
Reviewing the current environment, we are once again near a trough in what we’d call the natural China economic cycle. We can see this cycle via the growth of the money supply, which tends to oscillate on two-to-three year cycles as various easing-and-tightening measures influence the economic cycle. Money supply growth bottomed earlier this year; and if the historical cycle holds, we would expect this data point to accelerate over the next few quarters as there has been a relaxation of shadow banking, local-government debt issuance, and cuts to the reserve requirement ratio.
From an economic perspective, this cycle can be seen via active de-stocking of inventory levels (no new orders), transitioning to passive destocking (re-ordering less than what is being sold), to re-stocking (double-ordering to meet perceived demand). During the 2018/2019 downturn, the active de-stocking phase was particularly sharp due to the uncertainty around U.S.-China trade relations, but also likely means the re-stocking phase could be just as dramatic. On the ground, we are hearing that housing projects that paused mid-construction in 2018 could be ramped-up very quickly due to housing supply tightening. This is consistent with discussions we’ve had throughout the supply chain where uncertainty resulted in an abrupt pause during 2018-2019. While any recovery is likely to be met with skepticism, when this recovery does occur—it could still be a few quarters away—we’d expect demand to well outstrip supply as these depressed inventory levels will need to be restored.
In addition to the natural economic cycle, we are monitoring what we’ll call “China’s Stealth Stimulus.” In 2009, China announced a massive stimulus program, as did many governments around the world. This transparency made it “easy” for investors to identify the inflection that was occurring and position around sectors that would benefit from these investments. China remains a very policy-driven market, but with so many different policy directives—at times offsetting each other—it is a challenge to separate the meaningful programs from the headlines.
As we noted, there were two major programs announced (among many) that we considered to be the key accelerants in the natural-cycle recovery of 2016. One was the Public Private Partnership (PPP) program that accelerated many public works projects while simultaneously improving oversight and governance. The second was the Shantytown Redevelopment Program, which provided subsidies to move individuals from slums into new properties, freeing up these existing properties for new builds. When these programs were announced in 2015, they received very little attention, but they became key drivers in the 2016 industrial sector recovery, which is why our team often speaks of them as “stealth stimulus.” Given the impact that stealth stimulus can have, we focus much of our travels and discussion with policy leaders on attempting to understand where the next stealth stimulus program will originate.
Similar to the 2016 playbook, the emphasis today appears to be on public infrastructure projects and housing, although in a slightly different format. The Shantytown Redevelopment program is being wound down, as officials believe it is inflating home prices in some areas. Earlier this year, the program was cut in half from the more than six million units that were delivered during 2018. This has stoked concerns for the housing sector, but the government is already rolling out a new stimulus program that has the potential to dwarf the Shantytown program. A renovation stimulus package has been implemented in several pilot cities and is likely to be implemented more broadly later this year and in 2020. Policy leaders have estimated the scope of this project at four to five trillion yuan ($650 billion USD)—larger than the 2009 stimulus package unrolled after the Global Financial Crisis.
This new program targets socialist-style tenement block-like buildings that were built pre-2000 and provides grants to cover the cost of improving roads, water, gas, heating, electricity, trash handling, elevators, public areas, and new senior/children facilities. Coupled with the supply of units that stalled during the 2018 downturn, we believe there is significant demand pending for kitchen appliances, cabinets, air conditioning, elevators, and other home-related products—in addition to the positive impact we could see in industrial sectors. From an infrastructure perspective, China has allowed local governments to raise more funding from the bond markets to invest in infrastructure projects, even utilizing part of their 2020 quotas. We’ve also seen individual tax cuts implemented to promote domestic consumption.
It is very difficult to find an investor bullish on China at the moment, which is understandable given the daily barrage of trade headlines, concerns for excess leverage, and long-term questions around the sustainability of a socialist command-control-style government. However, if history is a guide, it has been at these darkest moments when the largest returns awaited patient investors who were able to parse through the headlines to understand the future opportunities. Today feels more like that moment. While the inflection may not occur today or tomorrow, we believe we are much closer to that turn and are focused on maintaining exposure to the industries and companies set to benefit from an eventual recovery and current policy priorities.
Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. The views and strategies described may not be suitable for all investors. References to specific companies, securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to buy or sell. The above commentary for informational and educational purposes only and shouldn’t be considered investment advice.
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