Over the past two years, when trading the Chinese market under the haze of the COVID-19 pandemic, a huge mystery has always lingered: China's onshore stock market seems to be unfazed by the new regulations that have swept through the education, online platforms and real estate industries. While many offshore Chinese stocks, including those listed in Hong Kong and the United States, are far more than half-hearted, China's onshore stock indexes have rebounded rapidly, even to new highs.
Experts pointed out that many of China's science and technology network giants are listed overseas, so the offshore China index has been hit hard in the environment of increasing the supervision of Internet platforms. However, the ChiNext board, known as "China's NASDAQ", is also the listing place for many of China's most famous technology companies. In addition, the Hang Seng Index has always been well known for the lack of technology elements of its constituents, and its weakness is in stark contrast to the strength of the onshore market. This is really confusing.
To answer this mystery, we will look to China's current account surplus, which is important to the performance of the stock market. Historically, the stock market has always peaked alongside current account surpluses. For example, current account surpluses peaked in early 2008, mid-2015 and early 2021, and the CSI 300 index also peaked in parallel. We believe the change in China's current account surplus can help us explain the polarization of China's onshore and offshore markets.
Throughout 2021, the COVID-19 pandemic has periodically resurfaced, and the global economy has been overwhelmed. As China emerged from its "landscape here alone" stand-alone market and China became an important source of supply for demand from Western countries, China's current account surplus climbed, backed by the huge dollars charged by strong exports.
Peaking the current account surplus will constrain the rise of the stock index: since the covid-19 pandemic, China has produced, exported and saved, while the West has been flattened, imported and consumed. China's accumulating current account surplus reflects the strong external demand relative to domestic demand. However, as the epidemic gradually recedes and the global economic restart is imminent, the accumulation of China's current account surplus is likely to slow. In fact, China's current account surplus is likely to have peaked in March. Historically, surplus peaks have tended to coincide with the top of stock indices, such as late 2007 to early 2008, mid-2015, and February 2021. At the same time, our quantitative model also predicts that the top of the trading range will be close to the peak in 2021 for the next 12 months.
Chart 1: Current accounts tend to peak in parallel with stock market indices
Source: Bloomberg, BOCOM International
China's foreign exchange deposits are "shadow feds" and are tightening: although the current account surplus has risen to near record highs in 2007, China's foreign exchange holdings and reserves have not risen significantly. Foreign exchange deposits in commercial banks have become reservoirs of dollar liquidity and have risen to about $1 trillion – in parallel with the Fed's balance sheet expansion under different stages of quantitative easing.
Chart 2: Fed balance sheet vs. Chinese foreign exchange deposits and SZSE
Therefore, China's foreign exchange deposits are very important to the price of China's risk assets, which we call China's "shadow fed". With the Fed having exhausted all its strength and all the excuses to start a debt-backsizing package, China's export growth is about to slow, and the rapid growth of foreign exchange deposits is likely to come to an end, constraining the potential market growth. Conversely, if the COVID-19 pandemic continues to rage, disrupt supply chains, and lead to sticky inflation, the Fed will have to tighten monetary policy more than expected. If so, this scenario is nothing less than worse for the operation of the market – it will be a co-ordination of stocks and bonds – stagflation.
Chart 3: Global central banks expand their balance sheets, pushing up stocks and inflation
Chart 4: China's foreign exchange deposit growth leads the Shanghai securities return rate by 6 months
Focus on the "Titanic" sector in 2021: Instead of betting on a broader-cap index with limited upside, we recommend focusing on the "Titanic" sector in 2021 – the consumer and internet sectors. Even the real estate sector is likely to rebound technically as market sentiment shifts, although a rebound of this nature is difficult to trade. Energy should continue to perform. These sectors (excluding real estate) are defensive in their earnings, but are still under-allocated in the investor mix. At present, investors' sector allocation adjustment is too slow, still does not reflect the trend of slowing economic cycle, so it is easy to catch off guard after the market turns.
Chart 5: The plate rotation model suggests that the market is on the top
Source: Wonderland, BOCOM International (Market Top Portfolio = Material + Energy + Daily Consumption, Bear Market Combination = Energy + Daily Consumption + Healthcare, Bear Market Late Combination = Healthcare + Utilities + Finance, Market Bottom Combination = Finance + Information Technology + Optional Consumption, Bull Market Combination = Information Technology + Industry + Materials).
Chart 6: The growth stock bubble has largely burst
Targeted easing to protect against systemic risks: As the economy slides from peak to trough in a short cycle, policy support will gradually increase to hedge downside risks. Still, a full easing of real estate is still a small probability event at this stage. The policy direction will mediate with market expectations in order to balance the policy determination to curb property speculation and the need to manage risks. Directional relaxation, or even waiting for opportunities to reduce the RRR is very likely.
Chart 7: China's foreign exchange reserves, central bank assets, reserve requirement ratio, RMB and real estate investment cycle
As expectations of house prices rising and not falling begin to shift, the reallocation of capital from real estate to other asset classes will lead to a more robust capital market. The renminbi will be slightly depreciated in stages. In a safe-haven market environment, bond yields will also fall.
Risk factors we predict
Our forecast assumes that as the COVID-19 pandemic subsides, strong overseas demand for Chinese exports will gradually weaken. As China's consumption begins to recover relative to external demand, the accumulation of current account surpluses will begin to decline, and the balance growth of foreign exchange deposit balances of Chinese commercial banks, the "shadow Fed", will also slow. It also reflects the marginal tightening of the Fed's monetary policy. In this benchmark scenario, the upward momentum of the Shanghai Composite will be contained, and its top will not be significantly higher than the 2021 peak.
But what if COVID-19 makes a comeback, as it continues to recur during 2021? What does this mean for the change in China's domestic demand relative to its external demand, as well as China's current account surplus and the "shadow Fed"?
If so, this would be the worst-case scenario. If COVID-19 continues to hit the global economy, inflation will not temporarily fall back due to the base effect, but will continue to run high. At the same time, as economic growth continues to slow and the Fed and other central banks will have no choice but to adopt monetary tightening policies that exceed expectations in the face of stubbornly high inflationary pressures. This would be a typical stagflation scenario in which both stocks and bonds would struggle to perform.
What would happen if real estate were to be completely relaxed to save troubled real estate companies? As we've discussed before, while we believe there will be targeted easing, it's hard to imagine china easing so quickly. With real estate investment growth still in the process of decelerating, some developers are still struggling to manage to repay their debts when they mature, and it seems premature to intervene in this marketization process. At present, despite the difficulties, the real estate industry has finally ushered in some long-lost positive changes: the pilot reform of the real estate tax is about to be carried out, and people's expectations that house prices will only rise and not fall have begun to change. With the aging of the Chinese population, the proportion of real estate allocation in household asset allocation is already too high relative to China's population structure. If we continue to leverage an asset class that has passed the golden age, it will seem so anachronistic in the midst of the current century-old changes.
(The author Hong Hao is the managing director and head of the research department of BOCOM International, and this article is excerpted from "Hong Hao | Outlook 2022: Xi Ti Ruoli", published with the author's permission)