While US interest rates have started to rise since 2015, the Fed has not been in a hurry to hike interest rates because inflation has been low, due to structural forces, despite the healthy economy. It has also announced plans to shrink its balance sheet though adopting a gradual approach that will extend until end-2025.
A focus on long-term objectives
China has also been on a tightening monetary policy bias. Interbank rates have firmed and the overall yield curve has shifted upwards as government policy from spring 2017 focused on containing the explosive growth in the shadow banking industry. The low M2 growth in recent months reflects the significant decline in banks’ lending to the non-banking financial institutions.
Increased commentary surrounding China’s potential Minsky moment – a sudden collapse of asset prices after a long period of growth, sparked by debt or currency pressures – has focused government action around the need to de-lever the financial sector. We believe that China will continue to tighten via the orthodox channels (raising rates), especially in light of the fact that officials have achieved their growth targets for this year. In addition, this year’s 19th party congress yielded a pronouncement to move away from quantitative policy targets, in favour of a focus on long-term objectives.
Meanwhile, the prospect of continuity in Fed policy under the new chair is positive for China. Powell’s appointment is not a controversial choice and he is seen as likely to adopt Yellen’s policies which are viewed to be on the dovish side, since we have not seen any preemptive hikes in recent years. Despite low unemployment and economic growth stronger than trend the Fed has proved reluctant to raise rates aggressively because inflationary pressures are absent.
Consensus expectations suggest that a hike on 13 December will be followed by three more in 2018. Assuming incremental rises of 25 bps, we can expect US interest rates to reach 2.25 per cent next year, which is still considered neutral although real US interest rates should finally turn positive, rising from -0.5 per cent to +0.7 per cent. Nevertheless, US banks are expected to continue lending because their balance sheets have improved significantly and corporate America is witnessing a revival in capex.
This dovish or neutral environment puts less pressure on Emerging Markets including China because it is unlikely to catalyse US dollar appreciation. Furthermore, China is a special case because it still maintains a closed capital sector (ie capital flows can be controlled), while its high savings rate and large trade surplus mean international reserves continue to expand.
Opportunities and potential traps
In a rising interest rate environment, bond-like equities such as utilities and telecoms are not expected to do well. Meanwhile, the insurance sector is expected to outperform as higher interest rates generally mean higher asset yields. As long as Chinese authorities do not tighten too aggressively and the economy is able to transition gradually into a service/consumer-led economy, as well as achieving its goal of quality growth, we would continue to favour sectors of the economy that are plays on vibrant domestic consumption in China.
Post the summer of 2015, markets have fretted about the possibility of China exporting even greater deflationary shocks via a disruptive devaluation of the RMB. However, by virtue of successful supply-side reform policies, China’s PPI recovered significantly from -6 per cent in December 2015 to 6.9 per cent currently. This means that not only has China been able to shake off deflationary pressures but is now exporting some inflation to the rest of the world.
We therefore expect the RMB to be stable or slightly stronger compared to current level of 6.62 to the USD. RMB is a political currency and operates in a closed capital account environment. It is best for China to maintain currency strength as it is supportive for the household sector and will make it easier to successfully restructure into a services/consumption-led economy. A stronger currency adds to consumers’ real wages with the effect of stimulating spending. The current tight monetary environment would also mean high interest rates, which should translate to higher returns on deposits, further expanding disposable income.
Consequently, we not only expect China to avert its potential Minsky moment, we believe certain areas of the economy will continue to expand robustly, broadly underpinning the equity market. However, we remain convinced that, in an environment which is likely to be characterised by clear winners and losers, an active approach to stock selection should add significant value.
Michael Lai is investment director at GAM