Wall Street’s crystal ball shattered: Why financial markets’ big bet on China’s economic boom is failing

Ever since China recovered last December from three years of COVID-19 restrictions that hit manufacturing and domestic consumption in the world’s second-largest economy, Wall Street has been bullish on the recovery and hoping it could help stem global recession as central banks hiked interest rates to fight inflation.

Now, seven months later, China’s economic recovery has disappointed investors.

The iShares MSCI China ETF

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The largest US-listed exchange-traded fund, which tracks Chinese equities, is down 7% so far this year, while the Invesco Golden Dragon China ETF

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which tracks the Nasdaq Golden Dragon China Index

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is down 4% over the same period, according to FactSet data.

In the Chinese market, the China CSI 300 Index

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The index, which tracks the 300 stocks with the largest market capitalizations and liquidity from across the A-share universe, is down 1.6% year-to-date and Hong Kong’s Hang Seng index is down 5, according to FactSet data % please.

“This entire view of China’s post-reopening boom was wrong,” said Gerwin Bell, senior economist for Asia at PGIM Fixed Income. “We have to grapple with the idea that consumers can also be called upon to drive the recovery – we never believed that.”

Consumer spending in China initially fueled the recovery in the first quarter of 2023, but will not be strong enough to lift GDP growth to 5% or 6% levels, Bell told MarketWatch in a phone interview. Data from PGIM shows that the real retail sales recovery is already faltering and is still well below the pre-2020 trend, which is the polar opposite of the US recovery.

China has set a modest target for economic growth of about 5% this year, its lowest target in a quarter century, after growing just 3% last year, one of its worst numbers in decades.

See: Obstacles remain on China’s journey from “zero-COVID” standstill to rampant consumption

Meanwhile, some Wall Street analysts have also “fundamentally misunderstood” the nature of China’s COVID-19 restrictions, as the Chinese government continued to keep factories open and most business activities continued, so didn’t really result in a sharp growth slowdown over the past year Blockings for passenger traffic, but also for the real estate sector, said Bell.

“Zero-COVID led investors to believe that the biggest issues with China were COVID policies, completely distracting them from the chronic disease,” said Marko Papic, chief strategist at Clocktower Group. “The zero-COVID policy came as an acute shock, but China’s chronic illness is that households are over-indebted. That is the root of the demand problem.”

See: China ETFs fall after PBOC rate cut disappoints markets

In response, the People’s Bank of China cut two more interest rates last Tuesday for the first time in ten months in a bid to lower borrowing costs for businesses and households. According to the PBOC, the benchmark one-year lending rate (LPR) was cut by 10 basis points to 3.55% and the five-year LPR, or benchmark, for mortgage rates by the same amount to 4.2%.

The cuts are the latest in a series of moves by Beijing to shore up a shaky economic recovery from the pandemic. The bank cut its 7-day reverse repo rate by 10 basis points to 1.90% from 2.00% last week. Meanwhile, the one-year medium-term credit facility (MLF) was cut to 2.65% from 2.75%.

However, economists were disappointed because the barrage of rate cuts provided no effective stimulus and was tantamount to ‘pulling on a string’ as there is no demand for credit from households and businesses that are allowed to borrow.

Papic told MarketWatch that China is facing a possible “balance sheet recession” due to a high debt ratio and a slowing real estate market. A balance sheet recession, a term coined by Richard Koo, chief economist at Nomura Research Institute, is a type of economic downturn that occurs when high levels of private sector debt cause individuals or companies to collectively focus on saving through redemption of debt rather than paying off spending or investments, even as borrowing costs fall.

“That’s the problem with demand and there’s no other way to solve it other than using the public sector,” Papic said. “You have to make sure that nominal GDP growth is high enough when trying to deleverage the private sector. If you austerity and deleverage at the same time, you won’t reduce your debt because of the denominator effect. This is what Chinese politicians will push.”

See: “Deep, sustained and persistent” skepticism about China’s growth potential is preventing global financial markets from accepting the country’s reopening

However, this does not mean that China’s recovery has been dashed, as further monetary easing, fiscal stimulus and government intervention may lie ahead.

China’s State Council, which coordinates government ministries, last week discussed measures to boost economic growth and pledged to take timely policy steps amid signs the post-COVID recovery is faltering, state media reported, without giving timeline details .

Papic said it is too early to say whether the forthcoming stimulus measures will be strong enough to stabilize the economy, especially given that the specific measures have not yet been announced.

But if you can think of what has been rumored for the past few weeks, such as lifting property buying restrictions and lowering down payments in prime cities, further financial support to speed up home completions and issuing special bonds worth one trillion, then he expects growth to stabilize “at least in the next few months,” said Papic.

However, Shehzad Qazi, chief executive of China Beige Book, said he believes some of those moves would make little difference as some real estate restrictions are likely to be rolled back in the coming months, but the stabilization of residential real estate is “a far cry” from real estate are reviving economic growth,” he said in an email comment seen by MarketWatch.

Bell and his team at PGIM remain confident that economic growth will rebound significantly over the next six to 12 months, as both monetary easing and fiscal stimulus will be “much bigger” than markets are expecting, because the message to implement stimulus measures will be “penetrated”. from Beijing to all local government officials so that there will be “gradual additional coordinated guidelines” by the end of the day.

“If you add it up at the macro level, it could be quite large. With that in mind, I think we’re somewhat more optimistic than the market on the prospects for China, particularly in the fourth quarter,” he said.