INSIGHTS

The uncertainties lingering around the Sino-US trade relations intensified in a notable way when the Trump Administration has released the 25% tariff 10against a total of USD50bn of imports from China (separated into 2 tranches: USD34bn to be effective on 6 July and USD16bn to be effective after public comment process)¹. China retaliated within hours in a tit-for-tat manner. China has also stated that the understanding reached in the visit by Ross Wilbur in the earlier part of the month has been nullified. These developments have been generally considered as a very big step on both sides in getting closer to a full-fledged trade war. 

The markets nose-dived on 19th June when they re-opened after the Dragon-Boat festival long weekend. We understand the risk-averse mentality of investors under such a macro backdrop. However, our view remains that the US business community will soon feel the pain of China’s retaliation and the swing in their stance might have a profound implication on the policy stance of the Trump Administration.  The underlying rationale of ours is that the economic repercussions from the trade war do not skew disproportionally to China in any major way. This is in contrary to the conclusion that one might arrive at if one only considers that Chinese goods exports to the US is 3.3x larger than US goods exports to China. This narrow focus on merchandise trade overlooks risks of higher prices for consumers, to services trade, to value added spillovers, and China’s ability to retaliate through non-tariff/trade policies. In fact, the 3.3x gap narrows by about 60% once the US’s larger services exports and much larger domestic value added (DVA) of US exports to China (85% vs 66% for China DVA of exports to US) are factored in².

China is still more exposed than US on trade if all these adjustments are taken into the equation, but the gap is not as wide as merchandise trade data would have superficially suggested. On the topic of risk of higher prices for US consumers, we are already beginning to see signs of this. Since January 2018, the US has a 20% tariff on imported washing machines, and laundry equipment under the US Bureau of Labor’s CPI has jumped 17% in the last 3 months, which is the largest price increase over a 3 month period in the last 12 years³.

The US public opinion on tariffs may shift drastically if more durable and non-durable consumer items experience a similar phenomenon. We maintain our view that these actions from the US are more likely to be intimidating gestures rather than effective tools to force China to comply with the rules that the US prefers.

As pointed out by various economists in the market, if these proposed tariffs are all imposed, the impact on the Chinese GDP would be no more than 0.4% points, even assuming the USD50bn Chinese exports to the US would simply evaporate (assuming 100% of the value-added of these exports is originated in China)¹. In reality, this wouldn’t be the case.  We think that a 10-25% reduction of trade volume is more likely to happen; hence the actual impact on China’s GDP would be 0.04% to 0.1%. Even if the other USD16bn China exports would be subject to same tariffs, the actual impact might be less than 0.15%, which we think is manageable given the fiscal and monetary leeway that the Chinese government currently possesses.

What happens between the two major economic powers over the next few weeks would be crucial. We shall keep close monitoring on this front and will update our readers here.

[1] Source: CICC Research as of June 2018
[2] Source: Citi Research as of June 2018
[3] Source: Ming Pao Finance as of June 2018

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. You may lose part or all of your investment. You should not make an investment decision solely based on this information. If you have any queries, please contact your financial advisor and seek professional advice. This document is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Recently, risk appetite continued to be dampened as the market became concerned over increasing bond defaults, in addition to external factors such as trade disputes and turmoil in emerging markets on the back of rising US interest rates and stronger US dollar. The rising bond market volatility has widened credit spreads and depressed corporate bond issuance.

Specifically, this round of credit default events was somehow triggered by the initiation of a set of new asset management policy guidelines which is an important part of the government’s de-leveraging initiatives for the financial sector. The new asset management industry rules have pushed up the funding cost for local Government projects and private enterprises. In addition, macro policies have tightened on multiple fronts under the general guideline of “deleveraging and risk-prevention”, which in turn lead to a notable slowdown of shadow banking and Total Social Financing (TSF) growth.

We do not expect these defaults to lead to systemic concerns as the total defaulted amount is a very small proportion of total outstanding corporate bond liabilities (less than 0.2%¹) and policymakers, from our observations, have a firm grip on the market conditions and at the same time, the People’s Bank of China (PBoC) has been quite responsive in providing liquidity relief to the system. The recent moves by the PBoC, including cutting the reserve requirement ratio (RRR) in April and targetted RRR cut to be effective in July and the expansion of collateral acceptances for Medium-term Lending facilities (MLF) with banks, are good evidences of the government’s pro-active approach in managing the risks of excessive liquidity tightening. To further iterate PBoC’s preparedness to act, it issued a statement on June 19 saying that it has placed a high priority to manage the impact of external shocks and may pre-emptively use policy tools to ensure stable domestic liquidity and manage the pace of deleveraging. We believe that its tool kit includes  RRR cuts and open market injections, increasing loan quota, accelerating government bond issuance, and fiscal easing as the ultimate support of the economy.

We have noticed that both the PBoC and the top regulators were more willing to take feedback and advice from market participants and experts before making policy decisions in the last 1-2 years. We hold the view that the quality of policy decisions made by the Chinese government has shown a remarkable improvement, admittedly after a number of tough and costly lessons learnt in the last few years. This string of credit defaults may have a negative impact on near-term sentiment as stock market investors are worried about potential domino effects and the shrinkage in financing channels for corporates. We also like to note that there is a potential relaxation of corporate bond issuance approvals from the regulators in the near-term as the issuance had been put on hold on regulators’ window guidance earlier on, which would imply that the government is keen to diligently manage the risks to the broader economy arising from the deleveraging initiatives.

Corporate bond defaults have been taking place in industries such as environmental protection and other urban infrastructure sectors which typically have aggressive private-enterprises embracing high leverage and liability duration mismatch involved. The defaults effectively freeze the new-issuance market of corporate bonds. Moreover, with a stronger risk-conscientiousness in mind, the central government has been eyeing the excessive local infrastructure investments disguised as Private-Public-Partnership (PPP) projects. Around 12% (or Rmb 1.53 trillion) of the planned PPP investment has been revoked from the project inventory between November 2017 and April 2018². This certainly has hamstrung the fixed asset investment impetus to overall GDP growth. Given this, we believe it would be wise to invest in companies with either a very strong operating cash flow to cover their financing needs or well-supported by banks given the robustness of their businesses.

In the short term, the rising defaults may increase bearish sentiments, but these developments will likely contribute to the normalization and resilience of the bond market in China over the long run. Furthermore, tightening credit conditions will likely accelerate industry consolidation as it is becoming more difficult for weaker companies to get funded. Liquidity pressure for Hong Kong listed companies will likely be manageable as they have multiple channels for funding, compared to their onshore peers. Overall, we believe that volatility and uncertainties will dominate in the short term, but economic resilience, thanks to a robust synchronized global recovery and Chinese Government backstop, should offer a more benign and constructive backdrop for the economy in the latter part of the year.

[1] Source: CICC Research as of June 2018
[2] Source: CICC Research as of May 2018

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. You may lose part or all of your investment. You should not make an investment decision solely based on this information. If you have any queries, please contact your financial advisor and seek professional advice. This document is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.