Chinese economy: Market participants expect fiscal and monetary stimulus

By Cosmo Zhang, Research Analyst and Carlos de Sousa, Strategist and Portfolio Manager at Vontobel.

Recent economic data shows that the Chinese economy continues to slow and the rising deflation risk underscores the necessity of immediate support from monetary and fiscal policies. Therefore, we expect the Chinese government to adopt economic stimulus packages in the coming months.

On monetary policy, we expect the People’s Bank of China (PBOC) to make another 25bp cut to the reserve requirement ratio (RRR) this quarter and a total social financing (TSF) growth to pick up to 9.8% y-o-y by year-end. The PBOC already cut the medium-term lending facility (MLF) rate by 10bps in June, and perhaps one or two more cuts are possible in the second half of 2023. Although the nominal interest rate appears low, China’s real interest rate is not, amid the current disinflationary environment.

In addition to monetary policy easing, the current situation requires fiscal solid policy measures to stimulate aggregate demand and boost business and consumer confidence. Fiscal stimulus from the central government funded by increased debt could be a more adequate way to counter downward economic pressures, as local governments’ funding sources were used to support the property sector and since then have been restrained by strict regulation on borrowings. We expect a mild fiscal stimulus package to come during the third quarter of this year, yet a bazooka-like massive policy stimulus is unlikely. Fiscal measures would be favorable for financial institutions, leading state-owned enterprises (SOEs), local government financing vehicles, and investment-benefiting sectors like construction and materials.

Weaker-than-expected economic data suggests that the economy has lost some of the growth momentum after reopening. However, it’s important to keep in mind that the Chinese economy is facing both cyclical and structural challenges. Although we believe the >5% GDP growth rate is achievable for 2023, there are strong headwinds for sustainable growth in coming years, especially considering secular trends like dropping birth rates, aging demographics, and disinflationary new trends. CPI inflation dipped to a lower-than-expected 0.0% y-o-y this June, from 0.2% in May. In line with a sharp decline in raw material prices, PPI inflation dropped further to -5.4% from -4.6%. Meanwhile, the official manufacturing PMI was 49.0, below the 50.0 expansionary level.

Opportunities in a broad investment universe

Inflation in developed markets reached heights not seen in four decades last year. Rate increases by major central banks resulted in tightening financial conditions in developed and developing countries alike. Emerging countries, faced with similar challenges and being more susceptible to volatile food and energy prices, began hiking earlier and, in most cases, faster. However, the impact of some of 2022’s negative supply shocks has been fading for a while now. Most countries have moved beyond peak inflation, and central banks are now preparing to – or have already begun to– ease their monetary policies.

This positive shift, coupled with relatively low bond issuance, is expected to drive down yields in emerging markets. It's worth noting the extra wiggle room emerging markets central banks have to maneuver on the way down, given their actions were more aggressive on the way up.

And, while neither the US Federal Reserve nor the European Central Bank has possibly not finished hiking yet, hawkish surprises are much less likely going forward given the growing signs of disinflation, slowing economic growth, and tightening financial conditions for different reasons than monetary policy. As a result, the likelihood of risk-off situations, like those witnessed in recent months, is materially lower now.

Additionally, major emerging economies have reduced their vulnerabilities these past years by running much healthier current accounts through improved terms of trade and relying less on external financing compared to the previous decade.

And, finally, expectations almost unanimously point to a widening growth differential between emerging and developed countries in the coming years. With the US and European economies slowing down while emerging economies pick up momentum, the growth differential is expected to increase for many more major emerging markets than before.

While sentiment towards the Chinese economy has turned gloomier over the past month, there is no reason to exit emerging markets debt. The investment universe is broad enough, and there are multiple investment opportunities. In hard-currency sovereign bonds, we believe that there’s still good value in a few low-rated sovereigns, particularly in non-distressed Sub-Saharan African sovereigns in EUR.

We also find attractive opportunities in Central Asian and Eastern European quasi-sovereigns, of which the majority are investment grade. Bahamas' external debt bonds, amid a full recovery of tourism and responsible fiscal policies, offer interesting opportunities, too. In local currency, long-duration strategies in Latin America and Eastern Europe look attractive given the ongoing disinflation process.

We think emerging markets central banks in these regions will be able to cut rates ahead of the US Federal Reserve in the next few months, which should boost local-currency bond prices. In corporate bonds, there are attractive opportunities in Latin America and Eastern Europe.