In our latest House View, "2024 Global Economic Outlook (I)," we delved into the economic trajectories of the United States and Japan this year and offered our outlook for 2024. Our analysis suggested a challenging path for the US CPI to reduce from 3% to 2%, signaling that the market might be overly optimistic about imminent rate cuts. We also anticipate the Federal Reserve to likely begin easing interest rates by the third quarter of next year, leading us to recommend favoring bonds and incrementally increasing the duration of investment portfolios. For Japan, we foresee entering its first rate-hiking cycle post-financial crisis in April, a development that could positively impact the yen and Japanese bank stocks. Today, we're expanding our focus to include insights on China and Europe.

Summary

• The growing interest rate gap between China and the US has put considerable pressure on the Yuan, leading to a consistent outflow of foreign capital. This trend, combined with waning investor confidence in the Chinese economy, has resulted in a shortfall in market liquidity and a noticeable weakening of equity performance, with the Hang Seng Index experiencing a significant downturn of nearly 16% over the year.
• The real estate sector in China, plagued by debt issues, is facing challenges that are too complex to be quickly resolved, unveiling deep-rooted, structural problems. We reckon a further decline in the property market, but its overarching impact on China's overall economy should diminish as the country transitions from an investment-led to a consumer-driven economic model.
• Our analysis suggests that the interest rate differential between China and the US will gradually narrow in the coming year, easing the strain on capital outflows. This outlook leads us to believe in the Yuan's stabilization in the 7-7.3 range and its potential gradual strengthening. As for the Hang Seng Index, we advise caution, forecasting continued fluctuations between 16,000 to 17,000 points over the next six months, aligning slowly with the broader economic recovery.
• European inflation has seen a surprising downturn in recent months, more so than anticipated. Due to Europe's relatively fragile economy and a financing structure that allows for faster transmission of interest rate changes, we expect the ECB to precede the Fed in initiating rate cuts, potentially starting as early as the second quarter.

China – Liquidity Shortfall, Sluggish Real Estate, Yuan Stability

Lack of Market Liquidity

At the outset of 2023, there was a consensus that Chinese and Hong Kong stock markets would benefit substantially from the post-pandemic economic rebound, with expectations of over 15% growth. Contrary to these expectations, this trend ceased by late January and persisted downward, driven by a decline in external demand and domestic consumption weaknesses. The credit crisis in real estate and subsequent ripple effects have deterred many overseas investors from Chinese assets. Policy measures to stimulate the real estate and monetary sectors introduced during mid-year have had minimal impact, with the market still anticipating further easing. As of December 27, the Hang Seng Index had declined by 15.96% to 16,624 points, and the CSI 300 Index by 13.83% to 3,336 points, with the USD/CNY exchange rate lingering around 7.15.  

This year's performance of the Hang Seng Index is undeniably linked to a broader issue of market liquidity shortfall. On one hand, the Federal Reserve's decision to hike the federal funds rate to a high range of 5.25%-5.5% to curb inflation sharply contrasted with the PBOC’s continued dovish monetary stance to bolster the economy. This growing interest rate disparity between China and the US has set the stage for carry trade opportunities, prompting investors to short the yuan in favor of dollar-denominated assets. As a result, the yuan tumbled from its early-year peak of 6.7, plunging below its post-financial crisis low of 7.35, marking a historic outflow of foreign capital from China's stock and bond markets.

On the other hand, a confluence of lackluster macroeconomic indicators — from deflation and subdued consumer spending to sliding imports, exports, and a worrying spike in youth unemployment rates — compounded by a teetering real estate debt issue (manifesting in trust system collapses, LGFV failures, and defaults among state-owned enterprises), and the demographic challenge of declining birthrates, has led to heightened investor caution towards Chinese assets. As our September Q4 outlook noted, “Regarding the stock market, the short-term stimulus measures introduced by the government have failed to convince investors of any significant changes in the macroeconomic fundamentals. Typically, stock prices rise briefly on the day of such policy announcements but quickly retract”, in an environment where confidence is in short supply, efforts to inject liquidity have proved to be unsustainable, precipitating an enduring weakness and downward volatility in equity market.

Real Estate Chaos

Despite recording a 5.2% growth in GDP during the first three quarters of 2023, China's economy faces significant challenges, particularly from the real estate sector, which has not yet fully absorbed the shock but extended its impact across various economic sectors. Many of these emerging challenges are deeply ingrained and structural. Consistent with our previous observations, “Chinese government will not take drastic measures but to revive the economy in a systematic and organized matter”. This year saw a lack of aggressive counter-cyclical measures, with policy-making taking a more conservative approach, signaling that a full recovery might be more protracted than anticipated.

Specifically, July CPI experienced a rare dip into negative territory for the first time this year. Although there was a brief uptick following the summer Politburo Meeting, the CPI has since continued to contract, with the latest figures in November showing a 0.5% year-on-year decrease. Similarly, the PPI also fell by 0.3% yoy, indicative of continued weak demand across various industries, perpetuating a trend of deflationary pressure. The PMI has largely remained in a contraction zone since spring, reflecting downturns in imports, exports, and an alarming spike in youth unemployment rates, which reached 21.3% in June before the data ceased to be published.

On the real estate front, new housing starts have plummeted 65% from their peak, and nearly half of private real estate developers are facing debt defaults. The 70-city housing price index, which tracks new home prices across various city tiers, has registered an average drop of about 2%-5%. Further complicating the landscape, developers' promotional discounts, like offering free parking or appliances, often don't get factored into the officially published data. The secondary housing market in major cities has seen even steeper price declines, ranging from 15% to 20% in top-tier cities, and over 30% in smaller cities.

Given the significant role real estate plays in China’s GDP—accounting for between 25% to 30%, including related industries like steel and cement, and representing 60% to 70% of the average Chinese household's total assets—fluctuations in housing prices weigh heavily on consumer sentiment. The demographic shifts towards an aging society and declining birth rates add another layer of complexity to the scenario, signaling a gradual but inevitable shift from an investment-led to a consumption-driven economic model, a transition fraught with challenges and requiring considerable time to navigate successfully.

China's urbanization rate currently sits around 65%, with a target set at 75% within the next decade. This equates to an annual increase of about 1%, or 14 million new urban residents. Factoring in an average living space of 42 square meters per person, the yearly housing demand from this urban migration is projected to be nearly 590 million square meters. In a notable shift, China's national housing sales in 2023 plunged from 1.6 billion square meters in 2021 down to 700 million square meters, closely aligning with the anticipated demand from ongoing urbanization. Given the existing 6 billion square meters of construction in progress and a two-year stockpile, it's estimated that clearing the current inventory could take about a decade. We foresee a further dip in the real estate market in the upcoming years. However, as the initial impact wanes and the economy continues to transition, the real estate sector's influence on China's overall economy is expected to gradually diminish and stabilize.  

Addressing some pressing real estate queries we've received from clients:

Question 1: Why has the market been unresponsive to government measures aimed at easing the real estate sector?

Answer 1: Recent measures, like the 1 trillion RMB projects focused on affordable housing, urban village renovations, and "dual-use" public infrastructure, alongside a trillion RMB boost in mortgage loans  via PSL and shantytown redevelopment, have been perceived as limited in scale and lacking in transparency, casting doubt on their long-term efficacy. With credit stagnation and rising risks of bad debt, the effectiveness of the central bank's expansionary efforts is still under scrutiny.

Question 2: How does the drop in real estate prices relate to consumer spending growth?

Answer 2: Taking cues from Japan's experience in the 1990s, lower housing prices might reduce the need for hefty down payments, thus potentially lowering the savings rate and, in turn, bolstering consumer spending and service sector growth.

Question 3: How effective have been the policy adjustments concerning down payments and mortgage rates?

Answer 3: Policies rolled out in August and September have had minimal impact. New housing sales are still down by about 20% compared to previous years, with prices continuing to fall, and developers facing financial strains.

Question 4: Can the whitelist of real estate firms and unsecured loans aid developers?

Answer 4: These measures can be beneficial to a certain extent, but much depends on the banks' willingness to cooperate. Banks, facing declining profits due to shrinking interest margins, might be hesitant to engage in riskier loans. Furthermore, developers not included in the whitelist are likely to see reduced access to loans. The introduction of the real estate company whitelist was initially reported by Bloomberg, yet official confirmation from Chinese authorities is pending.

Perspectives on Chinese Assets

The current interest rate differential between China and the US is at a historic high, mirroring levels seen in early 2006. As we previously mentioned, we believe the Fed has concluded its rate hikes in July and anticipates starting rate cuts by the third quarter of the following year. Based on our assessment of Fed policy, we expect the US-China interest rate gap to gradually narrow, thereby easing the pressure on capital withdrawals. Additionally, with the Bank of Japan poised to gradually exit its ultra-loose monetary policy next year, we anticipate a partial liquidity redirection back to Hong Kong, supporting a stabilization and gradual strengthening of the yuan within the 7-7.3 range.

In the equity market, companies with robust business models, such as Alibaba, JD.com, Tencent, and Meituan, retain their investment appeal, particularly as their profit levels have significantly improved following the release of third and fourth-quarter financial reports. This suggests their valuations are becoming increasingly attractive despite a downward trend in stock prices. However, considering the weak macroeconomic data, shaky investor confidence, and the time lag for policy measures to take effect, we're adopting a cautious approach towards the Hang Seng Index. We anticipate it will continue to experience fluctuations between 16,000 and 17,000 points in the next six months, gradually aligning with the broader economic recovery.  

Europe – Inflation Cooling, Q2 Rate Cuts, Weak Economy

By December 27th, the Euro Stoxx 50 Index, which mirrors the US S&P 500 and includes the Eurozone's 50 largest blue-chip stocks, recorded a notable year-to-date increase of approximately 19.5%. This growth was primarily fueled by a surprising ease in energy costs early in the year, a boost in consumer spending expectations, and a swift decline in inflation during the third quarter, setting the stage for anticipated rate cuts. We assess that the European Central Bank has likely rounded off its current cycle of interest rate hikes. Considering the European economy's relative fragility compared to the US, and a quicker transmission of interest rate changes due to its financing structure, we believe the ECB might precede the Fed in rate cuts, potentially beginning as early as the second quarter.

The rise in energy prices since the Russia-Ukraine conflict has consistently driven inflation in the Eurozone. Starting from 2022, with a reduced dependency on Russian energy, Europe has been facing a dual challenge of strained energy supplies and escalating prices. According to Eurostat, energy costs have contributed to more than half of the total inflation, squeezing consumer spending and impacting overall economic activities.  

Fortunately, the milder winters of 2022-2023 have allowed Europe to skirt around an energy crisis. Steps to enhance energy independence have included increasing natural gas reserves, developing liquefied natural gas terminals, ramping up investments in nuclear energy, and legislative moves to double the share of renewable energy in EU consumption to 42.5% by 2030. As natural gas prices receded and high interest rates started impacting the broader economy, core inflation in Europe cooled more significantly than expected in recent months, and wage growth has also shown signs of slowing, suggesting that inflation may have peaked.  

However, the absence of large-scale fiscal stimuli like in the U.S., coupled with the aggressive rate hikes by the ECB, led to a marginal quarter-on-quarter contraction in the Eurozone GDP by 0.1% in Q3, edging the economy close to recession. Another factor for Europe’s heightened sensitivity to interest rates is that, unlike the US where about 80% of corporate financing is via fixed-rate bond markets, over 70% of Eurozone corporate financing is bank-driven and typically at floating rates, making interest rate effects more immediate.

Germany, the powerhouse of the European economy, has been notably impacted by increased interest expenses and the prior sharp rise in fuel prices. The industrial output in its energy-intensive sectors is roughly 15% lower than in 2015. While Europe has made strides in reducing reliance on Russian energy, this is a multi-year transition. A severe winter could still transform the current energy challenges into a more critical economic downturn. Additionally, the economic gap between Europe and the US has been widening post the European debt crisis. For example, in 2002, US per capita income was 12% higher than France and 16% higher than Germany. By 2022, this difference grew with the US seeing a 30% increase in real per capita income, standing 28% and 23% higher than France and Germany, respectively.

Given Europe's relative economic vulnerability, a major rebound in inflation seems improbable. We anticipate the end of the ECB’s interest rate hiking cycle. With recession risks on the rise and inflation easing, the ECB is likely to adopt a cautious approach, allowing its existing measures to take effect. Contrary to the Federal Reserve, the ECB is expected to initiate rate cuts in the second quarter, as the European economy lacks the resilience to endure prolonged high-interest conditions.

For the UK, the easing of inflation has been predominantly driven by a slowdown in wage growth and labor market rebalancing. Though the UK's economic growth initially lagged behind the US and mainland Europe, it exhibited resilience later in the year, steering clear of recession. With reduced price pressures, consumer purchasing power has seen some recovery, likely to further stimulate internal demand and economic activity. Considering the improvement in core inflation, the Bank of England is expected to hold rates steady, in line with the Fed and the ECB. Nevertheless, constrained by post-Brexit aftereffects and changes in immigration patterns, the UK’s growth outlook appears somewhat subdued.