Will China’s stimulus package work?

The recent dramatic rally in China’s equity markets has taken many investors and commentators by surprise. Understandably, those who were positioned for it might argue that it was predictable, even overdue. The problems confronting the residential property market in China, where there is a glut of unfinished and unsold properties, developers going bust and falling prices, and the impact this has had on consumption growth, were all known and well-rehearsed. And the bear market in Chinese equities, which was more than five years old, was also clearly a concern to China’s political leadership. A package of substantive measures specifically designed to help address these issues was highly likely, but the timing of the decision to act was not at all clear.

China’s equity markets have responded very well to these measures but in many ways, they were primed to do so because Chinese equity valuations had fallen so far. International investor selling combined with fading domestic investor confidence had both driven the market down to a level that objectively discounted a significantly worse economic and corporate profit environment than the consensus was forecasting, even in the absence of this significant policy initiative.

Now that China’s equity markets have rallied so strongly, the key question for investors and policymakers is, will this stimulus package work? Clearly, different investors will have different interpretations of 'work', but before giving you our view, here are some relevant points.

Headwinds

China’s economic headwinds, like those confronting every major economy, are challenging and hard to resolve. They will require a determined and substantial effort on the part of policymakers to overcome. At the moment, it is impossible to assess whether the most recent package of measures will be sufficient. Time will tell. But importantly, with these announcements, China’s leadership has demonstrated a determination to tackle them. If this package is insufficient, we would expect more to follow.

Demographics

China’s policymakers cannot solve all of the challenges confronting the Chinese economy, especially those related to demographics. However, the coordinated policy initiatives announced last week appear well thought through and directed at things policymakers can and should seek to influence. Creating a more balanced growth environment in China, one that depends less on infrastructure investment, exports, and manufacturing and more on domestic consumption growth, is of paramount importance, and this appears to have been acknowledged by the authorities.

Fundamentals

China’s equity markets were and still are fundamentally too cheap. By only focusing on China’s economic and social challenges, many investors have lost sight of the many attributes of leading Chinese equities.

International consensus

International consensus still appears to be negative on the probability of a successful outcome for China’s economy, and many international investors appear to be sceptical about the market’s rally and its likelihood of being sustained. This is actually quite positive. We would be more concerned about the permanence of this rally if investors were more bullish and proclaiming this as a turning point for the equity market.

Our view

So, to our perspective on these events: First, we think this is a well-directed package designed to help address the key issues confronting China’s economy. If these measures are insufficient to turn around the property market and don’t lead to higher consumption growth, we expect more initiatives will follow. We believe it would be wrong to underestimate policymakers’ determination to deliver their target outcomes.

So, we are slightly hedging our answer. We don’t know if they will work with respect to the economy, but it is clear to us that if they don’t, more stimulus will come later. As for China’s equity markets, their valuation appeal and the still very negative positioning of international investors suggest to us that this turnaround has more permanence than many believe.