Iain Cunningham

Iain Cunningham, Head of Multi-Asset Growth, explores China’s structural shift towards a consumption-driven growth model due to ongoing trade shocks from US tariffs.

While markets fixate on the strategic policy pivot in the United States, few are paying attention to what’s unfolding within China. With President Trump back in the White House and tariffs on Chinese goods raised to 145%, a major trade shock is already underway. China’s export engine is under pressure — and policymakers are responding.

Last week, as Washington’s sweeping tariff hikes captured global attention, the People’s Bank of China quietly injected 800 billion yuan ($110.32 billion) of liquidity into the banking system. Simultaneously, the Finance Ministry added another $69bn via share placements in state banks. These are not isolated interventions.

In fact, recent evidence suggests that Chinese policymakers are recalibrating away from their economic priorities of the past four years.

In 2021, a new regulatory cycle took hold. Policymakers moved to curb the highly leveraged business model of property developers with the “Three Red Lines” policy while also cracking down on “the disorderly expansion of capital” to rein in monopolistic behaviour among large tech companies. This resulted in a material consolidation in the real estate market and a deterioration in private sector sentiment. Meanwhile, policy support focused on transforming China’s manufacturing and export model, moving it up the value chain. This helped the country establish global dominance in sectors like autos and green energy equipment.

This model now looks increasingly fragile. The pressure from renewed US protectionism has laid bare the limits of China’s post-2021 export-led growth strategy. With tariffs biting and external demand under strain, the need for a new engine of growth is clear.

So how does China intend to hit its 2025 growth target of ‘around 5%’ in the face of such a large exogenous shock — one that will undoubtedly inhibit the post 2021 growth model? The simple answer: consumption.

Over the past six months, several policy shifts suggest a pivot towards domestic demand is already underway. It began last September with a reaffirmation of the policy put under Chinese equities. This was followed by a striking shift in housing rhetoric – from ‘houses are for living, not for speculating’ to ‘stop the decline’. Stabilising the property market is crucial to arrest the feedback loop of falling confidence, a debt deflation spiral and the resulting negative wealth effect.

At the same time, President Xi has taken visible steps to rebuild trust with the private sector, meeting firstly with top Chinese executives and then with global business leaders. These moves signal an acknowledgment that private sector confidence is essential for any recovery in domestic demand. Fiscal expansion has also been slated to rise by around 2% of GDP compared to last year, providing a further boost.

Most importantly, the recent Government Work Report explicitly stated that boosting consumption is now the top priority for 2025.

So, what does this new consumption-led growth model look like? In March, policymakers released a high level ‘special action plan’ targeting a broad range of consumption drivers. These include boosting income for both urban and rural workers, improving training and unemployment insurance, stabilising the property and equity markets, and addressing the high household savings rate – which reflects weak social protections. Initiatives to expand health insurance, pension provision and public services aim to free up household spending.

Other measures include expanding trade-in subsidies for appliances, autos and electric bikes, and improving credit access. There’s also a push to reform the holiday system and grow the service sector – notably healthcare and tourism – to create more domestic demand.

While the full details and intricacies of China’s consumption-led pivot are still emerging, the direction of travel is clear. The current trade shock will create opportunities for long-term investors, and given the direction of travel for policy, Chinese consumption plays are worth consideration post the sell-off in global equity markets.

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Iain Cunningham

Since 2021, major economic cycles have been out of sync, presenting macro investors with opportunities to capitalise on policy divergence.

In August 2021, for instance, it became clear to us that US and Chinese policy was set to move in different directions. Chinese authorities had tightened policy notably in early 2021, while the Fed maintained exceptionally loose policy despite a booming economy. We proposed that tight policy in China would weaken the economy and force an easier stance from the People’s Bank of China in 2022, while the Fed would have to tighten aggressively to rein in a US nominal boom caused by excess stimulus in the years after the initial Covid shock.

We believed that Europe would sit somewhere in the middle. With this macro view in hand, we built long positions in the US dollar versus Asian (Chinese yuan and Taiwan dollar) and European (euro and Swedish krona) currencies to exploit these dynamics. These positions were then closed in the summer of 2022 after this period of policy divergence became priced by markets.

Over the next 12-18 months we see policy convergence rather than divergence in the offing.

Our view is that policy is currently very “tight” in the US and Europe, becoming increasingly “loose” in China, and remains very “loose” in Japan. In our view, tight policy in the US and eurozone should result in growth and inflation continuing to moderate, causing the Federal Reserve (Fed) and European Central Bank (ECB) to move into easing cycles over the next 6-12 months.

Increasingly loose policy in China is likely to be maintained to support a bumpy recovery, while the Bank of Japan (BoJ) will either do nothing or tighten modestly due to domestic inflationary pressures. So, while the past couple of years has been characterised by divergence (progressively tighter policy in the US and Europe vs. easier policy in China and Japan) it appears that we are now moving towards a period where these dynamics broadly begin to reverse.

In our opinion, the greatest asymmetry in positioning over the next 12-18 months is between Europe and Japan. Relative to what’s priced in, Europe will be compelled to ease and Japan to tighten.

In the second quarter of 2022 the ECB’s deposit rate was at -0.5%, while real GDP growth was running at c.4.5% p.a. and inflation was at c.8.5% – resulting in nominal GDP growth in double figures. Policy settings at this point were far too loose and inconsistent with prevailing fundamentals.

Currently, the ECB’s deposit rate is at 4%, while real GDP growth is c.0.1% p.a. and inflation a little over 2% p.a. Shorter-term measures, such as 3-month annualised, place inflation closer to zero at present. This is a radically different situation–on a nominal basis the economy is barely growing. In our view, there is a relativity high probability that the eurozone suffers a period of nominal growth contraction over the coming 6-12 months.

In Japan, the BoJ has maintained exceptionally loose policy in recent years. While the Fed and ECB have been raising interest rates and enacting quantitative tightening, the BoJ has been easing. This policy divergence has caused the yen to weaken against the US dollar and euro by c.25% and c.20% respectively since the end of 2021. The BoJ began a slow path of exiting from its yield curve control policy in late 2022 – slower than we had expected – and effectively removed that cap on bond yields in November.

Inflation in Japan has been slower to get going but is now higher and likely to be stickier than in the US and the eurozone. Should this prove to be the case the BoJ could be set to continue the withdrawal of policy accommodation through exiting negative interest rates.

To summarise, we expect major central banks to ease policy and converge base rates down towards that in Japan, with the ECB’s policy settings in particular being contrary to Europe’s weak fundamentals. As such we are expressing the prospect of policy convergence by being long the yen versus the euro in portfolios.

By Iain Cunningham, Head of Multi-Asset Growth

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Iain Cunningham

Ninety One’s, Iain Cunningham, Head of Multi-Asset Growth at the global investment manager with an emerging market heritage and perspective manager, discusses China’s structural headwinds.

This includes those which are well recognised by investors and Chinese authorities, and the winners and losers across local government, state-owned enterprise leverage imbalance, geopolitical headwinds and real estate.

“The primary structural challenges are fourfold: a real estate imbalance, a local government and state-owned enterprise leverage imbalance, weakening demographics and geopolitical headwinds.”

Mounting real estate woes

After a decade of rapid growth, real estate investment as a percentage of GDP peaked in 2014 at just over 14% (at the end of 2021 it was 13% of GDP), according to IMF data. China’s objective is to manage this sector lower over multiple cycles, in line with its “cross-cyclical policy.”

This means that the real estate sector has a significant headwind in front of it versus other areas of the economy. We should see real estate shrinking as a percentage of GDP over the longer term. This is therefore not a sector in which we want to invest.

In line with the China’s regulatory cycle, as times have got tough for the economy over the past year in particular, Chinese authorities have been busy repealing many of the macroprudential measures introduced in 2021 and providing targeted stimulus with the objective of cyclically stabilising the real estate sector.

Bailouts affecting the banking sector

Another key imbalance is local government and state-owned enterprise leverage. This is well known to authorities, who clamped down hard in 2021 in seeking to address off-balance sheet liabilities or “hidden debts.”

This has without doubt contributed to weaker growth in recent years through reducing the spending of local governments.

At July’s Politburo meeting, Chinese authorities pledged to “implement a comprehensive debt solution” for local governments.

In recent months, debt swaps have been announced for a number of provinces, and state banks have been told to do the same now more broadly. This is effectively a refinancing of debt, extending maturities at much lower interest rates. It is a bailout and will allow local governments to continue to function, but it will create headwinds for Chinese bank’s profits.

Geopolitical headwinds

“De-risking” and the reworking of supply chains have reduced foreign direct investment into China and direct Chinese exports to the US.

Our central scenario going forward is a multi-polar world, where connectivity between the developed world and China is reduced, but decoupling is impossible due to the degree that economies are interconnected.

While this is a headwind for Chinese exports to much of the developed world, trade with other countries around the world has been rising sharply. As a result of the increasing importance of countries outside of the G7, Chinese exports have continued to rise in recent years and remain stable as a percentage of global exports.

So, while China faces some material challenges, it’s important to remember that it’s a command economy with a relatively closed capital account.

Therefore, there is no reliance on the kindness of strangers to fund its economy, unlike many other countries around the world. This affords authorities more control in seeking to manage imbalances than elsewhere, in that they can continue to provide liquidity and credit to areas of the economy in need, and defaults are policy decisions.

An improving outlook – who will be the winners and losers?

We expect a more benign outcome for the Chinese economy in the next couple of years as policy makers continue to stimulate until a durable recovery takes hold. Economic growth will continue to moderate over the medium-term, but productivity gains should drive growth, given the low starting point.

While some areas of the economy will be actively managed lower, others should thrive. For example, the real estate sector will be in decline (as a percentage of GDP); the banking system will be required to absorb losses, but per capita income growth will support ongoing trends in premiumisation and localisation; digitalisation will see increased penetration; medical technology will be supported by an ageing population; and certain financial institutions will be beneficiaries of state efforts to divert future marginal savings from real estate into capital markets over time, through the likes of pension reform.

At present, due to the high degree of headline macro uncertainty and pessimism, great companies in China can be acquired at very attractive valuations.

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Iain Cunningham

Ninety One Portfolio Manager Iain Cunningham discusses how the failure of SVB Financial is a consequence of something much bigger – and how we might be facing the start, rather than the end, of a broader cycle of delinquency, default and bankruptcy.

US authorities have announced the full backstopping of depositors at SVB Financial, while also implementing a new system-wide lending program to ensure that banks can meet requests to withdraw deposits. Many will remember from the global financial crisis (GFC) that it was full deposit insurance that was ultimately required to halt deposit flight and, as a result, this action should stem the emergence of systemic risk for the time being.

However, the failure of SVB is a consequence of something much bigger. Over the past 12 months, we have been rapidly exiting from a false equilibrium that began to form in the years after developed world economies emerged from the GFC. A false equilibrium is a theoretically unstable or unsustainable situation that has been so long lived that it appears to be a true equilibrium. The false equilibrium here is the decade and a half of excessively easy money, through near zero or negative interest rates and quantitative easing.

Policy makers have, for some time, set policy far too loose relative to prevailing economic fundamentals, evidenced by the material appreciation in asset prices over the period. Policy makers have been willing to “pivot” or add stimulus at any sign of a wobble, seeking to minimise economic and market volatility. Such action has increased confidence and deeply embedded this false equilibrium in the decision-making processes of many households, corporations and even governments. Unfortunately, history shows that even relatively short periods of mispricing the cost of money can lead to capital misallocation with economic participants taking more risk than they should, with tolerance for leverage, duration and illiquidity risk all increasing during such periods.

By their nature, false equilibria cannot last forever. The doubling down of easy money during and post the pandemic ultimately created inflation, which broke the condition required to maintain the false equilibrium. Over the past 12 months several major central banks have, after a slow start, moved quickly to fight inflation and as a result, we have moved rapidly away from an environment that had become normality and the assumed equilibrium for many.

The most speculative “investments” of the prior cycle have already come under substantial pressure, whether it be crypto currencies, NTFs, SPACs or unprofitable technology companies. We are now beginning to see early signs of businesses that built their operating models around the false equilibrium begin to struggle, such as SVB Financial. Beyond this, we see material imbalance in household leverage and housing markets in several countries around the world beginning to consolidate. We also see evidence of zombie companies. Then there are the things we can’t see yet, which have a habit of floating to the surface as the rising cost of money and slowing growth begin to place pressure on cash flows.

Economic cycles tend to be characterised by the growth of imbalances or excesses during the expansion, followed by their cleansing during recession. The false equilibrium of the past decade has created obvious imbalance and excess, and inflation has clearly broken the condition required to maintain it. The failure of SVB is a consequence of something much bigger and is likely to be the beginning of a broader delinquency, default and bankruptcy cycle rather than the end.

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