Fundamentals Continue Weak Trend, ‘Six Stabilities’ Stressed Again by the State Council

The Macro Economy and Finance

Overall, August economic numbers continued the downward trend of July. The small increase in infrastructure investment cannot offset the weakness in terminal demand and enterprise production. The downward pressure further gains strength on the economy.

In August, industrial value-added fell back significantly, hitting a record low growth speed in history. The main reason behind the weak industrial output is a combination of the continuously weak domestic demand and active destocking by the companies. In addition, new tariffs imposed by the US indirectly affected the industrial production. From the manufacturer’s perspective, in the short term, businesses (especially the small businesses) will still lack motivation to produce, which could create a drag on the third quarter industrial output, and further slow down the GDP growth.

Investment in the manufacturing sector shrank in August after three months of recovery, causing the growth of fixed assets investment to drop compared to same period last year, although the drop was smaller than those in previous months, thanks to investments in infrastructure. Considering the increasingly pronounced counter-cyclical policy support, investment in the manufacturing sector is likely to rise again. At the same time, infrastructure investment is likely to continue the upward trend. Investment in the real estate sector stayed on the downward course but remained controllable.

On the domestic demand side, the effect of inventory clearance of the China 5 standard automobiles is fading. Weak demand caused auto sales to decrease further and dragging down the August consumer spending growth. Looking ahead, the downward trend in the job market and real estate sector will definitively dampen residents’ income and wealth growth. Second half consumption growth is expected to slow.  

Externally, the effect of US-China trade friction became more pronounced. Recessionary surplus further expanded while the exodus of processing trade was increasingly obvious. On the long term, even if cooler heads prevail in US-China talks, export will still inevitably slip in the slowing global economy.     

Corporate financing in August was level compared to the same period last year but an obvious increase compared to July. Renminbi loans increased steadily, while the amount of off-the-books undiscounted bills posted a positive growth. Direct lending, however, contributed less to the total amount of financing as it was limited by regional annual quotas and timing of issuance. Overall, August private financing growth steadied again at 10.7%, level compared to the same period last year. On the other hand, mid- and long-term loans to companies grew significantly in August compared to same period last year, both in terms of size and percentage share, reflecting a long-awaited recovery fueled by strong policy support and quickened infrastructure investment. Small and micro private enterprises still faced a credit barrier stubbornly against them and real economy demand was still uncertain. Considering that the State Council Executive Meeting had definitively allocated new quotas for targeted new debts for next year with a guarantee that it would be used at the beginning of the year, we estimate that part of the new 2020 regional debts will be issued before the end of this year. Acting in accordance with bank credits, infrastructure investments are expected to provide powerful support in the fourth quarter to boost the economy.

As a result of the intensification of trade war expectations, the Renminbi exchange rate in August fell to a level above 7, reaching a high point of 7.19. Over a longer term, as US economic increasingly risk going into a recession, a second rate cut is expected in September. With the 10-year national debt interest differential at 150 basis points, the room for further RMB depreciation is limited.

On a macro level, August data indicated further pressure against economic growth. The decision makers on National Council Executive Meeting on September 4th reiterated their plan to apply policies on specific targets and implement the “Six Stablizations” plan. Fiscally, targeted loans will be issued at a faster pace to boost effective investments, overcome certain weaknesses, and push up domestic demand. Monetarily, general and targeted required reserve ratio cuts will be used to lower financing costs of the real economy. While the governmental fiscal budget is tight, taxes and fees will still be lowered. These policies reflect both the serious situation that the real economy is facing and the determination of the government to support the economy. They are positive news for boosting confidence.

Looking ahead, four pieces of news are notable. One, infrastructure investments will further boost the economy with favorable credit and policy support. Although a rebound is not expected, fourth quarter would not likely see a significant slip. Two, the real estate sector is resilient. Although the regulatory agencies still try to suppress speculation, policy announcements since September indicate that real estate sector is still a stalwart of the economy and there is room for adjustments. Three, generous credit policies continue to be effective as August mid- and long-term loans to enterprises rose both in size and percentage share, a favorable news to future recovery of the real economy. Fourth, as the year closes, further escalation of US-China trade war  becomes less likely, boosting capital market confidence in both countries.

Lack of credit among certain real estate firms, credit crises of regional small banks, and further deterioration of US-China relationships are risk factors we focus on.

Private Equity Investments

Fund raising is in a chilling phase. Renminbi fund raising is slowing in both amount and closing speed. From the point of view of an individual investor, USD fund investors are relatively mature and more receptive to blind investing. High networth Renminbi investors tend to perform thorough researches on the projects. The researches are a two-edged sword in that they alleviate the pressure on the asset managers, but they make it much more difficult for asset managers to acquire assets and charge fees.

From an institutional point of view, many private enterprises face financial difficulties while the limited funds concentrate on top companies. Thorough researches are demanded for investments not into the top firms. State owned companies have a much easier time, but they increasingly ask for co-GP status or even direct management by themselves. The reason behind it is a. private equity institutions have not produced good returns for investors; b. irregularities still abound in domestic capital markets and professionals are not necessarily better money managers. Investors’ own teams do not fair much worse than professional money managers.

The difficulty to raise funds from local governments also increased significantly as four issues present themselves in many cases. 1. Local governments’ funding rates are dropping to around 30% from 40%-50%. 2. Specific requirements for use of funds are increasing. 3. No funding without project details. Local governments are demanding specific projects being acquired before investing, rather than funding first. 4. Governments are participating in management and even asking to be GPs.  Even with promised funding, newly appointed official often do not honor predecessors’ promises. Reneges happen frequently. The reasons are: 1. Local governments are facing tight budgets after several rounds of debt issuance. 2. Developed area governments have been the target of PE institutions repeatedly. They have developed an understanding of the sector and are less willing to open their pocket books. 3. Local governments aim to introduce industry into the region. However during previous cooperation with PE firms, funds were not always deployed but rather sat in the bank accounts, leaving a bad taste in the investors’ mouths. 4. As the PE sector experiences difficulties, more institutions are seeking funding from governments.

In August, Blackstone, Carlyle, and KKR, the three giants of US listed asset managers, issued their half year reports. Financial figures show a good growth picture as US equities rebounded from the low of December 2018 and fund raising managed to reach a new height.  However looking further into the future, considering that the first half global economy has shown signs of slowdown and IPO and M&A transactions are becoming more difficult, all of the three firms expressed concerns as to the future of private equity exits and returns in the next phase.