Seasonal Disturbance Brought Weak Demand and Supply, but Limited Downside Risk Seen


The Macro Economy and Finance

Overall, October domestic supply and demand were both weak. However, when we adjust for the seasonal decreases in industrial production and credit financing, the impact of the holidays, and the delaying effect of 11-11 super buying day on consumption, the real fundamentals showed no sign of worsening. We believe the downward risk of the economy has been abated. Considering the cuts in MLF rate and infrastructure investment reserve ratio, the economy is on solid support for the coming two months. It is unlikely that the whole year GDP growth will dip below 6%.

Supply side data shows October industrial output declined, following a seasonal pattern we witnessed in April and July, when the “quarter-end push” caused production to rise and then drop. The pattern is the result of the more pronounced effect of policies on bank credit during an economic downturn, which increased at the end of a quarter. Sector-wise, the drop in export production and production limits for environmental purposes are the main negative factors. As weak as October data is, it is still better than the August low. Whether industrial output can have a smooth recovery in the following two months and 2020 will depend on the timing of external demand, improvement of domestic private sector business environment, and further fiscal and monetary policy support. All the above factors will take time to materialize. As a result, industrial production will not see a massive reversal soon. We maintain our opinion that industrial output will hover at a low level with the presence of downward pressure.  However, production is expected to stabilize when it reaches a low level because of the presence of supportive policies.

Total fixed asset investment in October faced deceleration, but resilience remained. In the short run, there is little possibility of it dropping off a cliff.  Manufacturing investments rose from a low level, posting significant growth during the month. Notably, state-owned or government industrial investment funds were the main forces pulling the growth under the guidance of government policies. There is little enthusiasm among private companies to expand their investments. Endogenous investments in manufacturing is weak and its sustainability is yet to be determined. On the infrastructure side, October investment growth fell because of various factors such as the exhaustion of 2019 targeted debt issuance quota, but because of the underpinnings of policies enacted by the Standing Committee of the State Council on November 13, future infrastructure investment growth is expected to rise from its low level.  Finally, on the real estate side, October development slowed, but as strong sales figures provided liquidity, Fourth Quarter growth is expected to maintain current speed.  Over the medium and long term, infrastructure and real state sectors’ support cannot be sustained. As the tight local government fiscal situation persists, the former is limited by the decrease in revenues from land sales and taxes, despite the issuance of targeted debt. The latter is confined by the policy that excludes housing from investment purposes. The next round of real estate investments are not expected to repeat the same high growth story from the past.  In fact, manufacturing investment remains the key. Whether fixed asset investment as a whole will see a recovery will not only depend on policy guidance and industrial funds set up by state-owned capital sources, the support from capital market is also crucial.  Private equity institutions will play an important role in this process.

On the domestic demand side, consumption by the residents remained muted. November retail growth will be boosted by the 11-11 super buying day, but the Fourth Quarter is still expected to see a low consumption trend. External demand stayed weak as well with recessionary surplus expanding further.  Despite the optimism with US-China trade talks, a recovery in trade, brought by resurging export to the US from China, is not expected to come soon.

On the financing side, October private financing posted a steep drop in growth speed. On-the-books loans and targeted debts are the main drags to the private financing scene. Structurally, the shrinking on-shore short-term loans caused total credit to weaken.  The reason could be partially due to the BIRC’s scrutiny over real estate-related consumer loans and tightening regulatory pressure over internet-based loans. As a comparison, corporate medium to long-term loans, which usually reflect the real economy’s financing needs, have posted three months of growth.  The reason lies in the implicit debt replacements by the regional governmental investment vehicles, which move off-balance-sheet items around and seemingly increase medium to long-term corporate loans but are not necessarily a sign of recovery economy. In addition, the slowing of the decrease of off-balance-sheet financing could mean marginally improving real estate financing.  Finally, there are discussions in the market place about using next year’s local debt quotas this year. Year-end private financings will be firmly boosted if next year’s quotas could be moved into this year.

The exchange rate was boosted by the positive progress of US-China trade talks, Fed’s restart of debt purchasing plan announced in mid-October, and the third rate cut by the Fed in the year. Off-shore Renminbi to USD spot rate continued to rise a level below 7. Correspondingly, October foreign exchange reserve also posted a small increase.

Private Equity Investments

Firstly, fund raising continued to slide with a pronounced 20-80 effect. Angel and VC fund raising shrank at a much faster rate than private equity’s. Private equity funds were able to maintain a stable fund raising level, mostly due to the boost from infrastructure, real estate, and distressed funds. For most operating PE institutions, fund raising is much more difficult than the numbers look. To help ease the situation, the NDRC issued a new asset management guidance on October 25, clearly spelling out that VC and state-owned industrial funds are exempt from layering limits in a positive message to the sector. The institutions, on the other hand, have become more active in raising foreign currency funds.  USD funds have further diversified.

Secondly, there has been a significant drop in deployment of funds, including foreign currency funds. Many investors have adopted a wait-and-see attitude. Funds that actually are invested focused on hot areas such as IT, internet and healthcare, and on expanding and mature targets.

Finally, on the exit end, the STAR Board has seen a flood of IPO exits. During the first three quarters, Chinese equity market saw an increase by 54.4% of IPOs.  The STAR Board, with its high issuance frequency, has been the main contributor to the increase of exits. Nevertheless, return from the target companies that were listed in the first three quarters has not been stellar as a whole, despite the new path that the STAR Board blazed for them. Exiting remains a difficult process.

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