Abstract: In this article, analysts at the Zhongtai Securities discuss the reasons for the recent tumble of Chinese stock market, the impact of the sharp rise of the US Treasury yields on China’s monetary policy and capital market.
I. The impact of rising US Treasury yields on A-shares and concentrated holdings: a historical perspective
Xu Chi, a strategy analyst at Zhongtai Securities’ research institute, discusses the relationship between US Treasury yields and “meme trade” among Chinese institutional investors from a historical perspective. According to Xu, with the recent rally of commodity prices such as crude oil and copper, the US Treasury yield exceeded 1.5%, causing drastic adjustment in the global equity market, especially in crowded stocks.
With the booming of commodity prices, will the rising Treasury yields cause systemic risk in the global capital market? What will be the impact on the market structure, investment style, especially overcrowded stocks?
A study on the comparable periods in the history of the US stock market and A-share market shows that:
1. The US stock market fluctuated upward most of the time when Treasury yields rose, so there is no need to worry about systemic risk at the moment
First, in the past 50 years, the US stock market represented by the Dow Jones Industrial Average Index oscillated upward most of the time when commodity prices and Treasury yields rose, (e.g. in 2003-07, 2009-10, 2016-18, etc.), which is opposite to the market concern that rising Treasury yields may lead to the burst of bubble in the US stock market and cause systemic risks.
Here's why: rising Treasury yields and commodity prices reflect expectation on recovery of the US economy; and the outlook for earnings, not the liquidity condition, is the most important determinant of stock prices in the medium to long term.
In fact, large corrections in US stocks (20% or more) tend to occur during periods of rapid decline in Treasury yields, such as those after the dotcom bubble in 2000, the financial crisis in 2007-08, the trade conflict between China and the US in the second half of 2018, and during the COVID-19 pandemic in the first half of 2020.
Therefore, even if the Treasury yields continue to rise, there is no need to worry about systemic risks in the global market at present; neither will it change the positive trend of A-shares in the medium and long term.
2. Shift of investment style amid rising Treasury yields: high-valuation sectors heavily held by institutional investors may be most negatively affected
Although we don’t need to worry too much about the overall risk in the market, the booming of commodity prices and Treasury yields will have great impact on the structure of the market. For instance, high valuation sectors that are heavily held by investors will be affected the most. Therefore, rising commodity prices and Treasury yields can easily cause change in the investment style accompanied by strong market fluctuations.
"Overcrowding" refers to a situation in which funds of institutional investors continue to pile in even when valuation of the sector already reached historical high, while the contribution of company performance to stock prices become increasingly weak.
The rise of commodity prices and Treasury yields will impact the valuation-to-performance ratio of sectors heavily held by institutional investors from two dimensions. First, expectation on interest rate rise and tightening of liquidity will break the logic that pushed up the valuation of the crowded stocks; second, rise of raw material prices and interest rates tend to change the relative profitability of companies in different industries, which can weaken the expectation on the high profitability of the crowded sectors.
The collapse of the Nifty Fifty in the US in the 1970s was the most typical example. High economic growth in the 60s, rapid growth of company profits fueled by tax cuts as well as the loose liquidity conditions during the Nixon administration, together drove the valuation of the Nifty Fifty consumer stocks in the early 70s to more than 2.5 times of the S&P 500. However, the rise of commodity prices and interest rates during the oil crisis destroyed the logic behind the high valuation of these stocks. Besides, the Nifty Fifty enterprises were mostly specialized in consumer goods, so the rise in the price of raw materials led to rapid decline in net profits, a phenomenon known as the "Davis double play".
Meanwhile, Nasdaq was launched in the 1970s, when the digital revolution was just getting under way. Emerging tech companies represented by Intel were seeing high profit prospects and were less affected by rising raw material prices, which helped improve their valuation-to-performance ratio.
Over the past decade, the A-share market went through two cycles in which commodity prices and interest rates both rose: the post-financial crisis stimulus program in 2009-2011 and the supply-side structural reform in 2016-2018.
The two cycles both had great impact on the A-share market in terms of sector preference and investment style. The rise of commodity prices from 2009 to 2011 shifted investor preference from the financial sector which were overcrowded for three years since 2006 to beverage and medicine shares. The rise of commodity prices and interest rate in 2016-2018 broke the concentrated holdings of TMT stocks that began in 2014 and led to a market focus on ‘core assets’.
3. Implications
First, based on historical experience, rising Treasury yields will not cause global systemic risk, nor will it change the overall positive trend of the A-share market in the long run despite some short-term shocks.
Second, stocks which are heavily held by investors and overvalued can be highly risky amid rising commodity prices and interest rates. It is wise for investors to eye stocks with greater elasticity in performance than valuation, which include defense and tech stocks, stocks in the CSI Smallcap 500 Index with high growth prospect whose prices are suppressed, stocks on energy and chemical products, non-ferrous metals amid the large commodity cycle, as well as undervalued blue-chip stocks such as those in the insurance and financial sectors.
II. Will the rise of Treasury yields trigger interest rate hikes in China?
According to Zhou Yue, chief analyst of fixed income at Zhongtai Securities, despite the recent volatility in the equity market, China’s bond market has been relatively stable. The rising Treasury yields and inflation trade overseas have no obvious impact on China’s bond market at present.
This is because the Chinese economy will report relatively strong growth, possibly peaking in the first quarter, before slowing down.
But the peak of economic performance does not necessarily correspond to the peak of interest rates. Transactions based on the assumption that the peak of economic performance will occur in the first quarter could be risky.
First, it is important to distinguish between long-term trend and short-term fluctuations because quarterly peaks do not necessarily mean that monthly data will lose momentum. Economic performance in March and April will likely remain strong with little sign of rapid pullback in near future.
Second, commodity prices will still face upward pressure in the second quarter. At present, Europe and the United States are seeing rapid progress of vaccination, so their economies will very likely recover rapidly in the second quarter. However, the vaccination in countries rich of natural resources (developing countries in Latin America) may accelerate only in the third quarter, so there may be a mismatch between supply and demand of commodities in the second quarter, causing commodity prices to continue to rise. This can also be reflected in the reflation trade around the world and rising US Treasury yields.
Finally, regarding liquidity, market consensus is that policy is not expected to make sudden turns, i.e. a tight balance will be maintained. Judging from the stance of the PBOC, it might be wise for the market to assess monetary policy not only based on the quantity of liquidity, but also cost of capital. Considering both inflation and the exchange rate, it is unlikely that the PBOC will raise the interest rate.
It might be the opposite for bond investment, for which investors not only need to pay attention to the cost of capital, but also the amount of liquidity. One reason is that liquidity conditions are quite uneven for various segments of China's bond market, that is, liquidity conditions for large commercial banks, small and medium-sized banks, and non-bank institutions are quite different. Even when the cost of capital remains the same, liquidity can still be tight if the volume is not big enough.
III. What is the relationship between Treasury yields and China's stock and bond markets?
According to Xiao Yu, a fixed income analyst at Zhongtai Securities, the rise in US Treasury yields could be attributed to several factors such as the acceleration of vaccination, the $1.9 trillion stimulus package, rapid economic recovery, and the recent rise in oil prices, i.e. the so-called "reflation trade".
According to Bernanke's classic analytical framework, the long-term Treasury yield can be decomposed into three factors: expected real short-term interest rate, expected inflation and term premium. Of the 45 basis points (bps) increase in the 10-year Treasury yield in February, inflation expectations (as measured by breakeven inflation) contributed only a few bps as the market expected no rate hike until the end of 2021 assuming that real short-term interest rate remains unchanged. The main contributor to the 45 bps rise in the Treasury yield was the rebound of term premium. This reflects market's concern about the supply of Treasury bonds following the passage of the $1.9 trillion stimulus package and the tapering of QE by the Federal Reserve.
What would be the highest point of the 10-year Treasury yield? Inflation expectation in the US is around 2.2% at present, close to its peak since 2014. Even taking into account rising oil price, recovery of the US services sector, and improved consumer spending, the room for further rise in the Treasury yield is still limited.
Term premium peaked at around 0.1% in 2018 which is close to the current level. The current term premium is very likely to reach phased peak unless the Fed significantly reduces the scale of QE purchase. Assuming the Fed does not raise the policy rate, it is unlikely that the 10-year Treasury yield will rise above 2% by the end of this year.
In addition, the labor market is still far from full recovery. Under the dual mandate of maximum employment and stable prices, if the Treasury yields further rise, the Federal Reserve will likely implement yield curve control to bring down long-term yields.
As the anchor for the pricing of risky assets, rising US Treasury yields may have a great impact on global capital markets. In terms of US stocks, the 1.5% 10-year Treasury yield has exceeded the current S&P 500 dividend yield. From a valuation perspective, US stock market does face considerable correction pressure. Since 2008, 10-year Treasury yield has briefly jumped above S&P 500 dividend yield for four times, which occurred in May 2013, February 2015, November 2016 and December 2019, respectively. The S&P 500 fell close to 4% in a short span of time during the first two times, but did not change much during the last two times.
For the A-share market, the China-US interest rate gap narrowed to 170 bps, a significant fall from last year's high of nearly 250 bps. The market is worried that capital inflows will significantly slow down. Considering that China has not fully removed its capital account control, there won’t be obvious correlation between the China-US long-term rate spreads and the RMB exchange rate / cross-border capital flows.
Moreover, even if the 10-year US Treasury yield rises to 2% and the China-US interest rate spread narrows to 130 bps, given the “comfortable” range of 80-100 bps as proposed by PBC Governor Yi Gang in 2018, there is still a strong “safety cushion” against a reversal of capital inflows.
As long as the Fed does not raise the policy interest rate, it is unlikely that the PBOC will raise the interest rate to respond to RMB depreciation pressure. The narrowing of the China-US interest rate gap will mostly bring an emotional shock, and the impact on the domestic market is more of a short-term disturbance.
IV. What is the pressure on credit bonds if liquidity tightens?
Gong Chenghua, a fixed income analyst at Zhongtai Securities, points out that the repayment of credit bonds in 2021 (including repayment at maturity, buyback and early repayment of principal) will increase by about 17% compared with 2020. The repayment will peak in March and April this year, with a year-on-year growth of 66% and 21% respectively compared with last year.
Specifically, repayment at maturity has increased significantly, therefore the repayment pressure is large. The amount of repayment of urban investment bonds and industrial bonds is estimated to increase substantially, by about 101% and 51% year-on-year in March, and about 34% and 15% in April, respectively.
Since the end of last year, monetary policy has seen adjustments and credit expansion has slowed. Given increased amounts of bonds due and reduced issuance, the pressure on credit bonds repayment is expected to increase. For industrial bonds, the outlook for cyclical industries has improved, but corporate profitability is still uncertain, industrial bond issuers with weaker liquidity and financing capabilities may face growing pressure of immediate repayment.
Urban investment has played an important role in credit expansion and will continue to do so in 2021. However, because reliance on infrastructure construction for economic growth has reduced, and the related financing policies have changed, regional differences may emerge. It is necessary to keep a close eye on the tail risks in regions with poor financial performance and high debt levels.
According to Gong, traditional analysis of urban investment bonds is flawed because it is based primarily on local governments’ solvency and willingness to repay. Several dimensions should be added when assessing local urban investment enterprises:
1. Social financing in the region. The debt rollover of local state-owned enterprises mainly relies on funding from financial institutions, rather than fiscal revenue, so we need to pay attention to the condition of local financial resources and their changes.
2. Credit condition in the region. For prefecture-level cities, bank loans are often an important source of financing for poorly qualified platforms. Data show that cities reporting negative growth are mainly concentrated in northeastern provinces and Inner Mongolia. Urban investment companies in these regions may face refinancing pressure due to the shrinkage of credit resources.
3. Growth of fixed investment. Infrastructure investment in regions with high debt levels will be constrained by local debt regulation, so the growth of fixed investment can be used as an observable indicator to judge the debt pressure of a region.
V. Will investor preference switch to cyclical products?
Tang Jun, chief analyst of financial engineering at Zhongtai, believes that although concentrated holdings in the A-share market has briefly reduced, the long-term trend is difficult to change.
US Treasury yields fluctuate around the nominal GDP growth rate over the long run. The recent rise in Treasury yields reflects the market's expectations of economic recovery and reflation as the pandemic recedes. The rise in Treasury yields has very limited impact on China’s interest rates. The interest rate of China’s government bonds has long deviated from nominal GDP growth (potential average return on investment), and instead may be more influenced by regulations that seek to prevent funds from simply circulating in the financial sector.
Most of China’s corporate bond interest rates are also significantly lower than the nominal GDP growth, which may reflect the long-standing guaranteed repayment expectation. Therefore, abolishing this rule may be the most important factor affecting the overall interest rate level of credit bonds.
The shift away from the short-term overcrowding in the stock market may be attributed to falling risk aversion as the pandemic eases. In the short term, the valuations of crowded stocks such as leading consumer companies are at a relatively high level, while the valuations of leading companies in traditional sectors such as real estate and public utilities are at historically low levels, with a dividend rate of more than 4%. As risk aversion falls, the need for short-term mean reversion is very large.
In the long run, the real estate sector will be affected by the decline in labor force and the slowdown of the urbanization process, and the traditional infrastructure investment will be affected by local governments’ deleveraging efforts. It is difficult for the traditional cyclical industries to have an across-the-board recovery and a long prosperity cycle. Therefore, after the valuation of traditional cyclical industries gradually moves to a normal range, the long-term investment preference will continue, and investment opportunities for technology and consumption goods will remain significantly greater than those of traditional cyclical industries.
VI. Northbound funds: a make-or-break factor
Wang Shijin, a strategy analyst at Zhongtai believes that the rise in US Treasury yields has little correlation with inflation expectations. The rise in Treasury yields since February has been dominated by rise in real interest rates. Bond yields are mainly a reflection of economic growth and inflation. In most cases, rise of interest rates indicates that the profitability of the real economy is on the rebound and the return on investment is improving. Especially in emerging markets, interest rates tend to run in the same direction as stock indexes.
Nominal interest rates are composed of real interest rates and inflation expectation. Since September 2020, with the progress of vaccine development, a moderate increase in inflation expectations has driven interest rates upward, accompanied with the dual rise in global stocks and commodity prices. These all reflect the normalization of the economy. Since February 2021, the US 10-year Treasury bond yield has risen from 1.09% to 1.54%. Inflation expectation calculated based on US bond data has not changed significantly, while the real interest rate has risen rapidly by nearly 40 bps, a main contributor to this round of interest rate rise. This was also reflected in the price of gold. Usually, the price of precious metals is negatively correlated with the actual yields.
Generally speaking, a moderate rise in bond yields reflects expectations of economic recovery, while a sharp short-term surge is caused by shortage of liquidity. In particular, this round of US Treasury yields rise has started from a historically low level. The current market condition is similar to the “Taper Tantrum” in 2013.
The difference is that in 2013, US economy and employment had been recovering for a long time, and the market began to worry that the Fed would start to exit QE. This time the trigger may be the expected increase in supply. Government borrowing planned in 2021 is about 3-4 trillion US dollars, including the 1.9 trillion stimulus package, and 1-2 trillion infrastructure recovery plan. The market has shown responses to the mentioned plans.
Another important factor is debt repayment pressure. According to statistics in early January, 5.8 trillion US bonds will mature in 2021, and 2.5 trillion US bonds will mature in 2022. In contrast, only 1 trillion US dollars matured in 2020. On the whole, the Fed’s current purchase of debt of $120 billion each month cannot meet the fiscal demand.
The Fed is one step closer to implementing yield curve control. In the short term, the Fed can stabilize interest rates through forward guidance and other means, but the upward momentum is still strong. Increasingly high interest rates would put a drag on the recovery of G7 economies, and take the Fed one step closer to adopting yield caps, at which the buy point for gold may emerge. However, one of the concerns Fed has is that the QE has been the main cause of the widening income gap in the past 10 years. The rich have become richer, because their assets have benefited the most from monetary easing. Monetary policies around the world are also facing political constraints.
For the stock market, before the Treasury yields stabilize, global stock markets may still see volatilities for a long time. But the space for index corrections may be limited. The safety margin of individual stocks is very important at this stage. As the interest rates are rising, it is recommended to focus on companies with good cash flows. The impact of recent commodity price increases on inflation have not yet been revealed by data, but the pressure on the costs of some midstream industries is already obvious, which may affect the earning expectations of these companies, and we need to keep track of whether it can be transmitted to the downstream industries.
There is also a risk that may occur at some point in the future. At the end of last year, we emphasized that northbound funds from Hong Kong can hardly form the main source of capital inflows. The pricing of A-shares is determined by public funds. But we must note that northbound funds can be the largest source of capital outflow. Stocks dragging down the index recently are mostly those heavily held by northbound funds. They flood in when the US dollar goes weak and rush out when interest rates on US bonds rise.
VII. Recent volatilities will not reverse the uptrend in the long run
According to Chen Long, chief strategist at Zhongtai Securities, recent market volatilities were mainly due to short-term fund flows. On one hand, the market expects the liquidity to marginally tighten amid global economic recovery driven by worldwide introduction of vaccines and the Biden administration’s $1.9 trillion stimulus plan. Today, the yield of the US 10-year Treasury surged to over 1.5%.
On the other hand, given the stamp tax hike by the Hong Kong Exchange and the expectation for tighter liquidity, investors turned more risk-averse and preferred profit-taking. Stocks heavily held by institutional investors experienced more drastic adjustments, with wine stocks seeing the biggest tumble.
Economic growth and liquidity outlook will be two major factors determining the market situation this year. As most of the risks have been dissolved in the recent dive, we suggest planning in advance and investing in sectors with solid fundamentals and accelerating growth.
If we look at companies’ annual reports, as of February 26, 2021, a total of 2424 A-share companies released their earnings projection, 1391 of which expected positive net profit, accounting for 57% of the total, a proportion that has been rising for three consecutive quarters.
Our calculation shows that the growth in the profits of A-shares has surged from -6.3% in Q3, 2020 to 76.6% now with the inflection point around the corner. In 2020, midstream manufacturers had the biggest profit improvement, followed by companies in the TMT, consumer staples, upstream resource, midstream raw material, consumer discretionary, big finance and midstream industrial service sectors. The top three sectors are experiencing remarkable growth, with that of midstream manufacturers of new energy, power equipment, machineries, and defense products speeding up for two quarters in a row and ranking top among all major sectors.
Chen expects further growth in two sectors. First is consumer goods and services, including leisure food, frozen food, beer, cinemas, short videos, among others. With people staying put during the Spring Festival, growth of the food and entertainment sectors has beaten expectations and is anticipated to accelerate across the whole year. Second is high-end manufacturing, including new energy supply chains, high-tech manufacturers, defense product makers and high-end equipment makers.
VIII. Have mutual funds changed their investment pattern?
Liu Luoning, analyst at the financial engineering department at Zhongtai Securities, notes that the exposure of funds in the mid-upstream industries has significantly increased since February. As of February 25, the median of mutual funds’ exposure in the mid-upstream had risen by 4.7% while that of their exposure in the consumer goods industry had declined by 4.2%.
Liu does not see substantial change in the clustering behavior of institutional investors. As of Q3, 2020, the proportion of the market value of heavy holdings by the top 10 funds in China was 26.7% of the market value of all heavy holdings, which was high relative to historical levels. According to past quarterly data, there are 985 stocks that mutual funds hold heavily, while the top 200 contribute to 80% of total market value.
In fact, if we present the accumulated holdings of different stocks in descending order, we can see there are only 40-70 can be deemed as core holdings. As of Q3, 2020, the top 13% of stocks that were heavily held by funds contributed to 80% of the total market value of all heavy holdings, so the holdings by institutional investors are indeed quite concentrated. In history, only during June 2015 and June 2016 did the market witness a slight breakaway from such high concentration, when the top 28.4% of heavily-held stocks contributing 80% of the total market value of all heavy holdings. In addition, the choices of core holdings are quite consistent, with 70-80% from the previous period remaining in the pool. That’s why Ping An Group, Yi Li Group and Heng Rui Pharmaceutical are usually seen among the heavy holdings by funds.
Hence, Liu believes that clustered trading by institutional investors is a normal behavior and shows little sign of fading. It’s more important to pay attention to how the mutual funds adjust the weight of their various core holdings.
IX. Capital market in the era of globalization: valuation is of paramount significance
Li Xunlei, Chief Economist at Zhongtai Securities, pointed out in a report during the Spring Festival that China now faces three gluts—that of goods, of money, and of assets. This indicates strong supply capacity, as evidenced by the destocking, capacity cut and deleveraging moves in the real economy starting from 2016.
Many companies are waiting to go public on the A-share market, which had the largest scale of IPO financing in the world last year. That said, the proportion of direct financing is still low in China, which shows the whopping amount of total social financing here.
Despite oversupply in the aggregate amount, structural shortage of goods, money and assets exists, which caused the continued rise of core asset prices over the past four years and gave rise to the structural bull market.
But the price of core assets will not climb forever. Eventually the prices will be determined by valuations of the assets. If this wave of market uptrend is not driven by profit growth but by the rise in valuation, when the market interest rate goes up as the economy recovers, the valuation will go down. Besides, the interest rate of 10-year government bonds in both China and the US as well as DR007 are all around 80 bps higher than their lowest level last year.
Historical data show that only one in 100 companies can have a profit growth of over 20% for five consecutive years. So, as good as high-growth stories may sound, market valuation is tied to economic reality. Although the A-share market have never gone through a 12-year bull market like the US market, the stocks are not cheap if we examine the valuation of core assets. The collapse of the Nifty Fifty stocks in the US in the early 1970s could be mainly attributed to the fact that valuation of consumer shares had mounted to over 2.5 times of S&P 500 index at that time.
With zero interest rate in the US, Pfizer has a P/E ratio of less than 20, Coca Cola, 27, and Apple, 32. How will these companies be valued were they to be listed on the Chinese market? Over the past decade, the valuations of banks, real estate, public utilities and other cyclical sectors were significantly lowered and more in line with the valuations in the global market. However, because of structural shortages, the valuations of core assets such as high-tech and big consumption stocks have been going up which, however, cannot be sustained. If we call the global stock market rally against negative growth worldwide in 2020 a “spring in the winter”, will we go through a “winter in the spring” this year?
The rise in the US Treasury yields was only a trigger of the stock market volatilities. Historical data do not show any significant correlation between the Treasury yields and stock prices in the US.
However, changes in the fund flows from Hong Kong to the A-share market are definitely related to the US Treasury yield hike. Appreciation of RMB last year attracted a large amount of capital inflow into the Chinese capital market; similarly, the soaring dollar index last night would weaken the expectation for RMB appreciation, thus stemming northbound fund inflows or even resulting in outflows. While these funds are mostly invested in core assets, they are a maker or breaker factor to the A-share market.
Will the opportunity brought by the commodity price increase to cyclical stocks sustain? Li thinks that this wave of commodity price growth will be shorter and weaker than the one back in 2009-2011. The gap between supply and demand for commodities is caused by recovery from the pandemic. There will not be massive restocking as it is China rather than the US who has the biggest demand for them. China takes up half of the global consumption of commodities excluding crude oil, but its demand will not go up remarkably. The situation today is totally different from that in 2009-11 which featured heavy chemical industries and infrastructure investment booms.
The manufacturing industry only contributes to less than 20% of GDP in the US. In 2021, investments in infrastructure and real estate will continue to grow steadily in China. India with the second largest population is contributing less to global economic growth. Considering these factors, how strong will the demand for commodities be? Therefore, increase in the price of cyclical stocks is more a result of valuation increase.
Major economies are overdrawing their future when they inject stimulus with excessive money supply and massive borrowing, which will aggravate social division and conflicts. The underlying problems with the global economy are the lack of motivation for reforms amid long-standing peace and a distorted social structure. The countercyclical measures adopted by central banks and fiscal authorities seem to have solved the liquidity crisis without incurring much pain and had the best of both worlds by protecting the interests of the rich while subsidizing the poor; however, data show that the wealth gap has actually widened because the capital gains are much higher than the subsidies.
It will still take years for the A-share market to become truly internationalized, and the valuation of stocks is not geared up to international practice. Therefore, the valuation of core assets will remain at relatively high levels even after a round of downward correction.
Preventing systemic risks will remain a policy bottom line. Despite the changes in the behavior of mutual funds in the short run, it’s unlikely that they will turn to invest heavily in totally different stocks considering that China’s economic growth is transforming from being investment-driven to consumption-driven, with traditional industries gradually giving place to emerging ones.
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