The relationship between the real economy and financial markets is never straightforward, mainly because there are many factors other than growth that influence asset prices. An oft-cited adage on Wall Street is that the economy and the stock market are not the same thing.
Even in relatively transparent economies, where key indicators and policy signals are easier to read, the disconnect between the economy and markets can be stark. In the United States, data published last week showed that the economy grew at a blistering annualised pace of 4.9 per cent last quarter, powered by a resilient labour market and strong corporate earnings. Despite that, the benchmark S&P 500 index has fallen almost 8 per cent since July 31.
In developing countries, where the policymaking process tends to be more opaque and capital markets are not as mature and liquid, measures of investor sentiment are an even less reliable gauge of the state of the economy and where it is heading.
Market perceptions of China’s economy have taken on added significance in the past year because of the unexpectedly sharp deterioration in sentiment since Beijing abandoned the last remnants of its zero-Covid policy. The MSCI China Index, which tracks Chinese stocks listed at home and abroad, soared almost 60 per cent between the end of October 2022 and the end of January, but that dramatic reopening rally abruptly gave way to a protracted decline as confidence in China’s economy evaporated.
While expectations for growth were too high to begin with, the extreme bearishness – particularly among foreign investors – is striking and has been fanned by fears that China is falling into a deflationary trap akin to the one Japan found itself in during the 1990s.
Yet what is particularly troubling is that even a significant increase in the pace and scope of policy support for the economy in the past several months has failed to lift sentiment. Just as worryingly, stronger-than-expected third-quarter gross domestic product data – which caused Citigroup’s China Economic Surprise Index to swing back into positive territory for the first time since June – did little to brighten the mood.
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Can China learn lessons from Japan’s ‘lost 30 years’?
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If Beijing was sitting on its hands as the economy and markets continued to deteriorate, this would partly explain the pervasive pessimism. But even the most bearish investment banks, such as Nomura, admit the government cannot be accused of complacency.
Not only have policymakers eased restrictions in the stricken property sector more forcefully, they took the unprecedented step last week of scrapping a long-standing 3 per cent cap on the central government’s deficit-to-GDP ratio to boost spending on infrastructure in areas hit by natural disasters.
The combination of a stabilisation of the economy and more stimulus ought to provide some comfort to markets. However, foreign investors have sold US$23 billion of mainland Chinese equities via the Stock Connect scheme in the past three months, the largest withdrawal over a three-month period on record, according to HSBC data.
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China’s economy sees a resurgence in the third quarter, beating forecasts
It is also difficult to envisage a meaningful improvement in sentiment when the global backdrop is so grim, exacerbated by the escalation in geopolitical risk. A fourth possibility is that too many foreign investors have thrown in the towel, perceiving China as uninvestable given mounting regulatory, political and economic risks in recent years.
However, the fact remains that China still has the capacity to surprise markets positively, as it did late last year. As recently as April, respondents to Bank of America’s monthly global fund manager survey were still quite bullish about the prospects for growth. Even today, China’s economy does not figure among the top “tail risks” in markets.
A more compelling explanation is that nothing Beijing does in terms of policy will be sufficient to turn sentiment around for the simple reason that investors are at a loss as to what needs to be done to restore confidence in China’s economy.
In advanced economies, bad economic news is often treated as good news for markets because it increases the scope for stimulus, buoying asset prices. In China, the link between economic data and policy support is much more tenuous.
China’s economy is bottoming out, but that’s no reason to cheer
Beijing’s efforts to rebalance the economy and maintain financial stability preclude the deployment of large-scale stimulus. Moreover, investors’ concerns over the efficacy and type of stimulus favoured by the government – infrastructure spending as opposed to cash transfers to households – blunt the impact of policy action.
Crucially, China’s problems are structural, not cyclical. It is hard enough for policymakers to decide how best to counter the property-induced downturn while avoiding more severe financial turmoil, never mind ill-informed foreign investors who have enough problems assessing and pricing risks in advanced economies.
What is clear is that foreign sentiment towards China is a poor predictor of where the country’s economy and markets are heading. This does not mean that the bearishness is misplaced. It simply means the economic problems facing China today are too complex and multifaceted for global investors to grasp. This could explain why China is not at the top of global fund managers’ list of concerns.
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