China Market Strategy: Consolidation
Yicai Global
/SOURCE : Yicai
China Market Strategy: Consolidation

Simultaneous extremes in US and HK market sentiment suggest a market consolidation in the near term. The odds of a Fed hike this year have risen to 50%, and Yellen is speaking soon. A coin flip is not a good bet, unless one has an edge. China is unlikely to ease significantly in the near term. Strong property prices and low real interest rate are binding the PBoC's hands. China's falling FX funds position has long heralded lower M2 growth. If a vicious correction occurs, investors should continue to look for long-term allocation opportunities in Hong Kong.

Market sentiment approaching extremes; consolidation likely: Our models show both US and HK market sentiment approaching their extremes that tend to suggest looming market consolidation or correction ahead (Focus Chart 1-2). Investors should take note. While it is difficult to refute the idea that central banks will have to do more as conventional monetary policy is showing its limits, and we do not necessarily disagree, extreme market sentiment suggests that markets may be running ahead of themselves. They could be disappointed, at the whims of central bankers.

Focus Chart 1: Significant smart and retail sentiment divergence in the US; consolidation or correction.

In the US, smart money flow is approaching its extremes, and starting to diverge from retail sentiment. At these levels, it could suggest either a precipitous fall as it did just before the '97 Asian Crisis and the burst of '00 Internet Bubble, or the start of a prolonged bull market as it did in 2003 and 2009 (Focus Chart 1). That said, a simultaneous extreme in the Hang Seng suggests consolidation or correction in the near term is more likely. Our Hong Kong sentiment indicator has a good track record. It sent out a strong warning in late May 2015, just prior to the Chinese stock market bubble burst (Focus Chart 2).

A stabilizing RMB recently has helped to suppress the Hang Seng's volatility (Focus Chart 3). The upcoming G20 should see the RMB expectation continues to be managed. After all, the PBoC is a formidable counterparty to short sellers, and has proven its mettle in the past two rounds of RMB depreciation. As such, a consolidation is likely, unless the RMB volatility surges and spills. If a vicious correction occurs, investors should continue to look for long-term allocation opportunities.

Focus Chart 2: HK sentiment approaching extremes; consolidation or correction.

Focus Chart 3: Stabilizing RMB expectation has helped calm the Hang Seng's volatility.

China unlikely to ease significantly; real interest rate at historical lows; change in money creation:There are still hopes for the PBoC to ease again significantly. However, with property prices at their historical highs, and China's real interest rate at its long-term lows after considering property prices, the PBoC's hands are tied (Focus Chart 4). Cutting interest rate further could stoke an even bigger property bubble and a severe aftermath. Lowering RRR is possible, but it is to offset falling forex reserve.

Focus Chart 4: China's real interest rate at its historical lows; strong easing unlikely.

M2 broad money supply has fallen towards its long-term lows as well, while M1 narrow money supply growth has surged. There are hopes that a very high M1 growth will translate into strong M2 growth sooner or later, and then an overall liquidity relief. But a more structural perspective is that M2 growth is slow because China's money creation mechanism has changed. FX funds used to be a key component of China's money creation, as the PBoC took in USD from exports while issuing RMB.

But since 2015, the accumulation of FX funds has slowed, and even reversed course (Focus Chart 5). It is the reason why SLF and MLF are used more often now to replenish and manage macro-liquidity. Money created this way is more likely to be channeled to larger companies, especially SOEs through commercial banks, rather than to private enterprises that used to obtain money through exports. As such, this structural change in money creation can also explain the divergence between public and private investment seen this year.

Focus Chart 5: China's falling FX funds position has long heralded falling broad money supply growth.

Follow Yicai Global on