News analysis

A second phase of the Asian reflation trade

After a remarkable first quarter, China's economic engine has slowed to a more "normal" pace.

Macroeconomic indicators have shifted from exceptional to ordinary, and worries about the country's credit build-up and regulatory ambitions, coupled with the recent slide in prices of key commodities, have reignited investors' concerns about a China-led slowdown in global growth.

As the beating heart of the region, China's economic momentum holds disproportionate sway over Asia's and certainly Singapore's prosperity. Sentiment often rides high when China's gross domestic product clobbers expectations like it did in the first quarter, but it can swiftly turn gloomy when the country misses its targets.

The good news is, China should comfortably meet its GDP growth target of around 6.5 per cent this year. And even better, Asia's recovery is still on track even with a less vivacious China.


A water deliveryman in Shanghai. Changes in China's economic trends are always noteworthy occurrences, says the writer, but as the region holds its collective breath, investors should take advantage of the pause to prepare for the second phase of the
A water deliveryman in Shanghai. Changes in China's economic trends are always noteworthy occurrences, says the writer, but as the region holds its collective breath, investors should take advantage of the pause to prepare for the second phase of the cycle. PHOTO: AGENCE FRANCE-PRESSE

China's red-hot pace in the first quarter was a sight to behold. Every single macroeconomic indicator beat expectations, with nominal GDP rising nearly 12 per cent on the year.

The mighty first-quarter result was the amalgamation of explosive government-backed infrastructure investment (up 25 per cent year on year), which increased the most in a quarter since the third quarter of 2014; still strong housing sales and a rebound in exports.

This economic buoyancy has since dissipated over the past two months and is unlikely to return.

The property sector should cool more noticeably towards the end of the year as the government tightens the regulatory screws on new buyers. And infrastructure investment could moderate due to rising financial costs and the stricter supervision of government debt and non-standard credit channels.

Meanwhile, China's top financial regulatory bodies have taken advantage of the economic surge to embark on a tightening of the shadow banking system. Just this year, a plethora of bans and guidelines have been issued to deleverage the financial system, improve inter-regulatory coordination, and curb speculative lending which has become pervasive in the interbank bond market.

These measures are healthy for the longer-term sustainability of the Chinese economy, even as they inflict some short-term pain - corporate bond issuance is down this year, although traditional bank lending channels remain intact.


China's ever-rising pile of debt, which Moody's took exception to late last month, and ongoing regulatory campaign are notable risks to China's economic goals. But when considering both, it's important to not lose sight of the Chinese government's near-term objective of maintaining stability ahead of the 19th National Party Congress this autumn.

Moody's recent downgrade of China's sovereign credit rating from Aa3 to A1 was widely expected by the market - its rating outlook on China has been at negative since February last year, although the timing was a surprise.

The downgrade should have a limited impact on China's overall financing cost, because the market is almost entirely dependent on domestic funding. However, this doesn't mean that the country is clear of a potential credit crunch.

China's debt-to-GDP ratio has climbed to almost 260 per cent. And its ascent will most likely continue in the years ahead as the government keeps on fuelling growth by spending big on infrastructure.

Many believe this path is unsustainable, which could ultimately lead to the ruin of China's financial system. But this view misses the forest for the trees for several reasons.

First, China's debt is almost entirely held by domestic investors, which makes a classic balance-of-payments crisis unlikely. What's more, both the lenders and the shakiest of borrowers are state-owned.

Second, the high debt is funded by high domestic savings - the overall banking loan to deposit rate remains below 90 per cent, even including the shadow banks.

Third, focusing just on liabilities misses a crucial point about China. The asset side of its balance sheet compromises productive assets that will generate future returns. Also, an accommodative monetary policy and a proactive fiscal policy will help to stem any crises before they materialise.


The slowdown of Chinese growth marks a new phase for the reflation trade in Asia - one defined by slowing but still above-trend growth. The best of the cycle may be in the past, but there is still more juice left and investors should take this time to recalibrate their portfolios.

Growth throughout the region remains solid and well balanced.

Business sentiment has improved, and corporate earnings are rising, as evidenced by the recent reporting season. Improved profitability, low interest rates and recovering trade flows should support investment in the coming quarters; real investment growth looks set to accelerate by 1 per cent to 2 per cent in Asia this year.

Asian ex-Japan equities have risen 22 per cent this year, with Singapore equities not far behind at 19 per cent.

Two leading indicators, the US ISM manufacturing PMI and US inflation-adjusted (real) rates, which historically have been correlated with Asian equity market outperformance, suggest additional gains ahead but at a more modest pace than in the first five months of the year.

The best regional opportunities are likely equities in select financials, companies with secular growth at a reasonable price and quality dividend stocks.

China's equity market is still attractive on improving corporate fundamentals and relatively attractive valuations.

Singapore's equity market, meanwhile, has caught up with its longer-run price-to-earnings valuation, and appears more fairly priced.

Nonetheless, the economic and property market cycles look to be in their best shape in nearly four years, which calls for selected exposure to Singapore banks and property developers.

Changes in China's economic trends are always noteworthy occurrences. But as the region holds its collective breath as a result, investors should take advantage of the pause in momentum to prepare for the second phase of the cycle.

• The writer is the Asia-Pacific regional head at the chief investment office of UBS Wealth Management.

Tan Min Lan

A version of this article appeared in the print edition of The Straits Times on June 05, 2017, with the headline 'A second phase of the Asian reflation trade'. Print Edition | Subscribe