‘The Disconnect Between Fear And Reality Seems High’: Goldman Weighs In On China Stock Slump

On Monday, there was more selling in Chinese equities following a weekend during which Donald Trump continued to pound the table on the purported economic benefits of his increasingly aggressive protectionist trade policies. The beleaguered Shanghai Composite (which Trump appeared to reference in a Saturday tweet and then again later that evening at a campaign rally in Ohio), fell to its lowest levels since February 2016.

Friday seemingly marked the beginning of a new phase in terms of how China intends to approach things going forward. The USTR’s threat to up the ante by more than doubling the planned rate (from 10% to 25%) on prospective levies applicable to an additional $200 billion in Chinese goods was a bridge too far for Beijing. Policymakers in China announced on Friday differentiated tariffs on $60 billion in additional U.S. goods, set to take effect “as soon as” the Trump administration goes forward with the second round of 301-related duties. Simultaneously, the PBoC reinstated forwards rules designed to make it more expensive to short the yuan.

Simply put, China did what they could in terms of countenancing yuan depreciation and thereby getting out ahead of Trump by effectively negating the first and prospective second round of 301-related tariffs, but with the currency headed to 7.00, capital flight concerns look to have forced the PBoC to step in. Now, the door is open to more aggressive reciprocation via tariffs. Beyond that, it’s anyone’s guess what Beijing will resort to.

One thing you want to take note of is how quickly the bounce in Chinese equities that played out around the announcement of more “proactive” fiscal measures faded. The Shanghai Composite rose by 1% or more in three consecutive sessions around the fiscal stimulus news late last month, but has fallen in eight of the nine sessions since (see chart above). The renewed selling is the direct result of ongoing threats from Larry Kudlow, Wilbur Ross and, obviously, Trump himself. Here’s what we said on Saturday following Trump’s “performance” in Ohio:

Ultimately, this suggests Trump is almost sure to move ahead with the proposed tariffs on $200 billion in Chinese goods after he finishes implementing the first round of 301 duties (the U.S. will slap levies on another $16 billion in Chinese imports in the coming days and weeks to complete the first tranche). It also appears he’s going to be inclined to go ahead with the idea of raising the rate on the second tranche to 25%.

On Monday, Goldman is out with a new piece that takes a look at whether Chinese equities are pricing in too much doom and gloom from the trade frictions and right out of the gate, the bank says that in their opinion, “the implementation of US tariffs on US$200bn (on top of the announced US$50bn) of Chinese imports is likely.” Here’s a timeline that traces the evolution of this plunge into protectionism:

(Goldman)

Given the rather remarkable pace at which things are moving in terms of escalations, it’s no wonder that the mentality among investors is something akin to “sell first and ask questions later”, especially in light of the fact that there were already concerns about a deceleration in the Chinese economy prior to the tariffs. But is the scope of the selling overdone? Goldman thinks it might be.

“Our China economists see only 0.5pp or less direct hit to aggregate demand for the total US$250bn in goods related tariffs in three rounds: US$34bn+US$16bn at 25% and US$200bn at 10%, and US revenues represent merely 1.3% of listed companies’ earnings, with a high concentration in the hardware tech sector”, the bank writes.

(Goldman)

Further, Goldman says that while “concerns are plentiful, fundamental earnings have been resilient so far with 1Q aggregate profits growing 15% YoY for the listed universe.” The bank forecasts a “solid” Q2 reporting season and notes that “consensus earnings (in CNY terms) have been largely stable in recent months although HKD-based forecasts have seen a moderate markdown due to the sharp USDCNY spike.”

Bottom line (figuratively and literally in this case): Goldman is sticking with their 2018 EPS growth forecast of 21% for the MSCI China.

As for valuations, well, they’re attractive if you think the fundamentals are generally sound. Specifically, A shares are nearing 10X (in market-cap-weighted terms), which is the lowest in four years, and although the MSCI China is still trading a bit rich to trough valuations from the 2014-2016 cycle, multiples are hardly what one might call “stretched.”

(Goldman)

Also notable: Northbound flows are holding up and while you can probably thank MSCI inclusion for some of that, it’s still worth mentioning considering the scope of the selloff in the onshore market.

(Goldman)

Of course it’s not all rainbows and unicorns. Clearly the trade situation is the very definition of “fluid” and it’s entirely possible that the PBoC will eventually lose control of the yuan leading to capital flight. As Goldman observes, the “policy put” is squarely in the money, but more easing risks exacerbating the policy divergence with the U.S. China used that widening policy divergence to their advantage over the past couple of months, but it will become increasingly risky the weaker the yuan gets. Once capital flight picks up, it’s hard to stop, no matter how draconian your policies are.

Former Goldman Chief FX strategist and current Chief Economist at the IIF, Robin Brooks, weighed in on this on Monday, tweeting the following:

Will China capital flight resume if $/CNY heads above 7.00? Underlying question is how effective restrictions on outflows are vs how “lucky” China got in 2017 with Dollar weakness, which allowed lower $/CNY fixings that ended devaluation fears. I think there was a lot of luck.

In any event, at least you know both sides of the story. The overarching point is that considering the incessant headlines and the bombast emanating from the presidential Twitter account, it’s easy to get caught up in the hype.

Goldman isn’t suggesting the hype isn’t warranted or that somehow this is going to resolve itself without more pain. Rather, their point is simply this (from the note):

The disconnect between concerns and reality appears high.