China's Markets Can't Agree on How Good its Economy Is

By Shen Hong Features Dow Jones Newswires

China's financial markets are sending conflicting signals about the health of the world's No. 2 economy, where a strengthening currency, buoyant stocks and soaring commodities contrast with the pessimism popular among the country's bond investors.

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The country's latest economic data have made the picture even murkier, with the pace of industrial output, retail and housing sales and investment growth all decelerating in July. Some economists, however, argue the weakness was temporary and due to an unusually hot summer that affected construction work.

A closer look suggests bond investors' cautious outlook may win out. That is because the recent rally in other asset classes has come partly thanks to policies designed to preserve financial stability ahead of a key Communist Party political meeting this fall, and partly due to potentially excessive optimism about structural reforms.

"Although on the surface the markets are telling different stories about the Chinese economy, the overarching theme remains that the economy faces bottlenecks like a relatively primitive growth model and fresh drivers," said Shen Meng, director at Chanson & Co., a Beijing-based boutique investment bank.

Currency

The Chinese currency's resurgence has been one of the year's big surprises. The yuan now trades at a near one-year high and is up more than 4% against the U.S. dollar, after dropping 6.6% last year.

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The yuan's rise has some logic behind it -- the dollar has been weak against a range of global currencies in recent weeks as expectations for U.S. rate increases are pared back.

Still, some say the yuan's recent strength could also reflect Beijing's desire to reduce frictions with the new administration of President Donald Trump, who repeatedly accused China of keeping its currency artificially weak during last year's campaign.

"One can't simply apply textbook explanations to Chinese markets because based on economic fundamentals, the yuan doesn't have any basis for appreciation," said Mr. Shen.

The yuan's rise also reflects Beijing's desire to deter rapid capital outflows. The People's Bank of China sets a daily level for the yuan against the dollar and then allows it to trade in a tight 2% range either side.

"The yuan is a different story because the market is guided by the Chinese central bank everyday with a clear policy agenda," said Iris Pang, an economist at ING Bank NV in Hong Kong.

Stocks

China's stock market has also done well in the past two months. The SSE 50, a widely watched index that tracks the 50 most valuable companies listed in Shanghai--almost all of which are state-owned--has surged 16% this year to its highest level in more than two years.

While some analysts have cited signs of resuming long-stalled reforms of the country's inefficient state-run enterprises as a factor, others point to Beijing's political agenda as a more important reason for the market's bull run. Some market participants say state-backed investment funds, nicknamed the "national team," have been stepping in to prop up the market.

"If you want to stabilize the market, you need to stabilize these large stocks, and that's why the national team has been putting money in them, " said Major Teng, chief equities strategist at Everbright Securities, referring to investments by state-backed funds.

In contrast, the tech-heavy, Nasdaq-style ChiNext board in Shenzhen is down 7.6% for the year.

Commodities

China's notoriously frothy commodities markets are on the up again: Steel-rebar futures have rallied 32% so far, while coke futures have surged 80% since June, on hopes that Beijing's clampdown on over production by mining and steel producers will reduce supply.

Some say investors are trusting too much in the central government.

"Whether the capacity cuts will work and higher production costs can be passed on to consumers remains a question mark. The commodities traders are just betting on policies and there is a lot of speculation," said Shen Yuan, special adviser at ZYR Investment, a Nanjing-based private-equity firm.

Bonds

China's bond market is sending a more chilling message.

The yield on China's 10-year government bond is now just 0.09 percentage point (nine basis points) above that on the three-year paper, giving the spread or so-called yield curve its flattest shape in three years. A flat yield curve usually reflects investor pessimism about a country's long-term growth and inflation prospects.

"The flat yield curve does reflect caution among investors because as long as China's various reforms aren't completed, there will be uncertainties over the economy," said ING's Ms. Pang.

The fact that the vast majority of buyers and sellers in China's $9 trillion bond market are more sophisticated institutional investors partly explains the different view expressed there as opposed to those in the more speculative stock and commodities futures markets, analysts say.

Yifan Xie contributed to this article.

Write to Shen Hong at hong.shen@wsj.com

(END) Dow Jones Newswires

August 27, 2017 01:57 ET (05:57 GMT)