In a conversation with Yan Xiang, Chief Economist of Huafu Securities, he mentioned that the term "balance sheet recession" is not applicable to China.

With the release of various macroeconomic data and the introduction of policies in the first half of this year, the market's focus has shifted to the significance behind the data and policies.

According to data released by the National Bureau of Statistics, the consumer price index (CPI) in the first half of this year increased by 0.7% compared to the same period last year, while the producer price index (PPI) decreased by 3.1% year-on-year.

On July 24th, the Central Political Bureau held a meeting to analyze and study the current economic situation and deploy economic work for the second half of the year. The meeting proposed to boost bulk consumption in areas such as automobiles, electronic products, and home furnishings, and promote service consumption in sports, leisure, culture, and tourism.

Under the warm breeze of policies, whether the A-share market, which has been volatile, has reached a "policy bottom," and whether the theory of balance sheet contraction, which has been a concern in the market, holds water, have become topics of controversy.

With these questions in mind, the Huashang Jianwen · Xinfeng team attempted to find more answers through a dialogue with Yan Xiang, Chief Economist of Huafu Securities.

Ideals and Reality

Huashang Jianwen: How do you view the data on PPI and its subsequent development?

Yan Xiang: PPI represents the price trend faced by the industrial sector. From an internal logic perspective, we believe that the PMI of manufacturing in Europe and the United States, the growth rate of exports, and the year-on-year growth rate of domestic PPI are highly correlated. The core logic of these three data reflects global industrial production because only manufactured products are tradable. The global manufacturing or industrial industry is still in a bottoming-out cycle. In the first half of the year, the year-on-year growth rate of domestic PPI continued to be negative, which is consistent with the year-on-year growth rate of exports and the PMI of manufacturing in Europe and the United States, both of which are at a relatively low level.

Looking ahead, the space and possibility for these related indicators to continue to decline sharply have decreased. At a time when the overseas interest rate hike cycle is tending to end and domestic policies to expand domestic demand are gradually introduced, we believe that economic data such as domestic inflation and exports in the second half of the year are expected to bottom out and rebound.

Huashang Jianwen: The year-on-year GDP growth rate in the first half of the year was 5.5%, and some people think it is lower than expected, while others think it may be worse than the actual perception. Where does this contrast come from, and how should we understand this perception gap?

Yan Xiang: The spokesperson of the National Bureau of Statistics described this perception gap as a "temperature difference." The so-called temperature difference refers to the difference between macroeconomic data and personal perceptions: the downward pressure and employment pressure may be greater from a micro perspective, but from a macro perspective, the actual GDP has increased quarter by quarter in the first half of the year.

We believe that the most fundamental reason behind this temperature difference is the price factor represented by PPI. According to the inflation data released by the National Bureau of Statistics, the consumer price index (CPI) in June increased by 0% year-on-year, and the producer price index (PPI) decreased by 5.4% year-on-year. Among them, PPI has been in negative growth for 9 consecutive months.

Listed company profits, household income, and other indicators are nominal variables that include price factors. Price changes have a greater impact on short-term income and profits than GDP changes. In the first half of the year, due to the continued low prices and the year-on-year negative growth of PPI, these nominal indicators were dragged down, resulting in a temperature difference between macroeconomic data and personal perceptions.Wall Street News: You mentioned earlier that the "policy bottom" has already appeared in the stock market, and looking ahead, the overall market can be more optimistic. There is a clear possibility and space for an upward trend in the market, and it is expected that the market performance in the second half of the year will be better than the first half. Can you further analyze the basis for this speculation? What other disruptive factors do you think may affect this judgment?

Yan Xiang: Stocks are long-duration assets, and at this stage, even if there are fluctuations in the fundamentals, the impact on the market is limited. Previously, the fundamentals of listed companies in the A-share market experienced a rapid downturn cycle, which also led to a significant adjustment in the market. However, this round of profit downturn cycle is basically coming to an end, and at the current position, there is limited room for further substantial decline in corporate profits. As the profit fundamentals gradually stabilize, the negative impact on the stock market will also gradually diminish.

In addition, China's domestic demand is recovering steadily, and the policy environment is relatively friendly. Short-term data may cause disturbances, but the overall trend remains positive.

As for the stock market, the "policy bottom" has already appeared. Various policies from the management have demonstrated their attention and concern for the capital market. However, due to the constraint of prices on corporate profits, the market is currently characterized by "a dojo in a snail shell," with little overall volatility and significant structural differentiation. The key to breaking the deadlock in the future still lies in the price factor driving the rebound in profits.

The growth rate of listed companies' profits in the A-share market is highly correlated with the year-on-year growth rate of the Producer Price Index (PPI). On the one hand, due to the base effect, it is expected that the year-on-year growth rate of PPI will improve in the second half of the year. On the other hand, if the global economy gradually hits bottom and rebounds, it will further drive the upward elasticity of domestic listed companies' profits.

Therefore, we believe that the overall market can be more optimistic, and there is a clear possibility and space for an upward trend in the market.

Wall Street News: The latest economic conference did not mention "housing is for living, not for speculation," but it is unlikely to see a repeat of the housing reform market in 2015-2016. How should we understand the current regulatory policy objectives, especially the "changes in the supply and demand relationship in the real estate market"?

Yan Xiang: According to data from the National Bureau of Statistics, real estate development investment in China decreased by 7.9% year-on-year in the first half of the year, with residential investment down by 7.3%. In terms of sales, the sales area of commercial housing decreased by 5.3% year-on-year, while the sales revenue increased by 1.1%, showing an overall decline. In June, the Real Estate Development Prosperity Index (referred to as the "national real estate prosperity index") was 94.06.

These data reflect a profound change in the supply and demand relationship in China's real estate market. Currently, the operating model of some real estate companies with "high leverage, high debt, and high turnover" is unsustainable. The supply in the real estate market is undergoing a phased adjustment, and as the adjustment gradually takes effect, the market supply will also gradually stabilize. With the economic recovery improving, policies promoting the healthy development of the real estate market will show their effectiveness, and the real estate market will gradually stabilize.

As real estate policies continue to be optimized and the real estate market gradually adjusts, future real estate sales and development will gradually return to a reasonable level, and urban village renovations are also expected to usher in new opportunities.

"Debate on Balance Sheet Contraction"

Wall Street News: Recently, Gu Chaoming's theory of balance sheet contraction has sparked heated discussions in China. Many opinions have compared this theory to China. How do you view the applicability of balance sheet contraction theory in China?

Yan Xiang: We believe that balance sheet contraction is not applicable to China's current situation.

The fundamental reasons behind Japan's "Lost Decades" are twofold. Firstly, technological progress slowed down, leading to a stagnation in total factor productivity. After reaching a temporary high point in 1990, Japan's total factor productivity slightly declined, lacking the momentum for sustained growth. Secondly, Japan faced the issue of an aging population. After the burst of the economic bubble in the 1990s, Japan's birth rate dropped below 1%, and social problems such as low fertility rate and aging have become insurmountable obstacles to further development. Lastly, the competitiveness of industries weakened, and manufacturing shifted overseas. Since the 1990s, Japan's share of global manufacturing has continuously decreased.

On the other hand, China's economy boasts a significant advantage in its massive market size. This not only means that there is ample demand, but more importantly, through economies of scale, it can generate strong technological innovation competitiveness. Economies of scale benefit companies in diluting the upfront research and development costs and fixed costs required for the development of new industries. China's research and development expenditure (R&D) as a percentage of GDP has been steadily increasing since 1997, rising from 0.51% in 1996 to 2.55% in 2022. Although China's R&D expenditure as a percentage of GDP still lags behind developed countries such as the United States, Japan, and Germany, this is mainly due to different stages of development. However, the upward trend in China's R&D expenditure is very apparent, and it is expected to approach the level of developed countries in the near future.

In terms of absolute amounts, China's R&D expenditure surpassed countries such as the United Kingdom, France, Germany, and Japan between 2007 and 2012 and is currently second only to the United States. In the context of a massive market, China's economy has significant economies of scale, allowing for the parallel development of multiple technological routes. The market has sufficient potential space, which is conducive to the rapid development of enterprises that align with technological and industrial directions and possess competitive potential.

Furthermore, in the current and foreseeable future, China's total population remains abundant, with a huge labor force. Based on the annual birth population in previous years, if calculated based on individuals graduating from undergraduate programs at around 22 years old, China will still have a considerable volume of new labor force for a considerable period of time. According to population forecast data from the OECD, even considering the future decline in the labor force, the population aged 15 to 64 in China will still be higher than the total of the United States, Japan, and EU countries in the long term. This will provide sustained domestic demand support and factor guarantee for China's modernization.

In addition to quantity, a distinctive feature of China's population structure is the continuous improvement in labor force quality.

In summary, China's economy has a significant advantage in its massive market size, which helps dilute various fixed costs and research and development expenditures. As a major economy, it possesses significant economies of scale that encourage innovation. At the same time, in the current and foreseeable future, China has an abundant quantity of labor force and improving quality, which provides a clear competitive advantage globally.Wall Street News: The important reason why the theory of balance sheet recession has sparked much discussion in the industry is actually due to the lack of confidence among everyone. However, you mentioned that we should look at the Chinese economy from the perspective of the three-part theory, which states that there exists a "mild recovery" or "L-shaped" state between the economic downturn and the economic upturn. Can you specifically discuss the theory of the three-part perspective on the Chinese economy?

Yan Xiang: Compared to a "strong recovery" or "rapid recovery," the main distinguishing feature of our understanding of a "mild recovery" lies in whether commodity prices will rise significantly. If prices do not rise, it will lead to a slow nominal economic growth rate and a gentle slope during the process of economic recovery. What we are currently seeing is precisely this situation. Against the backdrop of a significant rebound in actual GDP in the first half of the year, China's domestic Producer Price Index (PPI) is still experiencing negative growth on a year-on-year basis, resulting in a slow or even slight decline in the nominal economic growth rate.

From the perspective of the nominal economic growth rate, the "mild recovery" corresponds to an "L-shaped" pattern. After the financial crisis, similar "L-shaped" economic trends were observed in 2013 and 2019. In contrast, 2017 and 2021 can be considered as periods of "strong recovery" or "rapid recovery," corresponding to a "V-shaped" trend in the nominal economic growth rate. It is highly likely that 2023 will also exhibit a "mild recovery" with an "L-shaped" trend in the nominal economic growth rate.

Understanding the characteristics of a "mild recovery" in the economy helps us comprehend the current situation in the A-share market. If we adopt a binary perspective where it's either up or down, we may find this year's stock market performance somewhat awkward. Despite the obvious signs of recovery, why is the market not showing strong momentum and instead leaning towards growth and thematic stocks?

However, if we view the Chinese economy through the lens of a three-part theory, recognizing the existence of a "mild recovery" or "L-shaped" state between the economic downturn and the economic upturn, it may be easier to understand and accept the market conditions we have seen this year.

Wall Street News: Infrastructure and fixed asset investment as a whole have continued to grow this year, which is an expression of the government's countercyclical adjustment. How should we understand the marginal impact of this data on economic recovery?

Yan Xiang: In the first half of the year, national fixed asset investment increased by 3.8% year-on-year. Among them, the growth rate of infrastructure investment was higher than that of overall fixed asset investment. In the current economic situation where external demand is weakening, consumption growth is facing some constraints, and the real estate market remains sluggish, countercyclical infrastructure investment has provided strong support for economic growth.

Statistics show that infrastructure investment (excluding power) increased by 7.2% year-on-year in June, slightly higher than the growth rate of 7.1% in the same period last year. Infrastructure investment is an important component of fixed asset investment. In recent years, the PPP (Public-Private Partnership) model has been continuously promoted, fully leveraging government funds, guiding social capital investment, stimulating private investment vitality, and activating existing social capital. It serves as an important means of countercyclical adjustment.Wall Street News: If the real estate snow slope is lost, what areas can we focus on for the "substitutes" of future balance sheet expansion?

Yan Xiang: We need to look for variables on the supply side that can replace the continuously improving total factor productivity of the demographic dividend, and on the demand side, we need to look for new directions and new products after the real estate cycle. The direction is clear, which is to rely on continuous technological innovation to promote the continuous emergence and development of new industries. On the supply side, we need to use technological innovation to improve production efficiency and compensate for the gradual decline of the demographic dividend. On the demand side, we need to create demand through high-quality supply and fill the gap in real estate with new industries and new products.

From the current perspective of technological development, the current new round of technological revolution and industrial transformation is deepening. The digital economy, green energy, artificial intelligence, and other fields are flourishing. Around technological innovation and industrial transformation, it will bring more investment opportunities to the A-share market, which can be focused on.