Key Focus of China’s Economic Policies Shifts in the Second Half

Summary

• The Politburo held a mid-year economic conference, making  new arrangements for the focus of future economic work. Two main changes are worthy of attention: First, the overall focus of economic policies in the second half will gradually shift toward improving the economic structure, with “anti-involution” being a key component.  Second, greater policy emphasis in the second half will be placed on boosting domestic demand and consumption.

• The core goal of the "anti-involution" policy is to boost the nominal GDP growth rate, which remained sluggish in the first half of the year. The policy aims to reduce of excess supply pressure by cutting some excess production capacity or lowering the capacity utilization rate in certain industries. In addition, it aims to increase the prices and corporate profit levels of midstream and downstream products and export goods,  while curbing the vicious price-cutting competition model among Chinese enterprises.

• Unlike the 2016 supply-side reform, the current policy focuses on boosting profitability in downstream manufacturing, particularly export sectors. Also, Chinese residents currently have no possibility of increasing leverage. Therefore, the current policy needs to, on the one hand, accelerate the integration of supply-side production capacity, and on the other hand, make further efforts on the demand side on the other.

• We believe the primary drivers of global stock market gains remain capital flows and policy expectations, rather than economic fundamentals. Therefore, although the economies and corporate profits of most countries performed mediocrely in the first half of the year, and the economic risks caused by US tariff hikes still exist, stock market investors are likely to temporarily overlook certain adverse fundamental factors.

• We remain optimistic about the recent continued rise of global stock markets. Driven by market expectations that the Fed will restart interest rate cuts in September and the continuous inflow of retail funds, US stocks are still likely to remain strong in the short term. The intensity of fiscal easing by the Chinese government in the first half was the largest in the world, which also boosted recent market sentiment and the accelerated inflow of funds into the stock market.  We hold a positive outlook on sectors including innovative pharmaceuticals, semiconductor manufacturing, emerging consumer industries, the military industry, and companies poised to benefit from “anti-involution” policies.

• Commodity trends are likely to diverge. The first wave of rising commodity prices, driven by expectations of the "anti-involution" policy is mainly influenced  by short-term speculative funds and market sentiment.

Previous Views:

We remain  optimistic about the performance of global stock markets. Market expectations regarding the risks of the tariff trade war have declined, and the passage of the "Big Beautiful Act" has led the market to believe that the Trump administration has shifted from fiscal austerity to fiscal expansion, which further boosted market risk appetite. A-shares and Hong Kong stocks have benefited from China's fiscal easing policy, which was the most aggressive globally in the first half of the year, as well as the resulting improvement in market liquidity.  Commodities are also expected to rebound after  excessive declines, particularly those that experienced sharp price drops earlier in the year.

Views in August

I. Changes in the Focus of China's Economic Policies in the Second Half of the Year

On July 30, the Chinese politburo held a mid-year economic work conference to set the agenda  for the second half of the year. The conference  reviewed and affirmed that China’s economic performance in the first half was generally positive, and it outlined new priorities for the months ahead. We believe there are two main changes worthy of attention: First, the overall focus of economic policies in the first half of the year was to "achieve stable growth", while in the second half of the year, the policy focus has gradually shifted to "improving the economic structure".

Second, while policies in the first half of the year focused on investment-driven growth and stabilizing exports, the second half will place greater emphasis on domestic demand and consumption. This is mainly because after  Trump took office, the US government continued to launch a tariff trade war, the policy focus in the first half of the year was mainly on stabilizing exports and using fiscal policies to drive investment and production. As a result, China's GDP grew by 5.3% in the first half of the year, significantly exceeding expectations . Exports, particularly substantial growth to developing countries in Asia and Africa outside the US, played a key role. Although China has performed well in stabilizing growth and hedging against the adverse impact of US tariff hikes, the continuous increase in domestic overcapacity and deflationary pressure has become a greater challenge facing China's economy.

In terms of macroeconomic data, this is reflected in  China's nominal GDP growth rate continuing to be lower than the real GDP growth rate with the gap  still widening. The nominal GDP growth rate in the second quarter was 3.94%, and the GDP deflator has been negative for nine consecutive quarters, hitting a new low (Figure 1). From a microeconomic  perspective, this indicates that China's overall output has increased, but prices have fallen, leading to weak corporate profits and government fiscal revenue. At the same time, enterprises are unable to raise workers' wages. Therefore, given that the real GDP growth target has been well achieved, the focus of future policies will shift to reducing deflationary pressure and increasing the nominal GDP growth rate.

The core goal of the "anti-involution" policy is to boost the nominal GDP growth rate. On the one hand, the policy aims to reduce the pressure of excess supply by cutting some excess production capacity or lowering the capacity utilization rate in certain industries. On the other hand, it seeks to curb excessive internal competition among Chinese enterprises through strengthened industry regulations, especially in the "new three" sectors with a high export ratio, such as solar, wind power, and EVs.

Chinese enterprises are expected to reduce internal competition so that they can jointly raise prices, improve the profit margins and value-added of China's industries, and change the past practice of continuously lowering prices to gain market share. Instead, they should obtain higher profits while maintaining essentially stable market shares. For example, as shown in Figure 2 , China's passenger car exports reached 2.95 million units in the first half of the year, a year-on-year increase of 17.3%, and its global market share further expanded. However, the overall losses in the automobile industry after deducting government subsidies, have further widened.

Given that the substantial fiscal subsidies provided by the Chinese government come from the purchasing power of China's domestic demand, this practice of continuously cutting prices and incurring losses to gain export market share is, in fact, equivalent to continuously subsidizing overseas consumers at the expense of domestic consumers. Although this has  stabilized China's export and economic growth data to a certain extent, it has not  led to higher incomes and profits for Chinese households and enterprises, and  is therefore not sustainable in the long term. Therefore, we believe that the "anti-involution" policy also serves as an important response to the current high tariffs imposed by the United States.

II. There might be some misunderstandings in this “anti-involution” policy

First, as  mentioned above, we believe that the primary goal of the "anti-involution" policy is not to create cost-driven inflation in China, nor  to encourage speculation on commodity prices. The primary goal of the "anti-involution" policy is to reduce excessive competition among Chinese enterprises, especially  vicious price competition in downstream industrial and export products. The aim is to increase the overall profit margins of Chinese industrial enterprises and the prices of export products, thereby improving corporate profits and creating room to increase government fiscal revenue and residents' income. Considering that China is a net importer of most industrial raw materials, significant speculation on commodity prices would further compress the profits of downstream industrial manufacturers and export enterprises already experiencing declining profits in China, and could  even create additional downward pressure on government finances and residents' income.

As expected,  if the export prices and profit levels of China's downstream enterprises improve in the future, it would be  reasonable for raw materials prices to rise. However, under the current background that the problem of downstream overcapacity has not been solved and product prices have not been increased, significantly speculating on upstream raw material prices is obviously contrary to the policy goals. This is the biggest difference between the current  "anti-involution" and the “2016 supply-side reform”. In 2016, China's surplus industries were mainly concentrated in the upstream coal and steel industries. Therefore, the policy goal was mainly to raise raw material prices and improve the profits of upstream enterprises through bankruptcies and mergers in upstream industries. In contrast, the goal of this round of policy is to improve profits in downstream manufacturing enterprises, especially export-oriented ones.

In addition, to truly reverse the trend of price declining prices, it is still necessary to address the issue by increasing demand. For example, consider the 2016 supply-side reform. . As shown in Figure 3, although the overall profits of China's manufacturing industry declined slightly in 2015, it was mainly affected by the price decline of upstream industries due to overcapacity, while downstream industries profits continued to grow. From 2016 to 2017, through supply-side reform, raw material prices rose sharply, and the profits of the overall manufacturing industry  increased significantly, which did not come to an end until 2018. This reflects that, at that time, the price increases in upstream products could be smoothly transmitted to end consumers. Otherwise, it is more likely that the profits of upstream enterprises would have improved while the profits of downstream enterprises would deteriorate, leaving the overall profits of the manufacturing industry largely unchanged.

In fact, the round of supply-side reform from 2016 to 2017 coincided with China's launch of a large-scale housing renovations and a period of large-scale urbanization in third- and fourth-tier cities. The significant increase in the debt ratios of local governments and residents provided room for upstream resource producers to raise prices following mergers and integration. Currently, the overall profitability of China’s manufacturing industry is relatively sluggish, evident not only in upstream sectors such as coal, polysilicon, and lithium products, but also in downstream manufacturing.

Therefore, without further policies to stimulate demand, it will be difficult to replicate the price increase transmission path of the 2016 supply-side reform merely by limiting production in upstream industries.

Of course, from the Politburo work conference held on July 30, it is clear that the central government has placed greater emphasis on policies to boost domestic demand and consumption. These include providing an annual financial allowance of RMB 3,600 for children under the age of three and exempting tuition fees for kindergarten education. We believe that it is a very likely trend for that future macro policies will focus more on boosting consumption. However, considering China's current household leverage ratio and population structure, it will be difficult to replicate the situation in 2016-2017, when the rapid leveraging of residents themselves provided room for significant price increases in overall industrial products and raw materials. This occurs because compared with the rapid leveraging of residents  (as shown in Figure 4, the proportion of China's household loans to GDP increased by an average of five percentage points annually from 2016 to 2017), the role of fiscal subsidies in boosting consumption is relatively limited and slow.

III. Fund inflows and policy expectations are core factors to drive the market up now

We believe that the core factors driving the rise of global stock markets  remain  liquidity and policy expectations, rather than economic fundamentals. Based on  economic data and corporate profits from the first half of the year, most countries  have not performed well. Although China's GDP growth rate is relatively good, but in terms of the profit indicators of listed companies, the performance is actually mediocre. However, global stock markets continue to benefit from the continuous inflow of funds and the encouragement of expectations for future policy benefits.

US stock market: Retail money inflows into the stock market hit a new all-time high in the first half of this year. Despite multiple risk factors, such as the tariff trade war and slowing economic growth, retail investors' remain highly enthusiastic  about entering the market. Especially since April, the amount of margin account increase by retail investors in US stocks has risen rapidly, exceeding US$1 trillion and continuing to hit record highs (Figure 5). US stock investors are not overly concerned about an economic downturn, as they expect that a slowdown would prompt the Fed to cut interest rates more rapidly, and the Trump administration might also introduce more aggressive fiscal easing policies to hedge against it. Therefore, investors remain highly optimistic about the overall market, especially industries with high expectations for future growth such as AI.

A fund-inflow-driven stock market bull run has also emerged in stock markets including those in Europe and emerging markets such as China. Investors in the market are no longer worried about who will be the losers in the tariff trade war. Instead, they believe that if exports are hurt, these countries will be forced to adopt more accommodative monetary policies and fiscal stimulus measures. Therefore, regardless of whether the economy is strong or weak, stock market investors expect more money to flow into the market in the future, thus further pushing up stock prices.

Looking at China's market situation, the intensity of fiscal easing by the Chinese government in the first half of the year was the largest in the world, which was reflected in the net increase of RMB 8.9 trillion  in government liabilities from January to July, more than double the RMB 4.1 trillion recorded in the same period last year (Figure 6). Therefore, fiscal easing and the resulting liquidity easing are also the most important fundamental reasons for driving the rise of domestic A-shares in this cycle. Similarly, the balance of margin purchases for A-shares has increased significantly recently, and after 2015, it has once again exceeded the RMB 2 trillion  mark, approaching the historical peak again.

Therefore, the main driving forces behind the continued price increases in both Chinese and foreign stock markets, as well as some commodities currently comes from capital conditions, especially the substantial inflow of short-term retail funds, and optimistic expectations for relevant policies in the future. At this stage, market investors are temporarily overlooking certain fundamental concerns, including adverse factors such as the continuous escalation of the US tariff trade war, the risk of a U.S. economic slowdown and the fact that China's real estate market and corporate profit levels have not yet emerged from the downward cycle, etc.

IV. Market strategy

We remain optimistic about the recent sustained rise in global stock markets. Although US economic data has been weak, this has significantly boosted investors' expectations that the Fed will begin another interest rate cutting cycle in September. As a result, the market will ignore unfavorable economic fundamentals data in the short term. At the same time, retail investors continue to put their funds into the stock market. Since the overall medium-term earnings growth of US tech stocks still exceeds expectations, the market's enthusiastic focus on AI-related thematic stocks remains high.

Overall, both A-shares and Hong Kong stocks are also in a situation where short-term retail funds continue to flow in, driving sustained increases in stock prices.

Commodity trends are expected  to diverge. The first wave of rising commodity prices, driven by expectations of the "anti-involution" policy, has been mainly influenced by short-term speculative funds and market sentiment. We expect this wave to be nearing its end.. The future market trend will gradually shift from short-term capital games to policy games regarding the implementation intensity of the "anti-involution" policy. At the same time, compared with stocks, commodity prices are more restricted by actual economic conditions. Therefore, although price fluctuations are greater in the short term, it is unlikely to have an independent upward trend that completely ignores economic fundamentals like stocks.