China: the big risk in 2018

House View 16 November 2017

The People's Republic may challenge positive expectations for the new year, says Mark Rider. 

China faces a multi-year task to stabilise and reduce debt across a number of key sectors: late last month the head of China’s central bank warned of the “fierce market reaction” that could arise from the nation’s flood of credit, claiming such stimulus would build “exuberance”, creating tension and possibly lead to “sharp correction”.

Those observations from People’s Bank of China governor Zhou Xiaochuan have been a concern for some time and China is clearly adopting polices directed to gradually reducing these risks.

The biggest risk posed by an over-leveraged China, as Zhou referred to, is that debt will build to a tipping point, alarming lenders who will sharply slow supply of credit, and then economic growth will soften. However, this is not the baseline view of ANZ’s chief investment office.

While China’s economic engine is a powerful force globally, it is especially significant to Australia, and the repercussions of its slowing to our economy could be harsh. The Australian dollar would drop if global economic growth was hit as the Chinese economy suffered.

There some reassurance though. Should this happen, we don’t expect it to be a repeat of 2015 as we see the improved European economy to offset the impact of a Chinese slowdown.

US inflation – the critical factor

The other major global risk is a more rapid-than-expected increase in United States inflation. Overall, we currently expect US inflation will lift to around 2 per cent next year, which should be a comfortable level for the US Federal Reserve (Fed) to continue to raise interest rates gradually.

However, if it rises faster than expected then the Fed would raise its cash rate sooner than expected. Higher rates means debts are harder to repay for consumers and companies’ earnings would slow and possibly decline.

Because of these risks we’re not fully in favour of holding an “overweight” to growth assets, such as equities, this month. We’re holding “neutral” in our investments and will wait and see how risks unfold.

And though we’ve outlined risks here, our focus is on our positive expectations in the months ahead, that:

  • interest rates will gradually rise and not spook markets
  • sharemarkets continue to deliver solid (but moderate) returns for investors.

Australia’s indebted households

The clear area of concern in Australia is the overheated property market, and the high household debt it has caused. But as employment has improved fears of a housing-related default has declined.

The outlook for the domestic economy has improved as the year has progressed. If this trend continues, as we expect, then interest rates are likely to rise next year. That will add to household debt burden, exacerbated by slow wage growth.

Investment position at November 2017

Asset class Position relative to benchmark/outlook1
Growth assets Neutral
Australian equities Neutral
International equities Neutral
  - United States Neutral
  - Europe Neutral
  - Japan Neutral
  - emerging markets Neutral
Listed real assets2 Neutral
Defensive assets Neutral
Fixed income Underweight
  - Australian Neutral
  - New Zealand Neutral
  - International Underweight
Cash3 Overweight
AUD/USD Neutral
NZD/USD Neutral
USD TWI Neutral

1. Equities, fixed income and cash are relative to benchmark. Currencies are relative to an absolute return outlook (short term).
2. Comprises of 50/50 split between GREITs and infrastructure securities.
3. Cash is the balancing asset class.