Source: CICC Commentary Author: Zhang Jundong, Fan Li, Zhang Wenlang With the expectation of a basic stable market and interest rate cuts in September [1], trading style has changed. After the June CPI and retail sales data were released, large-cap growth stocks led by AI concepts have clearly pulled back, while gold, small-cap stocks, and real estate, consumer, manufacturing, and bank-related stocks in the Dow have performed relatively well. The trading main line behind seems uncertain, and there has been a large discrepancy in the market's judgment on whether the US economy will have a "soft landing" or a "hard landing" after interest rate cuts. Is the market currently experiencing a short-term cut in style or a long-term change in style? We believe that with the basic expectation of interest rate cuts being largely fulfilled, the space for interest rate cut trading ("buying on expectations") may be significantly squeezed, while the "cyclical trading" after interest rate cuts is gaining momentum (see "All kinds of interest rate cut trading are the same, but the trading logic after interest rate cuts is different"). Unlike interest rate cut trading, cyclical trading mainly prices the recovery of terminal demand and the restart of the economic cycle after interest rate cutting. Its supporting logic is the resilience of US household demand, large fiscal and re-industrialization, and more deeply, the "realization from empty to real" of the total scale and structural resilience of the US economy. Under the support of total-scale resilience of the economy, the interest rate cut may be relatively limited (that is, a "shallow" interest rate cut), which is more beneficial to the real economy, especially profitable-supporting enterprises, and has a relatively limited boost to valuation. In terms of pace, Trump Trade 2.0 may accelerate the arrival of cyclical trading, given the increasing probability of Trump's recent election victory, stronger fiscal dominance (monetary coordination), industrial return, and potential weak US dollar in his policy ideology. At the same time, we also remind that due to the uncertainty caused by the election results, US stocks may enter a relatively high volatility period in the July-October of each election year; and after the uncertainty of the election dissipates, US stocks and bond rates often rise, and on average, value stocks perform better than growth stocks after the election (see "Major asset classes in US election years: seeking certainty in uncertainty").
Authors: Liu Gang, Zhang Weihan, Wang Muyao

What is the impact mechanism of the Fed's rate cut on China? Policy space, capital flow, sector and Hong Kong local market

For the Chinese market, including Hong Kong stocks, the main focus when observing the impact of the Fed's rate cut is how the peripheral easing effect is transmitted. In other words, the Fed provides policy space, and how domestic policies respond in this environment. This is also the core analytical framework and perspective, which can be further divided into policy space, capital flow, sectors, and Hong Kong local market.

► Policy Space: Under the constraints of the Sino-US interest rate spread and exchange rates, the Fed's rate cut will undoubtedly provide more relaxed window and conditions domestically, which is needed in the current relatively weak growth environment and still high financing costs. From this perspective, the Fed's rate cut, especially a substantial 50 basis point cut, will help to open up policy space. Currently, the short-term interest rate spread between China and the US is 320 basis points. If we assume that the Fed's projected 250 basis points rate cut space is correct, it is expected to narrow the interest rate spread to 70 basis points. However, it should be noted that space does not mean inevitability, and the actual degree of rate cut under real constraints is more crucial. A larger cut, if achievable, will have a more positive effect on the market.

► Capital Trend and Exchange Rate: During the Fed's interest rate cut cycle, the narrowing of the interest rate spread between the US and other countries and the temporary weakening of the US dollar to some extent help alleviate the outflow pressure of funds from emerging markets. At the same time, the Fed's interest rate cuts often accompany a phase of growth decline (though not necessarily 'recession'). Even the short-term risk-free return will correspondingly decline, thereby providing a certain motivation for capital outflow in search of higher returns. However, interest rate spread is not the sole reason for capital inflow. The inflow of foreign capital is the result of the comprehensive effects of overseas liquidity, geopolitics, and domestic fundamentals. In determining the factors affecting the inflow of foreign capital and the extent of recovery, domestic fundamentals and policy efforts are often more important. The fact that in 2019, foreign capital continued to flow out despite the Fed's interest rate cut, while in 2017 foreign capital still flowed in despite the Fed's interest rate hike, vividly illustrates this point.

► Global Sectors: Firstly, the Fed's interest rate cut will directly affect the USD financing costs of Chinese enterprises, especially those with high external liabilities and export-oriented enterprises. Secondly, because we determine that this round of interest rate cuts is not a deep recession, but instead can bring about a recovery for interest rate-sensitive sectors such as real estate, this will further boost China's related export chains.

► HK-based Companies: Compared to A-shares, due to the pegging of the Hong Kong dollar to the US dollar, the transmission of the Fed's monetary policy to Hong Kong is more direct. For example, the Hong Kong Monetary Authority has already lowered the base rate from 5.75% to 5.25%, and commercial banks are also expected to correspondingly lower the prime lending rate. All of these will directly reduce the financing costs for Hong Kong local companies, improve the liquidity environment of the Hong Kong dollar, and thus directly impact assets related to the Hong Kong local property industry and dividend-based assets.

The review of the impact of the Fed's interest rate cut on China: 'Average Rule' - Hong Kong stocks have greater flexibility, and growth and small-cap stocks outperform; similar to the cycle in 2019.

Based on the simple average of the performance of A-shares and Hong Kong stocks in 6 Fed interest rate cut cycles since the 1990s, the following patterns can be observed: 1) 1 month after the interest rate cut, both Hong Kong and A-shares gained positive returns, with Hong Kong stocks showing greater flexibility (average change Hang Seng Index +3.8%, Hang Seng Composite Index +2.6%), and A-shares having smaller gains (SSE Composite Index +1.6%, Wendt Full A +0.0%); the SSE Composite Index turned to a decline 3-6 months after the interest rate cut, while the growth rate of the Hang Seng Index also dropped to single digits, but maintained positive returns; 2) Growth outperformed value 1 month after the interest rate cut, and small cap outperformed large cap; but 6 months after the interest rate cut, large-cap outperformed small-cap, and the probability of value stocks rising also exceeded that of growth stocks; 3) Apart from consumer necessities and energy sectors, all sectors in A-shares generally declined after the interest rate cut, and most sectors in Hong Kong stocks rose 1 month after the interest rate cut, with the telecommunications (+11.5%) and information technology (+10.1%) sectors experiencing the largest gains. 4) Hong Kong local stocks initially performed worse than Chinese stocks after the interest rate cut, but maintained positive returns after the rate cut, while the Hang Seng China Enterprises Index turned to a decline 3 months after the interest rate cut.

However, it should be specifically pointed out that simple historical averages are not meaningful, especially in cases of small samples and large dispersion, where simple averages can be affected by individual disturbances, so they may not only lack practical significance but also be misleading. Interest rate cut cycles in different historical contexts are not the same, and it is more critical to find macro phases that are more similar for comparison. Two key issues are involved in specific analysis: First, whether the Fed's interest rate cut can directly correspond to a decline in returns, especially in comparing the relative returns of other markets, which is directly related to the US economic cycle; Second, when the Fed lowers interest rates, whether domestic policies move in the same direction to a greater extent, a smaller extent, or in the opposite direction, may be even more critical. In the current environment, neither the former (US recession) nor the latter (strong domestic stimulation) is necessary, so to some extent, it is more similar to the 2019 cycle. A-shares and Hong Kong stocks rebounded significantly, particularly in January-March 2019, when Powell announced a halt to interest rate hikes, and not during the official rate cut in July-September. The reason for this is that at the beginning of 2019 when Powell announced a halt to interest rate hikes, China also decided to cut the reserve requirement ratio, forming a resonance internally and externally. Conversely, after April, the policy reiterated the 'total gate of monetary policy,' and went in the opposite direction of loose Fed policy. Therefore, even with the Fed's official interest rate cut in July, A-shares and Hong Kong stocks as a whole remained volatile.

In the current environment, neither the former (US recession) nor the latter (strong domestic stimulation) is necessary, so to some extent, it is more similar to the 2019 cycle. A-shares and Hong Kong stocks rebounded significantly, particularly in January-March 2019, when Powell announced a halt to interest rate hikes, and not during the official rate cut in July-September. The reason for this is that at the beginning of 2019 when Powell announced a halt to interest rate hikes, China also decided to cut the reserve requirement ratio, forming a resonance internally and externally. Conversely, after April, the policy reiterated the 'total gate of monetary policy,' and went in the opposite direction of loose Fed policy. Therefore, even with the Fed's official interest rate cut in July, A-shares and Hong Kong stocks as a whole remained volatile. Referring to the 2019 experience, after the interest rate cut, growth stocks became stronger, leading sectors such as medical care, consumer discretionary, and information technology; the RMB exchange rate did not strengthen significantly; foreign funds also continued to flow out, only turning to inflow after September 2020.

In this cycle, the Chinese market is not benchmarked by the decline of the United States and domestic strong stimulation. In the short term, attention is focused on growth and export chains, while in the medium term, "high dividends + technological growth" remains the main theme.

Currently, the core factors determining the trend of the China-US cycle are the three pillars of large finance, technology and capital rebalancing. In the short term, the main determining factor is the credit cycle. However, before the US election, it relied on private sector credit (adjusting the relationship between monetary easing and investment return), while China, in the current situation of low private credit and continuing deleveraging, needs fiscal stimulus to boost the economy.

We calculated that the difference between China's real interest rate and natural interest rate is 2.3ppt (2.7% vs. 0.4%), which is significantly higher than the US's 0.2ppt (1.1% vs. 0.9%). Therefore, it requires large-scale fiscal stimulus to increase the natural interest rate, or large-scale interest rate cuts to lower the real interest rate. However, we believe that the short-term interest rate differential, exchange rates, as well as long-term constraints from population and leverage, all determine that the expectation of large-scale strong stimulus may not be realistic. If that is the case, Fed rate cuts can ease liquidity pressure and provide policy easing space, bringing about temporary boost, especially for interest rate-sensitive growth sectors. However, a complete reversal of the current market volatility may still require larger-scale domestic demand stimulus policies, which is why we believe that the impact of the US election may be greater than that of Fed rate cuts.

In terms of allocation strategy, Hong Kong stocks have greater flexibility than A-shares due to their sensitivity to external liquidity and the arrangement of the linked exchange rate system. In addition, Hong Kong stocks have relatively better profitability, lower valuation, and more thorough position liquidation, which also support the relative performance of Hong Kong stocks. Based on our calculations, the current 10-year US Treasury yield at 3.6-3.7% already incorporates the expectation of rate cuts to a large extent. If the risk premium returns to the level of last year, it corresponds to a Hang Seng Index of about 18,500-19,000; if profits grow by 10% on this basis, it corresponds to a Hang Seng Index above 21,000. At the industry level, growth stocks sensitive to interest rates (biotech, technology hardware, etc.), sectors with higher proportion of US dollar financing, HK-based dividend stocks, and export chains benefiting from US rate cuts driving property demand may also benefit marginally.

In the medium term, before seeing greater fiscal support, a structural market with wide range volatility (high dividends + technological growth) will still be the main theme. Firstly, high dividends serve as a response to the overall decline in returns, with stable returns through abundant cash flow, known as the "cash cow". Internally, dividends follow the sequence of the economic environment, from cycle dividends, bank dividends, defensive dividends, government bonds, and cash. Secondly, certain sectors with policy support or improved business conditions are still expected to receive positive stimulus and show greater elasticity, such as sectors with their own industry prosperity (internet, gaming, education) or policy-supported technological growth (technology hardware and semiconductors).

Editor / jayden