(Mar 6): Trade ministers are speaking optimistically of a return to normal as Covid-19 comes under control. Australia’s iron ore producers are equally optimistic as they look forward to the traditional infrastructure stimulus tool that China used to overcome the impacts of the 2008 GFC.
They are wrong for one very important reason. The economic recovery will call for the recapitalisation of China business, big and small. This is a financial stimulus, not a construction stimulus. The recapitalisation will impact on investment activity both within China and outside of China with a reduction of outward flows of capital. The apartment in Sydney may become much cheaper as the Australian dollar falls and Chinese investment capital stays at home.
Consider a typical example at an individual level. He lives in Beijing and runs a successful SME business. The business gives him an income that allows him to purchase a house in Sydney, or Singapore. It allows him to send his child to a university in the US, Australia or Singapore. He can also support the new love of his life, an imported American sports car.
It is all discretionary expenditure, even if it is an “investment” in property overseas.
But wait.
His business has been at a standstill for the past eight weeks and even now he cannot get back into full production because his workforce remains quarantined. His cash flow has completely dried up, and even if he can restart tomorrow, it is going to be several weeks before he can tool-up to the previous cash flow levels. His bank is starting to get nervous, because even though they have been directed by the government to go easy on borrowers, the reality is this cannot last.
So, what gets cut first? The everyday luxuries like A2 baby formula milk from Australia, the French wine, the car, university fees? The first cut will probably be the planned investment in overseas property because that relies on some borrowing.
One thing is for sure, he is going to need to generate cash flow and reduce cash expenditure rapidly so he can service existing debt required to keep his business afloat.
To help make these personal decisions the central government will probably offer some incentives for the “big men” to redeploy their capital in the domestic Chinese market rather than send it overseas. China policy, like Chinese education, more often relies on using the stick rather than rewarding with a carrot so he expects it will become more difficult to shift capital overseas. It will become harder to get approval from the National Development and Reform Commission and the State Administration of Foreign Exchange to transfer funds for larger scale investments in overseas projects and business enterprises. But that is not his problem.
As a small and recently prosperous SME, he no longer has spare capital for discretionary expenditure. Now it is all about survival.
His story is repeated millions of times across China.
Imagine, for a moment, that your Singapore business had no cash flow income for eight weeks. How many would go to the wall? How many would never recover? Of those that survived, how many would thrive without fresh capital support? Wuhan, with twice the population of Singapore, faces this problem. Magnify this across China and it is easy to understand why things will not return to as they were before Covid-19.
The GFC called for replacement of market demand as Western markets contracted, and demand fell.
The infrastructure stimulus was an appropriate answer.
Covid-19 calls for a recapitalisation of business so they can meet established demand. That calls for a stimulus of an entirely different nature. The subsequent shrinking and diversion of China’s capital investment overseas will dash the hopes of many who rest their recovery plans on a Chinese infrastructure stimulus.
Technical outlook for the Shanghai market
The resilience in the Shanghai Index is remarkable. Following the gap down and retreat on February 28, the index then rebounded strongly. The rebound returned the index to the relatively narrow trading band between 2,980 and 3,040. This behaviour adds new analysis tools to the understanding of the Shanghai Index.
The retreat and rebound behaviour enable the placement of an uptrend line. The behaviour of the Shanghai index since making the low of 2,783 is no longer characterised as a rally.
It can now be defined as an uptrend because there are two anchor points for the uptrend line.
A reliable trend line has three anchor points, each created by a clear retreat and rebound point. The low of these patterns is used as the anchor point for the trend line. The low point of the retreat and rebound at 2,879 provides the second anchor point for the uptrend line.
Investors now wait for a second retreat and rebound to establish the third anchor point for the trend line.
If successful, this will involve a test of the new uptrend line value currently near 2,930. A rebound from this support feature enabled the Shanghai index to again move into the narrow sideways trading band between 2,980 and 3,040.
Some observers have suggested the longer-term pattern in the Shanghai Index shows a head and shoulder trend reversal pattern. The left shoulder is the high near 3,039 in December 2019. The head is the peak near 3,127 in January. The right shoulder is the peak near 3,059 in February.
This is not a valid head-and-shoulder pattern. The pattern is an end of trend pattern that develops after a prolonged uptrend. The features on the index chart come after a prolonged sideways pattern and the high near 3,127 is well below the 2019 peak high of 3,288 last April.
Additionally, the head-and-shoulder pattern does not usually include market disruptions which lead to massive market retreats as occurred in February. This unusual behaviour invalidates many of the usual pattern developments.
The focus for Shanghai Index development is the strength of historical support near 2,980 and the test of the new support feature provided by the value of the new uptrend line.
The bottom of a new retreat and rally sequence may lead to the adjustment of the position of the new uptrend line, but this will not be confirmed for another week or more.
A fall below the new trendline has support near 2,850.
Daryl Guppy is an international financial technical analysis expert and special consultant to Axicorp. He has provided weekly Shanghai Index analysis for mainland Chinese media for more than a decade. Guppy appears regularly on CNBC Asia and is known as “The Chart Man”. He is a national board member of the Australia China Business Council
