COMMENT: China is risky, but watch out for interest rates

The downturn in China will continue to generate negative headlines, but there won't be a hard landing. The real risk to eurozone property values will be from interest rate changes, says Richard Barkham, chief global economist at CBRE.

What should we make of the economic news from China? Since the take-off in growth in the early 1990s the Chinese economy has been very well managed. The attempt to pump up the stock market earlier this year to create a market for securitised debt is perhaps the first big mistake that Chinese policymakers have made. The Chinese economy is in the process of moving from export- and investment-led growth (approx. 65% of GDP) to growth driven by consumption.

That transition is long planned, well thought out, but was always likely to be bumpy, and so it is. Part of the transition is to bear down on excessive investment through lending restrictions, higher interest rates and higher-than-warranted currency value. This is really hurting, but needs to be done to avoid misallocation of capital. Consumption has not yet taken up the running, but there is evidence that the service sector is growing well and retail sales are picking up.

The slowdown in China’s growth has not yet bottomed, but there is ample space to cut rates further to boost growth. In fact, it is likely that markets have been ‘betting’ that the Chinese would re-stimulate and so they have to a limited degree, hence the very positive reaction to this week’s rate cut. Nevertheless, we should expect ongoing weakness in China, and this will create problems for other emerging markets. We should also expect that policymakers will do enough to keep growth in the range of 5 to 7%. There will be more negative headlines, but this is a major economic shift and there is no quick fix. There will be no hard landing, but it will be rough from time to time.

What about the impact on world stock markets? Three factors, in equal measure, have caused values to fall: correction, reaction and overreaction. For the last 12 months or so it has been clear that markets were underestimating the risks in the global economy probably due to the delay by the Fed in raising rates and the Quantitative Easing programmes of the Bank of Japan and the ECB. Risk premiums had compressed too far. This is the correction. The reaction, also warranted, is to a weaker-than-expected economic environment in China and the other emerging markets. The overreaction is partly due to the time of year and the natural tendency of liquid markets to be affected by sentiment. We should expect markets to be volatile to mid-September and then to start to regain ground. There may be a six-month impact on economic sentiment.

The real risks to eurozone real estate values are long-term, and arise from changes in interest rates. The US could easily gather pace on the back of lower oil prices finally feeding through to consumer spending and revived business investment. As a consequence, there would be an unexpected jump in wage growth, leading to a serious bond market sell-off. This would reverberate around the real estate market. It’s a possibility for 2016 and at the very least it would cause a pause in investment activity. We can take this scenario further. The US posts solid economic growth and the eurozone surprises on the upside, with Beijing responding by stimulating aggressively. This could start at any time, and by late 2016 or 2017 we would be in a world not dissimilar to that of 2007, only property yields would be even lower. Rental growth would be quite strong, but there would also be an aggressive response from the Fed and the ECB which would hit values and activity in 2018 and through 2019.

The third major risk is rather different in nature but is also linked to interest rates. Growth is weaker than expected and interest rates peak at very low levels. This would mean that the next cyclical downturn has no policy offset. Interest rates could not be cut far enough because they are already at near-zero levels and QE could not be enacted because investors would begin to question the fiscal underpinning of central banks’ balance sheets. This is not a near-term risk because the upward pressure on rates is still very weak. But it could happen. In the event, albeit remote, of a hard landing in China in two to three years’ time, we would have a recipe for a very nasty fall in asset values. For the time being, though, we should expect this weak and volatile cycle to continue with interest rates and economic growth providing good support for real estate values.

Richard Barkham is global chief economist at CBRE