The impact of the Fed rate cut on A-shares: 2 paths and 3 constraints

Report Summary

The U.S. added fewer non-farm jobs than expected in August, but the unemployment rate fell from the previous 4.3% to 4.2%. Following the data release, Federal Reserve Board member Wall made a speech, leaning slightly hawkish, stating that the labor market continues to be weak but not deteriorating, not believing that the economy is in recession or will soon head towards recession, the Samuelson rule may be ineffective, and rate cuts will begin in September but will be cautious.

Overall, the U.S. non-farm data for August was slightly below market expectations, but did not point to a recession. The signal for a rate cut by the Federal Reserve in September is further clarified, but the magnitude may be a cautious "25bp". In addition, according to CME FedWatch, the market expects the Federal Reserve to cut interest rates 9 times by June next year, totaling 225bp. In fact, the current rate cut path may already be quite sufficient, and at the September meeting, it is more important to focus on the dot plot's guidance on the future pace of rate cuts.

So, as the Federal Reserve rate cut cycle is about to begin, what impact will it have on the A-share market? In this weekly report, we further discuss the two paths and three constraints of the impact of the Federal Reserve rate cut on the A-share market, and attempt to answer the following questions:

1. Will the Federal Reserve rate cut definitely lead to capital inflows into the Hong Kong and A-share markets?

2. Will the Federal Reserve rate cut release domestic policy space, and can domestic policies further strengthen?

3. Can the Federal Reserve rate cut reverse the U.S. recession expectations and bring expectations of domestic fundamental improvement?

Report Body

The Impact of the Federal Reserve Rate Cut on the A-share Market: Two Paths and Three Constraints

The U.S. added fewer non-farm jobs than expected in August, but the unemployment rate fell from the previous 4.3% to 4.2%. The contradiction between non-farm and unemployment rate data has increased market divergence, with U.S. stocks, U.S. bond yields, and the U.S. dollar index falling in the short term, and the market appearing more sensitive to the weaker-than-expected non-farm data.

Following the data release, Federal Reserve Board member Wall made a speech. This is also the last heavyweight speech before the silent period of the Fed officials before the September meeting, attracting high market attention. However, his stance remains slightly hawkish, stating that the labor market continues to be weak but not deteriorating, not believing that the economy is in recession or will soon head towards recession, the Samuelson rule may be ineffective, and rate cuts will begin in September but will be cautious.

Overall, the U.S. non-farm data for August was slightly below market expectations, but did not point to a recession. The signal for a rate cut by the Federal Reserve in September is further clarified, but the magnitude may be a cautious "25bp".

In addition, according to CME FedWatch, the market expects the Federal Reserve to cut interest rates 9 times by June next year, totaling 225bp. In fact, the current rate cut path may already be quite sufficient, and at the September meeting, it is more important to focus on the dot plot's guidance on the future pace of rate cuts.

So, as the Federal Reserve rate cut cycle is about to begin, what impact will it have on the A-share market? (1) Impact Path One: Funding and Risk Preference

From a liquidity perspective, theoretically, a rate cut by the Federal Reserve → easing of the US-China interest rate spread, easing of Renminbi exchange rate pressure → opening up of the central bank's monetary policy space, expectations of further liquidity easing → driving the valuation repair of rate-sensitive assets.

Furthermore, with the expectation of global liquidity easing, improved risk appetite, low-priced stagnant varieties or rate-sensitive assets may be the first to see repair, such as US small-cap stocks, real estate, biotech, as well as Chinese concept stocks, Hang Seng technology, small-cap A shares, and sci-tech innovation board, etc.

However, this aspect mainly involves the logic of valuation repair, and there are two obvious constraints in its transmission path: "US-China interest rate spread → central bank's monetary easing space", "liquidity easing → capital inflow into A shares", both of these paths have uncertainties.

Specifically:

Constraint One: The impact of the decline in US bond yields and the narrowing of the US-China interest rate spread on the central bank's monetary easing space may be limited; the downward space of deposit and loan interest rates will also be affected by factors such as the speed of bank deposits flowing into wealth management products, and the extent of narrowing of bank net interest margins.

Zou Lan, Director of the Monetary Policy Department of the People's Bank of China, stated at a press conference on September 5 that there is still room for reserve requirement ratio cuts, but there are certain constraints on further downward movement of deposit and loan interest rates. Director Zou Lan emphasized that the downward movement of deposit and loan interest rates will also be affected by factors such as the speed of bank deposits flowing into wealth management products, and the extent of narrowing of bank net interest margins. Currently, the net interest margin of Chinese commercial banks has continuously declined from 2.2% at the end of 2019 to 1.54% in June 2024.

Constraint Two: Macro liquidity easing is a necessary but not sufficient condition for capital inflow into the stock market.

Whether from the interbank liquidity indicators (DR007) or the overall society's surplus liquidity indicators (M2 year-on-year - social financing stock year-on-year), the trend of macro liquidity does not provide direct or clear guidance on the trend of the A-share market.

Path One impacts the repair at the valuation level, but it is difficult to determine the trend of asset prices decisively, and the determining factor of asset prices still lies in the fundamentals.

For example, from November 2023 to January 2024, US bond yields continued to decline by over 100 basis points, which helped boost the risk appetite for global equity assets. However, at the same time, the weakening profit expectations of A-share assets (PMI below 50 and further decline) have become the core factor in pricing A-share assets The market performance is still struggling to improve.

From the long-term trend of asset prices, the determining factor lies not in liquidity, but in fundamentals. Whether it's the CSI 300 or the Hang Seng Tech Index, the long-term trend aligns better with China's manufacturing PMI.

(II) Impact Path 2: Fundamentals

From a fundamental perspective, for A-shares, the core impact of the Fed rate cut cycle lies in the resilience of external demand. Looking at the performance of asset prices before and after the Fed rate cuts in the past, the sequence may involve dealing with macro uncertainties first (soft landing or hard landing), followed by the resurgence of trade (boost in real estate, manufacturing, and consumer demand). The transmission chain of A-share fundamentals comes from:

(1) Global rate cut cycle begins → Accelerated recovery of North American real estate cycle → Rebound in North American durable goods demand → Rebound in new export orders from China

(2) Global rate cut cycle begins → Global manufacturing PMI rebounds → Rebound in global pricing of commodities (such as copper) → Upward trend in commodity profits

The above transmission links mainly come from the external demand side, but another key pricing factor for A-shares comes from domestic demand. However, in this process, the extent of local government fiscal expansion serves as another constraint.

Constraint Three: The extent of local fiscal expansion may limit the strength of domestic fundamentals recovery.

Historically, the general fiscal deficit ratio has shown a clear and stable leading significance for PPI and ROE. In the current cycle, the expectation for fiscal efforts may be weak, and the expectation for driving force of A-share fundamentals is not high.

In summary, from the perspectives of liquidity and fundamentals, US bond yields for A-share assets can be "icing on the cake," rather than a "lifesaver."

Taking the new energy industry as an example: ① In 2020-2021, as new energy profits rise and US bond yields increase, fundamentals are priced in, and US bond yields are not sensitive; ② In the first three quarters of 2022-2023, as new energy profits decline and US bond yields rise, the market may face a situation of a double blow to profits and valuations ③In the fourth quarter of 23-24, the profitability of new energy declined, while the US bond yield rose. It is still based on fundamental pricing, and the US bond yield is not sensitive. During a "icing on the cake" phase in Q2-Q3 of 21, the increase in new energy profitability coincided with a phase of decline in US bond yields.

Analysts:

Liu Chenming: SAC License No.: S0260524020001

Zheng Kai: SAC License No.: S0260515090004

Li Rujuan: SAC License No.: S0260524030002