Waiting for a significant interest rate cut on the right side: What do we use to "counterattack"?

Abstract

Summary of Previous Reports and Market Focus

Review of Previous Views: If interest rates can be significantly lowered in September, it will "sound the horn" for the market offensive. On the overseas front, overseas bullish assets are cautious, do not "long for battle". Once the U.S. economic recession is confirmed, it may form a negative feedback intertwining three major risks of "hard landing - liquidity trap - yen appreciation", at that time, global assets will experience a significant decline in "four levels". Domestically, the non-financial performance of the entire A-share market in 2024H1 continues to decline, with only electronics, automobiles, transportation, and utilities showing relatively good profitability. It is expected that the domestic "profit bottom" (asset side) will not be reached until at least 2025H1, and the "necessity, urgency, and feasibility" of interest rate cuts are proposed, achieving the "market bottom" in the short term through improving the liability side. Awaiting the landing of an interest rate cut of more than 50bp in September, and then switching styles, it is recommended to use the "right-side trading interest rate cut" logic. Before that, the A-share market still faces upward pressure on volatility, maintaining a defensive stance.

Market Focus: 1. How to interpret the recent overseas economic data's impact on U.S. interest rate cuts and the magnitude? 2. How to interpret the August domestic economic data and its impact on the market and policies? 3. What are the overseas and domestic asset allocation strategies? 4. If there is a significant interest rate cut in September, how to select undervalued, small and medium-cap growth stocks for "offensive" strategies?

As overseas interest rate cuts approach, domestic "loose money" urgently needs to be increased

In August, U.S. manufacturing PMI, non-farm employment numbers, and other indicators all accelerated their decline once again, and the global economy still shows a downward trend, with the U.S. unemployment rate likely to rise further. Once the U.S. economic recession is confirmed, it may form a negative feedback intertwining three major risks of "hard landing - liquidity trap - yen appreciation", at that time, global assets will experience a significant decline in "four levels", and may even trigger a "crisis". Regarding bulk commodities and overseas equity assets, we maintain our core views and recommendations: (1) Apart from gold, bulk commodities are cautious. (2) U.S. stocks will rebound under interest rate cut expectations, and it is recommended to "take profit" on rallies. (3) Risks in Hong Kong stocks come from overseas "hard landing" + "liquidity trap", making it difficult to achieve excess returns compared to A-shares.

Recently released PMI and real estate sales data show that macroeconomic pressures in China may further increase in August. Currently, there is a "necessity", "urgency", and "feasibility" for interest rate cuts domestically, we maintain the prediction: only by cutting interest rates in September, especially by more than 50bp in the 5-year LPR, and as long as China's exports do not show a significant decline, maintaining the actual return rate of enterprises in a controllable range (-1% to 0%), there is hope to see the "market bottom" within the year. It is recommended to use the "right-side trading interest rate cut" logic, await the landing of the interest rate cut before switching styles, gradually transitioning from banks and high dividend stocks to consumer stocks, especially small and medium-cap growth stocks for "offensive" strategies. Before that, the A-share market still faces upward pressure on volatility, maintaining a defensive stance.

How to select undervalued, small and medium-sized growth "offensive" stocks?

We explored small and medium-sized stocks with greater rebound magnitude behind important market bottoms in history, and found the following characteristics: 1) The smaller the market value of a stock, the greater the rebound magnitude, that is, the rebound magnitude of small and medium-sized stocks is ">" than that of large-cap stocks; 2) The greater the previous decline of a stock, the greater the rebound magnitude; 3) Companies that focus more on shareholder returns, i.e. companies with higher dividend yields or more buybacks, have seen greater rebounds in recent rebound periods. In addition, the correlation between other factors such as ROE and rebound magnitude is unclear. In summary, if the market bottom arrives, priority should be given to: ① small and medium-sized stocks with large declines, ② if their shareholder returns are good, it is a further bonus point. Based on these conclusions, we have selected the "PE valuation cheap + sufficient adjustment magnitude + small and medium market value" consumer, growth industries, and added industries with high dividend characteristics, including electronics, computers, defense industry, pharmaceuticals, food and beverages, social services, beauty care, and light manufacturing.

Maintain the "large-cap value defense" strategy significantly before the September interest rate cut

Recommendation: ① Bank core positions; ② Gold + innovative drugs "offensive"; ③ Non-cyclical potential high dividend industries. Diversification strategies include: (1) Bulk commodities retain only "gold". As the expectation of a US interest rate cut approaches, bulk commodities that have benefited from global liquidity surplus, including copper, aluminum, etc., may be constrained by the "liquidity trap"; only gold will continue to benefit from the "two-way" drive of declining real interest rates and a weaker US dollar. (2) Innovative drugs are waiting for the US unemployment rate to exceed "4.2%", and will benefit from the trend of declining US bond rates. (3) High dividends combined with potential dividend rate upward logic, including: banks, transportation, utilities, and communications. Waiting for the interest rate cut to "land", then switch styles.

Main Content

I. Summary of Previous Reports and Market Focus

Review of Previous Views: If there is a significant interest rate cut in September, it will "sound the horn" for market offensive. Overseas, overseas bullish assets are cautious, do not "long for war". Once the US economic recession is confirmed, it may form a negative feedback intertwining the three major risks of "hard landing - liquidity trap - yen appreciation", at that time, global assets will suffer a significant decline in "four levels". Domestically, the non-financial performance of the entire A-share market in 2024H1 continues to decline, with only electronics, automobiles, transportation, and utilities showing relatively good profits. It is expected that the domestic "profit bottom" (asset side) will not arrive until at least 2025H1, and the "necessity, urgency, and feasibility" of an interest rate cut are proposed, achieving the "market bottom" in the short term through improving the liability side. Waiting for the interest rate cut of 50bp or more in September to land, then switch styles, and recommend the logic of "right-side trading interest rate cut". Before that, the A-share market still faces upward pressure on volatility, maintaining a defensive stance. Market Focus: 1. How to interpret the impact of recent overseas economic data on the US interest rate cut and its magnitude? 2. How to interpret the August domestic economic data and its impact on the market and policies? 3. What is the asset allocation strategy for overseas and domestic markets? 4. If there is a significant interest rate cut in September, how to select undervalued, small and medium-cap growth stocks for "offensive" purposes?

II. Strategic Views and Investment Recommendations

2.1 With the overseas market interest rate cut approaching, domestic "loose monetary policy" urgently needs to be strengthened

The probability of a September interest rate cut by the Federal Reserve is almost certain, with the main divergence being the magnitude of the cut at 25bp or 50bp. The market is currently trading the scenario of a "soft landing," but through four dimensions: ① the trend and threshold of the unemployment rate - natural unemployment rate, ② the Sam Rule, ③ global economic conditions, and ④ the magnitude of the interest rate cut, we judge that the probability of a "hard landing" for the US economy is now over 70%. We are focusing on global economic indicators, including: 1) the August US manufacturing PMI at 47.2, below market expectations; 2) the August US JOLTs job openings at 7.673 million and non-farm employment at 142,000, both below market expectations; all indicators are accelerating their decline again, indicating a continued downward trend in global economic conditions, which will lead to a further decrease in US job openings. At the same time, with the flattening of the Beveridge Curve, the US unemployment rate may continue to rise. Once a "hard landing" is confirmed, the impact on global assets will be significant and significant, and it may lead to a negative feedback loop of "hard landing" - "liquidity trap" - "yen appreciation." At that time, as US assets accelerate their decline, due to their high debt levels and bluntness on the liability side, there may be a progressive decline in the "balance sheets" from the US government to residents to businesses, with consequences ranging from a "liquidity crisis" to a "four-tier decline" in global assets; and even trigger risks in more countries.

Clearly, the derivation and impact of overseas risks may be more persistent than imagined, and the depth and breadth may continuously exceed market expectations. Regarding bulk commodities and overseas equity assets, we maintain our core views and recommendations: (1) Apart from gold, bulk commodities are cautious, sell on rallies, or even wait for further weakening labor data in the US, and can go long on "gold-silver ratio," "gold-copper ratio," and "gold-aluminum ratio." (2) US stocks will rebound under the expectation of an interest rate cut, but under the impact of "weak economy + increased expectations of interest rate cuts," US stocks are likely to adjust again, so it is advisable to "take profits" on rallies. (3) Risks in Hong Kong stocks come from overseas "hard landing" + "liquidity trap." At that time, Hong Kong stocks will weaken again due to their high sensitivity to the domestic economic fundamentals and the tightening of offshore US dollars, making it difficult to achieve excess returns compared to A-shares.

Recent data shows that the pressure on the domestic macroeconomy in August may further increase: 1) The August domestic manufacturing PMI shows a "simultaneous decline in quantity and price." The value is 49.1, below market expectations, and has been declining for 5 consecutive months. Among them, PMI production, new orders, backlog of orders, and purchasing volume are 49.8 (-0.3 pct), 48.9 (-0.4 pct), 44.7 (-0.6 pct), 47.8 (-1.0 pct), respectively, showing a significant decline in demand; And the prices have all seen significant declines on a month-on-month basis, whether it is the PMI purchasing price index dropping significantly by 6.7pct to 43.2, or the factory price only at 42.0 (-4.3pct), all indicating that the August PPI may see an expanded month-on-month decline, putting pressure on industrial enterprise profits. 2) In August, the year-on-year sales of the top 100 real estate companies decreased by 27.8%, and both real estate sales and housing prices have yet to stabilize, which also means that the long and medium-term loan data for residents in August may continue to weaken.

In previous reports, we proposed the two meanings of "market bottom": ① valuation bottom, real estate risks are controllable, and the worst times are over; ② credit bottom, residents and enterprises are willing to consume, produce, and invest. Considering that the repair of the "asset side" for residents and enterprises comes after the "profit bottom", the only way to achieve the "market bottom" is to reduce the pressure on the "debt side" for residents and enterprises, control the risk of continued price decline, and guide residents' consumption and enterprises' production, which can only be achieved through interest rate cuts— this is the "necessity" of interest rate cuts.

Considering the risk of an overseas economic "hard landing", which will intensify domestic export pressure, forcing domestic prices to continue to decline and actual corporate returns may fall to "negative", it is also proposed to expect an "early interest rate cut", with the best interest rate cut window forming continuity in July, August, and September to boost market confidence and address issues such as insufficient impact of a one-time interest rate cut due to exchange rate constraints— this is the "urgency" of interest rate cuts.

Since 2024, the premium level of the RMB "spot exchange rate - midpoint price" has been at its highest level since 2015, reflecting significant depreciation pressure on the RMB. However, with the significant economic weakening announced overseas in August, this exchange rate premium has significantly narrowed. At the same time, considering that China's existing loan interest rates are above 3.8%, with a scale of up to 38 trillion, accounting for about 1/5 of the total loan size, even if the 5-year LPR is lowered by 100bp, a deposit rate adjustment of only 20bp can maintain a relatively stable interest margin for commercial banks— this is the "feasibility" of interest rate cuts.

We maintain our forecast: only by leading the interest rate cut in September, especially by more than 50bp for the 5-year LPR, and with no significant decline in China's exports, can we maintain the actual return rate of enterprises within a controllable range (-1% to 0%), and we may see the "market bottom" within the year. We recommend the "right-side trading interest rate cut logic", waiting for the interest rate cut to land before switching styles, gradually transitioning from banks and high dividend stocks to consumption, especially mid-cap growth stocks. Before that, the A-share market still faces upward pressure on volatility, so we maintain a defensive stance.

2.2 How to select undervalued, small and medium-sized growth stocks for "offensive" strategies?

If the "market bottom" is approaching, what kind of stocks should we allocate to in order to achieve a greater rebound? Based on our "dual-cycle rotation framework," when switching to consumer and growth styles; further explore the characteristics of industries with greater elasticity as follows: 1) Stocks with smaller market capitalization usually have a larger rebound, that is, the rebound of small and medium-sized stocks is ">" than that of large-cap stocks; 2) Stocks that have experienced larger declines in the previous period will have a larger rebound; 3) Companies that focus more on shareholder returns, i.e., companies with higher dividend yields or more buybacks, tend to have a larger rebound in the rebound range in recent years. In addition, other factors such as ROE, profit growth rate, valuation percentile, public fund holding ratio, financing balance ratio, etc., have unclear correlations with the rebound magnitude. In summary, if the market bottom is approaching, priority should be given to: ① small and medium-sized stocks with significant declines, ② if their shareholder returns are good, it is an additional bonus.

Note: The market bottom discussed in the article corresponds to the decline and rebound intervals as shown in the following figure and table, totaling 6 times, with an average decline time of 15 months and an average rise time of 6 months.

We classify companies with a total market value ranking in the top 300 at the market bottom as large-cap stocks, and the rest as small-cap stocks. Based on this, various data are calculated (as follows), and it is found that the average rebound of small and medium-sized stocks is greater than that of large-cap stocks, a conclusion that holds true after each market bottom.

Furthermore, we rank the small and medium-sized stocks by total market value, dividing them into 5 intervals from small to large, and calculate the average increase for stocks in each interval. Considering the significant differences in rebound magnitude after each market bottom, for horizontal comparison, we standardize the price changes of each type of stock, i.e., standardized average increase of interval stocks = average increase of interval stocks / all stock increases, as follows. The results show that the smaller the market value of stocks in small and medium-sized stocks, the greater the rebound, and this conclusion holds true in most major years.

We rank the decline range of the downtrend interval, divide small and medium-cap stocks into 5 intervals (the top 20% of companies with the largest decline are in the range of 0% to 20%, and so on), and calculate the average increase of stocks in each interval. From the results, it can be observed that the stocks with larger declines in the small and medium-cap stocks tend to have larger rebounds, and this conclusion holds true in most major years.

Among the top 20% of companies with the largest decline, we have compiled the frequency of industries, and it is mainly dominated by cyclical and growth style companies. The industries with the highest frequency include machinery equipment, power equipment, basic chemicals, pharmaceuticals, electronics, computers, etc. On the other hand, based on industry indices, it can be observed that the industries with larger declines in the previous period also have larger rebounds.

As the macroeconomic growth gradually slows down, shareholder returns of listed companies have become a key factor in determining excess stock returns. Therefore, we have explored the performance of two factors, dividend yield and stock repurchase, in the rebound interval. It can be observed that companies that focus more on shareholder returns, i.e., companies with higher dividend yields or more repurchases, tend to have larger rebounds.

We rank the dividend yield at the "market bottom," divide small and medium-cap stocks into 5 intervals from small to large, and calculate the average increase of stocks in each interval. From the results, it can be observed that stocks with higher dividend yields in the small and medium-cap stocks tend to have larger rebounds, and this conclusion is particularly significant in the three years of 2016, 2018, and 2024.

In examining the repurchase factor, we found that the average increase of companies with repurchases in the rebound interval is greater than those without repurchases (the number of companies repurchasing shares before 2016 is relatively small, with low reference significance, and not included in the results). Among the stocks with repurchases, the larger the proportion of repurchase amount to the market capitalization, the larger the rebound, especially evident in 2024.

Based on the above conclusions, we select industries with significant declines, a higher proportion of small and medium-sized companies, and lower current valuation percentiles as directions worth paying attention to after the market bottom appears; in addition, based on this, we select industries with high dividend characteristics as a bonus.

The comparison of the latest PE valuation percentiles and the decline rankings from November 2021 to now for each industry is shown in the following figure. We select industries with significant declines and lower current valuation percentiles (bottom left corner): 1) current PE valuation percentiles within 50%; 2) industries with decline rankings within 0.5 (i.e., the half of industries with larger declines). Considering that the average market value of the selected industries is smaller than the large market value threshold we defined, these industries all meet the conditions of small and medium market values. Therefore, we select "cheap PE valuation + sufficient adjustment amplitude + small and medium market value" consumer, growth industries including: power equipment, beauty care, retail trade, food and beverage, electronics, pharmaceuticals, computers, light manufacturing, social services, and national defense military industry.

Considering that companies that focus more on shareholder returns, i.e., companies with higher dividend yields or more buybacks, have seen larger rebounds in recent years, we further select industries with high dividend characteristics from the above industries. We screen industries with potential high dividend characteristics based on profit factors, dividend capabilities, and dividend intentions, including: 1) profit factors, i.e., ROE higher than the industry average or showing an improving trend; 2) dividend capability, i.e., operating cash flow as a percentage of revenue is higher than the industry average; 3) dividend intentions, i.e., higher dividend payout ratio, higher than the industry average. According to the above criteria, we further select industries with high dividend characteristics including: electronics, computers, national defense military industry, pharmaceuticals, food and beverage, social services, beauty care, and light manufacturing.

Furthermore, we use the Golden Stock Model to select 100 stocks from the above industries as shown in the table below for reference. (Note: Our Golden Stock Model uses a scoring system, weighting fundamental factors (25%), valuation (20%), capital (30%), and technical factors (25%), with a full score of 1.)

2.3 Style and Industry Allocation: Maintaining the "Market Value Defense" Strategy Before the Significant Interest Rate Cut in September

Recommendation: ① Bank core positions; ② Gold + innovative drugs for "offense"; ③ Non-cyclical industries with potential sustained high dividends. Diversification strategies include: (1) Only retain "gold" in bulk commodities. As the expectation of a U.S. interest rate cut approaches, bulk commodities that have benefited from global liquidity surplus, including copper, aluminum, etc., may be constrained by a "liquidity trap"; only gold will continue to benefit from the "two-way" drivers of declining real interest rates and a weakening U.S. dollar. (2) Innovative drugs will wait quietly for the U.S. unemployment rate to exceed "4.2%", benefiting from the trend of declining U.S. bond yields. (3) High dividends combined with the logic of potential dividend yield increase, including: banks, transportation, utilities, and communications. Waiting quietly for the interest rate cut to "land", then switch styles accordingly.

Author of this article: Zhang Chi (SAC Practitioner Number: S1130523070003), Source: ChiCeLunShi, Original Title: "【GuoJin Strategy】Waiting for a Significant Interest Rate Cut on the Right Side: What Do We Use to "Counterattack"?", some content has been edited by Wall Street News