At a time when most investors are looking eagerly to the United States for tax cuts and other stimulus measures from the new US administration, the peaking of nominal Chinese GDP growth will be the major driver of global equity performance, according to analysts at one investment bank.
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In a note released at the end of last week, a team of analysts at Bank of America Merrill Lynch - led by equity strategist Ajay Singh Kapur - argued that global investors should adopt a defensive stance, as growth in China, which accounts for nearly a fifth of the world's GDP, has passed its peak.
They recommended investors focus on local and defensive sectors and away from the cyclical stocks that have benefited the most from a surge of US economy-led confidence in recent months.
At the National People's Congress in late March, the Chinese government announced a 6.5 per cent annual growth target for 2017 - the lowest figure in two decades. Chinese growth has exceeded expectations in the first quarter of this year, with GDP growing 6.9 per cent. But BoA Merrill Lynch analysis suggests growth has peaked and will slow in coming quarters.
The equity strategists use five leading indicators to assess China's expected nominal GDP growth, which they argue is more "potent" than real GDP growth that accounts for inflation in its effect on global asset prices.
The indicators cover financial conditions (which take into account real interest rates, total loan growth and the real effective exchange rate), Chinese money supply, input prices from Chinse PMI surveys, and year-on-year change in the credit multiplier (the country's loans divided by its monetary base). Since February this year, these indicators have suggested that Chinese growth has peaked and is likely to slow in coming quarters.
The analysts acknowledge that theirs is a counter-consensus call and they've received some pushback.
Most analysts are arguing that the world economy is recovering and bond yields are due to rise as investors seek out riskier asset classes, meaning cyclicals should still have an edge over defensive stocks.
This is the basis of the so-called "reflation" trade that has seen global equities markets, particularly the S&P500, rise very strongly from the second half of last year.
Many believe this trade still has time to run. But not the equity strategists at BoA Merrill Lynch.
"We disagree," they wrote, arguing the impact of Chinese nominal GDP growth on asset class price movements, particularly when assessing cyclical over defensive stocks, is "overwhelming".
"We think that a potential peak in China's nominal GDP growth means a weakening in its impulse to global nominal growth, and a possible peak in PPI [producer price inflation] suggests it will export less inflationary impulses globally - the opposite of the past five quarters."
Using just one indicator of global demand to make global asset allocations can seem insufficient, the analysts acknowledged. But given the sheer importance of Chinese nominal GDP growth, a series of other considerations, such as earnings momentum, relative valuations and investor positioning, would need to be "equally as strong to prefer cyclicals over defensives". China's share of global GDP rose to an estimated 17.8 per cent in 2016 - up from 11.4 per cent in 2007.
Cyclical sectors like energy, materials and industrials highly exposed to China are likely to underperform in times of falling nominal GDP growth, even with equity markets either remaining stable or rising strongly, the analysis states.
This includes Australian equities, where sectors with an above-average association with the China nominal GDP growth estimate are materials and energy, while food and staples retailing, as well as software, are also highly exposed.
Meanwhile, discretionary retailing, telecoms, financial stocks and utilities - domestically focused and defensive sectors - have the least exposure to Chinese growth. With the cycle coming off the peak, it is these sectors which are likely to do best in response, according to the BoA Merrill Lynch analysis.
On average, cyclical stocks on the ASX have tended to grow 26.7 per cent over the duration of rising episodes in Chinese nominal GDP growth, which in recent years have tended to last two to three years. Such boom periods have seen defensive stocks grow a more modest 9.2 per cent on average.
But during periods of falling nominal GDP growth, cyclical stocks have grown 5.6 per cent while defensive parts of the market have surged 39.6 per cent.
Surprisingly given the centrality of exports to China to Australia's economy, when it comes to equity markets, bourses in Russia, Indonesia and Brazil are far more exposed to Chinese growth than the ASX. Globally, equity markets in Japan and the US are the least exposed.
Periods of strong nominal GDP growth in China can have a large bearing on the price of the Australian dollar, which is the fifth most-exposed currency to Chinese growth globally.
In commodity markets, tin, silver and copper are most associated with periods of strong economic growth in China. Gold, zinc and aluminium are the least exposed, and thus likely to outperform in periods of slowing Chinese growth.
