Is this a turning point in the economic cycle?
That remains to be seen.
It’s been only a few months since hopes for a re-opening led boom in economic activity were dashed.
We think activity is now stabilising on a cyclical basis, and China’s economy can continue to gradually recover into the end of the year.
But structural drags on the economy are heavy and deep rooted.
In his article we explain how far the current recovery could extend; which structural issues are most limiting; and what are the implications for global growth and investing.
Last week we saw the latest release of hard economic data from China.
As Reuters reports here, monthly industrial output sped up and retail sales grew faster.
By most accounts, the data beat market expectations.
Yes, expectations were fairly low to begin with and therefore easy to beat. But these latest numbers suggest that sequentially, things are improving for the world’s second-biggest economy.
The fixed income team at Pendal thought this would be the case.
Electricity output is a good place to look for how the Chinese economy is going.
Electricity output is driven by energy use in the economy. Although this can fluctuate depending on weather, supply issues and other exogenous factors, a rise in energy use tends to happen when activity levels within the economy are rising.
This is why the Li Keqiang index (a proxy measure for Chinese growth) relies on electricity output as one of its three components to track economic activity.
Electricity output has been rising over the past few months, and points to upside to come in the hard data.
Another place to look for the health of demand in the Chinese economy is producer prices.
Although they track commodity prices closely, given that China is such a large global consumer of commodities, a falling PPI has usually been synonymous with a slowing of Chinese demand.
China’s Producer Price Index (PPI) – a measure of the change in selling prices received by domestic producers for their output – has been in deflationary territory since October 2022.
But it bottomed in June at -5.4% and has been clawing its way back in the last few months.
This may be good news for the Chinese economy, since generating positive inflation momentum is one way to combat debt-deflation dynamics.
But it has mixed implications for the rest of the world.
As the Bloomberg chart below shows, there has long existed a close relationship between China’s PPI and US inflation.
The relationship was likely solidified after China joined the World Trade Organisation in 2001 and became a heavy-weight influence over most tradeables (goods) inflation.
The dislocation between 2016-2018 was likely as a result of Trump’s trade wars against China. The dislocation since 2022 has been the dominance of services-led inflation in the US.
In fact, China’s deflation has been incredibly helpful for inflation in the developed world in the last 18 months.
Without it, goods inflation would still be high, and the market would not be so sanguine about the future path of the US Fed and other central banks.
The turning point in China’s PPI may signal that the freebie of goods price deflation is coming to an end for the rest of the world.
This may not lead to a big second wave of inflation. But it may mean a stickier path for US and other developed world inflation.
It will put the focus squarely back on local labour market dynamics and whether policy settings have become sufficiently restrictive to slow wage growth.
This recovery stands out because the aim of recent piecemeal measures on stimulus was not about starting a new property cycle.
The aim has been to contain the fall-out of the property downturn while finding ways to pivot towards other sources of growth.
To that end, recent measures targeted at relaxing macro-prudential restrictions on home buying are more about easing off on the brakes rather than stepping on the gas pedal.
I would argue these measures have been working.
A huge blockage in the property system formed when property transactions slowed.
Since pre-sale down-payments were a key source of developer funding, it limited the ability of developers to continue or even initiate construction on properties they had pre-sold.
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This meant buyers couldn’t take delivery of finished property. But due to the way the mortgage system works in China, they were already on the hook for servicing a part of the mortgages.
This all too easily snowballed into a crisis of confidence, which fed into a further slowdown in property sales, property prices and so on.
A crucial way to alleviate the blockage was to get sufficient funds to developers to finish what they‘d started.
Property completions have been up strongly this year as backlogs of paused works have resumed.
But this is a very different kind of property stimulus compared to the past. It certainly won’t lead to new waves of strong demand anytime soon.
This is why land sales are still contracting.
Developers only buy new plots of land when they see strong demand prospects in the pipe, as you can see in this Bloomberg chart:
Even without a new wave of property demand, it’s a good to see things are moving again in the Chinese property space.
The property sector accounts for more than a quarter of Chinese economic activity, so the flow-through effects will be positive.
China’s structural problems have not changed.
They centre on an economy that saves too much, causing growth to rely on debt-driven investment rather than by income-led consumption.
China’s national savings rate is over 45%, compared to an OECD average of just over 20%.
The high propensity to save by the private sector in China is partly due to a lack of safety nets.
This increases the burden on the working age population to care for old and young and save for their retirement.
Housing affordability is another issue. Chinese cities have some of the worst housing affordability ratios in the world.
This means parents have to save in anticipation of their offspring one day needing help on a down-payment.
Fiscal measures aimed at easing the burden on households and boosting the social safety net are essential for supporting consumption in China.
Helicopter money is traditionally unacceptable to Chinese socialist principles. It is the main reason why even in the depths of the COVID crisis, the extent of fiscal stimulus unleashed by Beijing paled in comparison to what we saw in the rest of the world.
However, faced with the prospect of a nasty property crisis, fiscal stimulus to the consumer is now being embraced by policy-makers as the lesser of two evils.
Fiscal measures can lead to more near-term upside for the Chinese recovery, but cannot remove a higher-order headwind to consumption.
That headwind is the crowding out of entrepreneurial spirit as President Xi has consolidated his political power in recent years.
Xi’s motives are likely triggered by geopolitical insecurity (including Trump’s anti-China policies).
The outcome is a disruption of incentives for the private sector to borrow, invest and consume.
Against low expectations of any Chinese economic revival priced into Chinese assets, any upside surprise in data in the next few months is likely to have a bigger effect than disappointments.
This limits the ability of bearish China bets to work in Chinese markets, be they rates, currency or equities.
We have closed our short RMB bias now to be neutral, and are short China rates.
It is harder to play for upside in other risky assets though, because not much downside relating to China was priced into those markets in the first place.
Even US companies with big exposures to China’s growth outlook have remained resilient.
However, if Chinese economic momentum is basing here, it reduces the immediacy of tail risks for risk assets more broadly, which is supportive.
A more resilient US economy likely also plays into a supportive backdrop for risky assets ranging from credit to equities.
Our income funds are currently not shying away too much from risky assets, but we are mindful of this being a tactical play.
It is difficult to chart a path of “not too hot, not too cold” growth for the US economy when unemployment is at record lows.
Therefore, it is vital to take the extra risk in the most liquid way so as to preserve the ability to actively de-risk.
When that time comes, bonds will come back into play.
As for currencies, be mindful of a tug-of-war playing out on the US dollar.
It is counter-cyclical in nature, so a stronger global manufacturing cycle should weaken the greenback.
However, if China’s revival causes a sticky inflation headache, the greenback’s ability to weaken will be limited by higher for longer rates in the US.
Amy is Pendal’s Head of Income Strategies. She has extensive experience and expertise in emerging markets, global high yield and investment grade credit and holds an honours degree in economics from Cambridge University.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2021 the team won Lonsec’s Active Fixed Income Fund of the Year Award. In 2020 they won the Australian Fixed Interest category in the Zenith awards.
The team oversees some $20 billion invested across income, composite, pure alpha, global and Australian government strategies.
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