- We believe China's industrial activity has slowed more than is widely appreciated by investors, though not as much as in 2015.
- Recent actions by China’s central bank may represent an acknowledgement of these trends and a policy shift toward easing.
- The global economy remains in solid shape with low risk of recession, but growth may have already peaked.
- With downside risks to growth and upside risks to inflation, portfolio diversification across multiple asset categories is even more important than usual.
In recent months, our proprietary industrial production index has dropped precipitously and is showing the weakest industrial activity in China in years (see chart, below left). In contrast, China's government data continues to show stable industrial production, much as it did during the major manufacturing deceleration that led to China's growth recession in 2015. Similar to 2015, when China’s slowdown eventually convulsed the global economy and financial markets, we are concerned that official data and investor consensus expectations are not acknowledging the weakening trends in China's cyclical outlook.
Broader economy not as weak as in 2015
When we compare trends across all of China's economic sectors today to the industrial slowdown in 2015, we find that the weakness is not as broad-based as it was 3 years ago (see chart, below right). Housing market activity has flattened but is not recessionary. The global economy is in much better shape overall and external demand from Europe and other countries is boosting China's export growth. In addition, China's consumer is playing a greater role in driving economic growth, although consumption growth was also strong in 2015 before eventually following industrial production lower.
One high-level explanation for China's deceleration is that economic policymakers are directionally tightening economic conditions. The large fiscal and monetary response to 2015’s slowdown has given way over the past several months to an emphasis on improving the quality of growth and accepting some moderation in its place. Production restrictions on steel and other heavy industries are aimed at reducing pollution and addressing chronic overcapacity, while the crackdown on shadow financing is an attempt to rein in China's credit boom and help the economy digest the massive leverage built up in the system over the past decade.
Credit growth in China has slowed markedly over the past 2 years and is at roughly the lowest level since the 2008 global financial crisis (see chart, below left). While some of this is intentional on the part of policymakers, our models indicate that China's recession risk is rising and we believe the risks to the growth outlook have shifted to the downside.
Policymakers ease: Sign of major policy shift?
On April 17, China's central bank announced a 1% decrease in the required reserve ratio (RRR) for banks, to free up additional funds for lending. Historically, policy easing via RRR cuts—particularly of this magnitude—has occurred only after economic growth has significantly deteriorated (see chart, below right). According to our business cycle framework, RRR cuts implemented over the past decade occurred only after the Chinese economy had entered a growth recession.
So is the RRR easing evidence that Chinese policymakers are aware of the degree of the slowdown and have now shifted to a broad-based easing policy? We suspect the answer is directionally, yes. But more evidence is needed to ascertain whether this is a small shift or a big one. According to the People’s Bank of China (PBOC), 70% of the RRR cut is aimed at large banks that will simultaneously be required to pay back medium-term loans of the same amount. In other words, the RRR action was more of a reshuffling of the type of funding large banks receive as opposed to a net easing of credit conditions. The other 30% of the RRR cut was an outright easing of lending conditions for small- and medium-size banks. Going forward, we’re watching to see whether the PBOC takes further action we would interpret as policy easing, including additional RRR cuts, allowing outstanding medium-term loans to be rolled over, and currency depreciation.
It's important to keep in mind, however, that even an outright shift toward policy easing may not immediately be greeted as a welcome sign from investors. If consensus expectations are too optimistic about China's near-term outlook, the first step may be recognition of the growth disappointment. For example, policymakers cut the RRR in the first quarter of 2015, but it took nearly one year for global equity markets to fully digest the extent of China's slowdown.
Global business cycle
Since China's economy emerged from its growth recession in early 2016, it provided a positive catalyst for global growth via its influence on trends in global trade, industrial activity, and commodity prices. Two years later, the switch from a massive policy stimulus to the early stages of tightening has begun to restrain growth and push China into the late-cycle phase of expansion (see chart, below).
- Global: The global economy is experiencing a steady expansion, with most developed economies in more mature (mid-to-late) stages of the business cycle with low risk of recession. However, Germany and Japan are beginning to show the effects of weaker demand from China as industrial and export activity have rolled over from high levels and leading indicators are inflecting negatively. More broadly, just over half of the 40 largest economies in the world are exhibiting positive leading indicators over the past 6 months, down from 70% at the beginning of the year, signaling global activity may have peaked.
- US: The US has remained on a gradual progression through its business cycle, experiencing mid- and late-cycle dynamics, and low risk of recession. Growth remains healthy, but is likely near peak levels and has limited upside. Tighter employment markets have put upward pressure on wages, and enabled the Federal Reserve (Fed) to tighten monetary policy. We expect the Fed to continue to gradually hike rates as the cycle matures.
Trade risk is a wild card
The more aggressive US policy stance in 2018 is increasingly targeting China's alleged unfair trade and investment practices, and represents a risk to the global economic outlook—and to China in particular. With Chinese exports providing a stable bright spot amid a broad industrial deceleration, a significant increase in trade barriers would further undercut China's economic momentum. We believe an all-out US-China trade war is not the most likely scenario, but we expect the US to continue adding restrictions to Chinese trade and investment in certain sectors. This could lead to Chinese retaliation and raise additional risks for China's near-term growth outlook.
Asset allocation outlook
China's deceleration is a sign of the maturing global business cycle. Global growth and inflation remain solid enough to continue supporting a broad move away from monetary policy accommodation, but China's industrial deceleration represents downside risk to the outlook and makes it likely that global activity has already peaked. From an asset allocation standpoint, we remain constructive on global equities, which are being bolstered by a strong rebound in corporate profits. However, we expect the maturing business cycle and China's deceleration to be accompanied by elevated market volatility, which implies that smaller cyclical portfolio tilts are warranted at this stage of the cycle. Facing both downside risks to growth and upside risks to inflation, portfolio diversification across multiple asset categories is even more important than usual.
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