China’s Baloney Sandwich

By Ben Norris, CFA, Senior Investment Strategist, Vice President
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Bill Gross, the famed PIMCO bond fund manager, once called China the “economic mystery meat” of the global economy: “Nobody knows what’s in there and there’s a little bit of bologna.” Over the last few weeks, the economic mystery meat has started to go bad, which in turn has weighed on markets around the world. Economic data coming out of the country continues to disappoint with industrial output, business investment, and retail sales all coming in below expectations last week. China’s is one of many developing economies working to make a transition from predominantly manufacturing-based to a more diversified marketplace similar to Western nations.

Disappointing data on both manufacturing and services components of the economy is in stark contrast to the situation in the U.S. where manufacturing is weak while surprisingly robust services activity continues to power economic growth. China maintained pandemic restrictions much longer than other major economies, a decision that is directly tied to its current economic woes. Worsening matters, many economic powers took steps to onshore manufacturing following the pandemic, meaning that exports out of China aren’t the driver of growth they once were. The Chinese government has attempted to stimulate the economy so that it can catch up with the rest of the world’s recovery, but progress has been slow. Last week, the country’s central bank surprised the rest of the world by cutting a key interest rate as it desperately attempts to kickstart the sputtering economy. This move is in contrast to most other major economies where interest rate hikes have been the norm for more than a year now.

The Chinese economy has never been particularly transparent (hence Bill Gross’s comments), but the country has continued to take steps that decrease transparency. Last week, China’s bureau of statistics announced it was suspending the publication of data on youth unemployment. This decision and its rationale have been met with skepticism from the rest of the world given China’s history with questionable data in the past. Many feel that China’s economic growth metrics have long been inflated. Last October, China didn’t release monthly trade data as scheduled and then abruptly canceled the release of quarterly gross domestic product data right before it was supposed to be released. It’s ironic that China continues to disclose less about its economic situation when many feel that less disclosure is actually hurting confidence in China’s economy. Less data and more obfuscation are fueling lower levels of outside investment from companies that believe they can’t trust what is being reported. China is at risk of creating a sort of negative feedback loop that could see the country paint itself into a corner.

China is home to the world’s second-largest economy and a potential downturn would have global implications. Economists at a prominent European bank published a note warning that China is experiencing deflation. True deflation is an economist’s worst nightmare because it creates an environment where economic activity comes to a halt. As prices fall consumers will wait to make purchases because they expect goods and services to be cheaper in the near future. Prices continue to fall as businesses try to entice consumption and the process tends to repeat itself. Sustained bouts of deflation can lead to all sorts of problems – spiking unemployment, lower demand, overall economic decline, etc. And while the theory behind combating inflation is relatively straightforward, the playbook for reversing deflation is thin and unreliable, which is why economists try to avoid deflation at all costs.

While the eventual outcome of China’s situation is to be determined, investors haven’t wasted any time adjusting portfolios to protect against a potential downturn that could spread to other economies. China has been the worst performing emerging market this year with the MSCI China index down nearly 7% year to date while most other geographies have seen double digit gains. August trading has seen a risk-off shift from investors that is at least partially tied to the situation in China. Month to date, each of the major indices are in negative territory with growth underperforming value and small-cap stocks underperforming large-caps. We’ve voiced our concerns about stretched valuations among mega-cap growth stocks in recent weeks and while the current bout of weakness is a step in the right direction, valuations are still well above historic norms. Last week, the S&P 500 lost 2.05% while the NASDAQ Composite and Dow Jones Industrial Average lost 2.59% and 2.10%, respectively. Global markets fared even worse with the MSCI EAFE and Emerging Markets indices both losing more than 3% while the MSCI China index fell 5.61%. Interest rates in the U.S. continued to move higher last week with 10-year Treasury yield eclipsing recent highs to end the week at 4.25%, its highest close in more than a decade. The yield on the 2-year Treasury also rose to near 5% as concerns about resurgent inflation come into focus.

U.S. economic data continues to outperform most of the global economy and last week was no different. Retail sales data came in better than expected and showed that a recent online shopping holiday was a major boost to consumer activity. Industrial production and capacity utilization numbers also came in ahead of expectations, which is a notable positive given that the manufacturing side of the economy has generally lagged the services side in 2023. Finally, housing data outperformed expectations as housing starts – an indicator of future homebuilding activity – rose compared with the prior month’s level. Still, there have been signs that the Federal Reserve’s attempts to slow the economy and ease inflation are beginning to work. Employment conditions have begun to weaken, and inflation is well off the peak levels seen last year. However, data so far has remained resilient enough that the Fed and other global central banks might think they need to hike interest rates further to reach their policy goals. We remain concerned that the Fed will eventually overtighten, but for the time being it appears their plan is on the right track.

The coming week features a relatively light slate of economic data but will be headlined by the Jackson Hole Economic Symposium where economic sandwich makers gather each year to discuss current and future policy.

Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Weekly Market Commentary/Market