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Right now, China is experiencing a financial crisis with communist characteristics. The country is attempting to accomplish the twin goals of permanently downshifting GDP growth and rebalancing economic drivers. But Beijing’s insistence upon maintaining financial and economic stability throughout, effectively transfers deflation risk from the market in the near term, to the real economy over the longer term.
While it may certainly seem that all is well in China (for now), we continue to sound the alarm bell on the “Old China” economy in particular with respect to 2H17E and beyond.
Take a look at this morning’s China Industrial Production report in context:
- JUNE +7.6%
- JULY +6.4%
- AUG +6.0%
In rate of change terms, they are slowing.
Far and away the most important development in China’s most recent GDP release is the fact that the nominal growth rate of China’s manufacturing sector decelerated from a cycle-peak of +14.2% year-over-year in 1Q17 to +12.7% year-over-year in 2Q17. While that may not seem like much of a pullback, it does mark the first sequential deceleration since nominal growth in this sector bottomed at +0.9% year-over-year in 3Q15. Moreover, its trailing twelve month contribution to broader Chinese economic growth remains overextended at a historically unsustainable rate of 46.5%.
Case in point, already in 2017, the People’s Bank of China has pulled back significantly. PBoC Open Market Operations are down -246% year-over-year in 2017 versus an increase of +689% year-over-year by this time last year. For the full year of 2016, the PBoC pumped a staggering net 1.727 trillion Chinese yuan into mainland financial markets.
All told, we reiterate our bearish bias on the “Old China” economy with respect to the intermediate term and suspect that the nascent deceleration highlighted by the Q2 GDP data will morph into a full-blown negative trend over the next few months. This outcome should help perpetuate another leg down in commodity-oriented reflation over the intermediate term.
China represents roughly half of global demand for major base metals, according to the IMF. A slowdown in China should help perpetuate another leg down in commodity-oriented reflation over the intermediate term. Investors should avoid Energy (XLE) Metals and Mining (XME) stocks domestically.