The odds for a cyclical upturn are high in the next few months thanks to the improvement of demand in housing and the automobile industry.
The People's Bank of China (PBoC) has recently surprised financial markets with several small cuts in its benchmark lending rate. This has led some market participants to believe further rate cuts might be forthcoming.
But the room for further monetary easing may be more limited than what the market believes, and it is difficult for interest rates to fall further in China. This is because the economy is likely to set for stabilization or even a small cyclical rebound after six straight quarters of slowdown, as the outlook for housing and automobile are quite positive.
Also, the economy is not heading for deflation. The year-on-year decline of the producer price index is probably ending, while the consumer price Index will surge further due to the rise in pork prices.
In addition to that, the external pressure may ease slightly if Beijing indeed could strike a truce with Washington.
The latest data are showing contradictory signals on the cyclical trend of the Chinese economy. The first contradiction can be found in the purchasing manager index (PMI). The divergence between the official manufacturing PMI and the Caixin PMI is stunning. The official gauge for October fell to 49,3 – the lowest since February, suggesting further shrinking manufacturing activity, while the Caixin PMI picked up to 51,7, implying a return to an expansionary environment.
This is very unusual because for most of the time since the PMI surveys began in China in 2005, the two series have moved in the same direction, and the Caixin PMI often tended to underperform the official one.
But 2019 is an exception. Not only do they diverge, the Caixin PMI has also outperformed the official one for eight months and the gap has widened to the largest since 2010.
The assumption always was that the official PMI better represents the activities of large companies in China, while the Caixin PMI better reflects the business conditions of small and medium-sized firms. This argument was used to explain when the Caixin PMI underperformed the official PMI – but it does not hold much water at this moment, because it is unlikely that small and medium-sized firms should be having a much better time than large firms today.
In fact, the official PMI does offer the breakdown by enterprise size, which says large firms are still better off than their smaller peers. Looking at the breakdown of the two surveys, one component showing the biggest divergence is new export orders. The official one says the new order index shrank further, while the Caixin PMI reports a rebound.
The Caixin PMI has a better track record and thus a higher probability to be correct. The last time a similar pattern was noticed was in late 2015 and early 2016: the Caixin PMI started to rebound in Q3 of 2015, while the official PMI continued to shrink and did not find a bottom until February 2016.
While the Caixin PMI may correct a bit in the coming months, it is more likely that the official PMI will bounce back. After all, there has not been a case that the Caixin PMI expanded for four straight months without any pick-up following in the official PMI.
Apart from history, the Caixin PMI is also more likely to be correct because the underlying demand may currently be better than expected.
To be clear, nobody anticipates a big reflation in the Chinese economy like 2016-2017, because credit growth is still very subdued, and Beijing is not interested in delivering a new credit boom. Credit data in October was mediocre, and the year-on-year growth of total non-financial debt slowed slightly to 10.4%. The volume of new corporate loans was small, and shadow finance continued to shrink.
But the property sector, which is arguably the biggest demand driver in China, is holding up well. Sales volume is flat year-on-year in the first nine months, and construction starts are up over 10%. It could get even better, as the sales growth reported by the country’s largest developers is showing a strong increase in recent months.
Sales volumes of the top four domestic developers went up by 43% year-on-year in October, accelerating from September’s 31%. In the extremely fragmented housing market, the top four developers account for just 15% of national sales, but their share has gone up over time and their performance is usually a good leading indicator in the cyclical transitions.
The property market is supported by strong credit expansion of the household sector. Household loans account for over half of new bank lending these days, and they are still increasing at 17% year-on-year.
The other driver of domestic demand, the automobile sector, may be bottoming out too. Auto production took a big hit in the second quarter of this year because of the earlier-than-expected shift of emission standards in over 20 provinces. This policy change caught auto makers by surprise, and they were forced to clear out existing inventories before shifting to new models.
This impact is now fading. Total inventory of passenger cars has declined to 750'000 units, down 40% from the peak in 2018 and the lowest since 2016. At the same time, the decline of sales growth has also narrowed, to -5.8% in October.
This trend could continue. In fact, auto sales as a share of total GDP has declined by roughly one percentage point from 5% to 4% after two years of contraction. This means even if sales growth does not rebound at all, the negative impact on the economy is smaller now.
Another contradictory signal in the economic data is inflation. The consumer price index (CPI) and the producer price index (PPI) are moving in opposite directions. China’s CPI year-on-year growth accelerated to 3.8% in October, well above the 3% target set by the State Council.
Meanwhile, the PPI year-on-year growth has again fallen into negative territory after being positive for three years, to -1.6% in October. This reminds many observers of the deflationary period that was experienced from 2012 to 2016.
However, producer prices may have hit the bottom. The PPI usually moves along with the prices of industrial materials, especially steel. The good news is that prices of many industrial materials peaked in October 2018 and saw a sharp decline after November 2018. This offers a favorable base effect for PPI from now on.
Also, final demand in the economy should be positive in the short-term as discussed above, while the output will be somewhat restricted due to environmental protection policies during winter.
Thus, the divergence of the two inflation indicators may be ending, and the probability is high for both CPI and PPI to rise in the next three to four months.
All in all, China's economy is set to slightly surprise to the upside in the next few months.