Could deflation end up being good news for Chinese equities?

David Rees

Bad economic news could eventually become good news for Chinese equities if the rising risk of outright deflation prompts the authorities to take more aggressive fiscal and monetary action.

Investors are crying out for a catalyst to trigger a turnaround in Chinese equities. While we have nudged up our growth forecasts, marginally better activity data seem unlikely to drive a major rally. Instead, the trigger is more likely to come from an about-turn in policymaking. In this respect, while there was little to cheer at the National People’s Congress (NPC) this week, bad news could eventually become good news if the rising risk of outright deflation forces Beijing into action.

Coming into this year we expected China’s economy to enjoy a mild pick-up in growth in the first half of the year. This was anticipated on the back of an improvement in manufactured exports along with the effects of some easing of policy. However, we did not think the improvement would last long, given that sluggish global growth was unlikely to support a strong export cycle, while policy support was relatively small.

Strong external versus fragile domestic picture
Our view from last summer that a recovery in the global manufacturing cycle would support China’s exports is starting to become more mainstream after the recent surge in manufacturing PMIs. Several leading indicators are now consistent with China’s nominal exports reaching growth of about 15% year-on-year (y/y) by mid-2024. Chinese exports have certainly got off to a good start to 2024, with growth in January and February much stronger than expected at 7.1% y/y. The January and February data is reported together to account for disruption around the annual lunar new year holiday.

Meanwhile, we’ve significantly upgraded our global growth in our latest forecast round, particularly in the US where the consumer picture is robust. This implies that final demand will be strong enough to support further gains in exports than we had previously assumed. There is some evidence that Chinese firms are having to cut prices to clear output, with exports growing far more quickly when measured in volume rather than value terms. But while that is a concern for producer margins, it is good news for real GDP growth. As such, whereas net trade subtracted around 1 percentage point from GDP growth over the past year, it should start to add a similar amount in the months ahead.

However, the domestic picture remains fragile. There has been an improvement in the credit impulse in recent months on the back of government bond issuance as looser fiscal policy has started to show up in the data. The poor state of local government finances suggests that this fiscal support will be less effective than in the past. But history shows that the credit impulse typically leads activity by nine months meaning that this should offer some support to activity in the months ahead. The issue is that stimulus has so far been piecemeal and the NPC signalled only a marginal planned additional easing of fiscal policy this year. As a result, this prop to growth is likely to fade later this year, exposing very weak underlying private sector demand for credit.

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