The improvement in the services activity index is unexpected, in light both of the rising Covid cases and tightening restrictions, and of the 1.5pp drop in the official services PMI for July. The explanation most likely lies in the different samples of the two surveys, and the concentration of recent Covid cases away from the coastal regions, which dominate the Caixin measure. The firms sampled have instead enjoyed a continued reopening rebound. New orders also rose, to 53.8 from 52.4, suggesting more activity in the pipeline, though the subindex is a poor predictor of the output index.
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One sign that the rebound is fading, however, is the drop in work backlogs, to 49.2, from 50.9. To the extent that the gains in the headline have been driven by catch up growth, this suggests a weaker print next month. Employment also fell, to 48.8, from 49.6, which implies limited confidence amongst firms that the purple patch will continue. The index should pull back in August.
Nor expect much going forward. BofA:
In recent decades, Chinese policy makers have responded very strongly to growth slowdowns, flooding the economy with liquidity and fiscal stimulus. That has not been the case since last summer. Periodic speculation of strong action ahead have repeatedly been proven wrong, including in the last week:
•Despite speculation of a wide range of reflation policies, policy makers only announced a stronger use of existing tools.
•This reinforces our call for a weaker than expected rebound from the COVID-related lockdowns.
•The impact on the US and global outlook is mixed: weak Chinese demand helps contained energy prices but also weak demand for other imports.
Our China team has had a below-consensus growth forecast since spring 2021. Our analyst Helen Qiao and team have repeatedly argued that China is putting a relatively low priority on growth versus debt control, more state control of production, zero COVID, preventing property prices from rising, improving income distribution and so on.
This continued to be the case with the latest Politburo announcements. Markets had been expecting new easing measures such as issuing special treasury bonds, front loading local government bond quotas from next year to this year, and establishing a property stabilization fund. None of this happened and instead they announce a better use of existing measures.
Year-over-year GDP growth tumbled to just 0.4% in 2Q. With Shanghai and Beijing reopening, the worst of the lockdowns in China is likely past. This makes a sharp rebound in Chinese growth almost inevitable in the second half, in our view. However, Helen and team continue to expect growth to disappoint expectations. This partly reflects an expected tepid policy response. In addition, they believe Chinese consumers will be slow to re-engage knowing that getting COVID triggers a very aggressive quarantining response, in addition to stiff headwinds from weaker exports.
A relatively weak recovery in China is mixed news for the US and global economy. The good news is that China’s supply chain issues seem to have eased substantially. With a lag, this helps the recovery in global supply chains. That means both lower inflation and a slightly better growth. In addition, weakness in China helps ease pressure in commodity markets. That is good news for commodity importers and less good news for the US. The bad news is that weak Chinese demand hurts countries that export a lot to China, such as German capital goods producers. In sum, it is hard to find a global growth engine these days.
Finally, Taiwan just made it worse. Lombard:
US Speaker of the House Nancy Pelosi’s visit to Taiwan marks the lowest point in US-China relations in 27 years and likely presages the most dangerous period of military activity around Taiwan since 1995-96. We still think a China invasion is highly unlikely, but at the same time we recognize that political and economic incentives are aligned for Beijing to hit back with a strong and protracted military, economic and political response. The quasi-blockade of Taiwan, starting tomorrow, is likely the first in a series of moves targeting the island. Predicting the precise counter-measures are difficult, but the broad direction and impact on macro and markets is clear:
assets exposed to China/Taiwan tension will warrant a higher risk premium over the coming weeks, while deteriorating US-China relations will accelerate decoupling, increasing pressure on Chinese ADRs as well as the global semiconductor and electric vehicle industries. However, the global economic fallout is likely to be limited to periodic shipping disruption. We stick with current market positioning: negative RMB, neutral equities (long infrastructure-related stocks) and with a preference for bond steepeners. We are underweight Taiwan equities and short the Taiwan dollar.
Playing with fire. For China, the visit strikes at the foundation of US-China diplomatic relations – that is, the countries’ respective “one China” policies. Moreover, the trip is not viewed in insolation but as the latest part of a worrying (from the Chinese perspective) trend of closer US-Taiwan relations and the salami slicing away of American “strategic neutrality” on the Taiwan question. Beijing has no choice but to respond, given rhetoric and domestic political optics, and political and economic incentives suggest a strong protracted period of military, economic and political actions. The third Taiwan Strait crisis of 1995-96 is a useful benchmark. In response to President Lee’s “unofficial” visit to Washington, China conducted military drills for nine months, with America ultimately moving two carrier strike groups to the region to shore up support for Taipei. The planned PLA special exercise, which will take place from August 4th to 7th, is significantly larger than any that occurred in 1995-96. Moreover, the location – in close proximity to Taiwan’s major ports, inland waters and international shipping lanes – is broader and, for this reason, economically disruptive.
Two other crises offer clues to the Chinese response – the Diaoyu-Senkaku dispute and theongoing Russia-Ukraine conflict. The spat over the disputed islands occurred in Q3 2012 in the run-up to the 18th Party Congress. Despite its traditional preference for economic and political stability in the lead-up to the five yearly set-piece, Beijing hit out strongly against Japan and Japanese companies operating in China. With regard to Russia-Ukraine, as we have noted previously, there is a strong feeling in Beijing that eastward Nato encroachment “forced” Putin toact. Based on this assessment, we wrote in March that China would likely push back strongly against alliance building in Asia.
Past cross-strait crises and more recent geopolitical events suggest China is just getting started in its military, economic and political pushback. On the military front, exercises around Taiwan’s major ports could be extended in duration: the island imports 98% of its energy, a vulnerability Beijing may seek to probe. Economic options range from the already announced sanctions on agricultural imports from Taiwan to a ban on rare earth exports and the disruption of Taiwanese companies operations on the Mainland. All aforementioned measures could apply to the US should it intervene; however, given its own economic weakness and large trade deficit with Taiwan (almost entirely semiconductors) Beijing is likely to lean more heavily on military rather than trade measures.
Macro and market spillovers will be determined in part by the counter-countermeasures taken by Washington. Biden’s China strategy is unclear and has just been made even more opaque by Pelosi’s visit in apparent opposition to White House wishes. As yet there has been no official statement. American pushback is likely to be trade- and market-focused, at least initially. Senators today called for the blacklisting of Chinese memory chip producers – the prospect of NEV decoupling will be examined in tomorrow’s Daily note. And there is also the prospect of an accelerated delisting of Chinese ADRs (here for details). The much talked-about reduction in Trump-era tariffs is now highly unlikely.
In Taipei, the visit and international attention has been welcomed. Neither President Tsai nor Pelosi mentioned China directly in their speeches, but the emphasis on strengthening bilateral relations was clear. The ruling DPP will maintain a firm line against Chinese pressure and look to take the momentum generated by Pelosi’s visit into a series of upcoming regional elections. Voting in China, Taiwan and the US leaves limited scope for the sides to compromise. The major spillovers from a protracted period of military tension are likely to mean a higher risk premium for China- and Taiwan-exposed assets and greater US-China friction, the fallout from which will accelerate financial and trade bifurcations between the two superpowers. At present, global economic spillovers will likely be limited to sporadic periods of supply-chain disruption.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
