A resilient US economy and weak recovery in China? Think again

Expectations earlier this year of a US recession and a rapid rebound in China have backfired, leading to consternation among some investors
Even so, many investors are uncomfortable with the notion of a resilient US and an underperforming China and could will the narrative to change

At the beginning of this year, two of the most popular bets in financial markets were that aggressive monetary tightening in the United States would cause a recession while the sudden reopening of China’s economy would trigger a sharp rebound.

Despite differences of opinion among investors over the timing of a US recession and the strength of China’s recovery, the consensus was that the prospects for China following three years of self-imposed isolation were a lot brighter than those for the US and other advanced economies.

Nearly halfway into the year, those bets have backfired. This is mostly because of unrealistic expectations on the part of investors but also because of confusing economic signals.

China has been the big disappointment this year. A slew of indicators during the past several weeks point to a faltering recovery. A gauge of manufacturing activity in May contracted at a faster pace than in April, exports shrank for the first time in three months, credit demand is weakening and industrial profits continue to fall amid deepening producer price deflation.

Sentiment towards China has deteriorated dramatically. The results of Bank of America’s latest global fund manager survey, published on June 13, showed that only 20 per cent of respondents expected stronger growth, down from 90 per cent in January. Moreover, an underweight position in Chinese stocks is now one of the most crowded trades in markets, amplified by the fact that two key equity gauges recently entered a bear market for a short time.

© Provided by South China Morning Post
A man reads a sign for employment posted at a Chipotle business in Los Angeles on June 6. A recent US Bureau of Labour report shows that the public and private sector added 339,000 jobs in May despite the Federal Reserve’s aggressive interest rate increases in an attempt to lower inflation. Photo: EPA-EFE

The US economy, by contrast, has proved more resilient than expected. While there are clear signs growth is slowing – manufacturing activity is contracting, retail sales are tepid and a string of bank failures earlier this year has caused lending standards to tighten more sharply – the country’s labour market has remained remarkably tight as persistent pandemic-induced shortages of workers fuel intense competition among employers.

Robust demand for service sector businesses is maintaining upward pressure on core inflation, which strips out volatile food and energy prices. That measure is rising at a fast enough pace for the US Federal Reserve to leave the door open for further interest rate increases. On Wednesday, the Fed paused its tightening campaign yet signalled further increases were forthcoming.

However, many investors appear less concerned about the threat high rates pose to growth. The anticipated timing of a recession has been pushed back to the end of this year or early next, according to the findings of Bank of America’s survey, with nearly 15 per cent of respondents convinced the US can avert a recession altogether.

US equity markets are pricing in a “Goldilocks scenario” whereby the Fed is able to tame inflation without causing a surge in unemployment. Last week, the benchmark S&P 500 index entered a bull market, turbocharged by large technology stocks which are benefiting from the sudden burst of enthusiasm around generative artificial intelligence.

Even so, beneath the surface of diverging sentiment towards China and the US, there is a palpable sense of confusion and scepticism over the performance of both economies. This is partly because expectations have been confounded. It is also because many investors are uncomfortable with the prevailing narrative of a resilient US and an underperforming China.

Why are doubts about China’s export data increasing?

While the strong US labour market has defied the doubters, it is the main reason the Fed has been forced to keep tightening its monetary policy, setting off financial landmines and making a recession hard to escape. Yet, equity markets are priced for perfection, signalling that the US is likely to enjoy largely painless disinflation.

This is wishful thinking. It has been clear for some time that prices are not coming down fast enough for the Fed to start cutting rates, which markets expect to happen next year.

A more realistic scenario, which is beginning to dawn on investors, is that underlying inflation remains sticky, keeping rates higher for a much longer period. This would up the stakes significantly as policy rifts within the Fed would deepen, the risk of a recession would increase sharply, a disorderly sell-off would become more likely and the scope for less restrictive policy would remain limited.

© Provided by South China Morning Post
A woman selects clothes at a shopping centre in Beijing on June 15. China’s central bank has ramped up its monetary stimulus to help spur the economy amid signs of a weakening property market, a slump in business investment and record joblessness among young people. Photo: AFP

When looked at through a US lens, the problems facing China’s recovery become less acute. The weaker the upturn, the greater the need for Beijing to provide more forceful stimulus – a policy option the Fed does not have because of high inflation.

Further rate cuts by the People’s Bank of China are not going to jump-start growth when the underlying problem is a lack of confidence in the economy. Even so, the signalling effect is important: more stimulus is on the way, not on the scale markets want to see but further support nonetheless. Targeted measures to boost domestic demand, especially in the ailing property sector, could help lift the gloom over China.

Yet, the main reason the market narrative around the US and China could shift is because global investors want it to. The world economy needs a stronger Chinese recovery and some slack in the US labour market to help steady the Fed’s hand. The consensus at the beginning of this year may yet be proved right.

Nicholas Spiro is a partner at Lauressa Advisory