China Rebalancing Trends Depend on H2 Stimulus Focus…

While the consensus obsesses over GDP growth, the key issue for China remains the quality and sustainability of incremental activity. We introduced the China Rebalancing Index back in the February monthly note; it’s an equally weighted diffusion index taking a standardized composite measure of seven key economic trends to act as a statistical summary of evolving structural trends, rather than looking for contemporaneous or lagging correlations or cyclical turning points as with a composite leading/coincident index approach. The components offer an insight into whether the Chinese economy is evolving in a sustainable direction toward greater household consumption/private sector service growth or further structural imbalance by experiencing incremental growth driven by SOE/heavy industry/fixed investment activity. China now faces a choice between a consumer oriented fiscal stimulus or another surge in fixed asset investment funded by bank lending; the latter seems to be already in motion, as covered in recent notes.

In fact, the overall officially calculated profits of Chinese industrial enterprises fell for the third straight month in June, slipping by 2.2% in H1 y/y, compared to 29% y/y growth in H1 2011. With construction related heavy industry comprising 22% or so of A-share trailing earnings, added to the 45% in banks, it’s no surprise that Chinese equities have been battered by endless downgrades/profit warnings, and despite some very constructive regulatory changes. However, profits fell by a more moderate 1.7% y/y in June, an improvement over May’s 5.3% y/y drop, perhaps an early signal that recent policy easing/fast-forwarding of infrastructure spending by the NDRC may be stabilising the sector. Across Asia, the latest total new orders less inventories data looks soft, particularly for Japan, Korea and Taiwan while new export orders also remain weak.

However, the euro zone uncertainty has been a key factor in dampening activity, and further tangible progress should be reflected not just in equity risk premia but real forward looking economic activity by late Q3. China’s PMI sits at 50.1 on the official measure and at 49.3 on the unofficial HSBC measure and the consensus is looking for real GDP growth to accelerate from 7.6% y/y in Q2 to 8.5% by Q4. That pace looks very unlikely given the structural nature of the recent slowdown, and certainly couldn’t be sustained for long, but a free-fall scenario has also looked unlikely at this stage, particularly if the export outlook stabilises. Recent M2 and lending growth data, as well as the PMI numbers, support the view that the Chinese industrial sector will at least suffer a diminishing policy headwind in H2, albeit at the cost of prolonging structural imbalances.