East - West divide: how China’s manufacturing sector is weakening and what this means for global growth
There is a strange dynamic going on in the global economy right now. A year ago, everyone thought that China held the key to the economic recovery post the Covid pandemic, however, this does not appear to be the case as October’s non-manufacturing PMI report highlights. This index fell to 49.2 from 49.6 in September, the market had expected a slight improvement to 49.7. Anything below 50 is considered a contraction, thus last month’s index suggests that China is experiencing a mild manufacturing contraction in Q3 and into Q4. In comparison, Europe and the US’s manufacturing sectors are powering ahead. The questions now are, how much more pain will there be for China’s manufacturing sector and how this will impact global growth.
China’s economic woes: the problems run deep
In recent months, there has been a major focus on China’s beleaguered real estate sector. It’s high debt load, and the high-profile collapse of real estate giant Evergrande, have focused attentions on this sector, which makes up nearly 30% of China’s economy. However, the second straight decline in China’s PMI suggests that the problems for China’s economy run far deeper than just the real estate sector. A mixture of electricity shortages, a labour market shortage, high energy prices and, worryingly, softer domestic demand, has weighed on the manufacturing sector. With rising Covid infection rates in China, particularly in the factory regions in Northern China, this could impact manufacturing growth in the country for the rest of this year.
Will China’s growth problems impact the rest of the world?
As we mention above, investors will want to know how this could impact the global economy. A slowdown in China in Q4 is likely to weigh on global growth because of the sheer size of the Chinese economy. After the US’s slowdown in Q3, driven by a rise in Covid infection rates during the summer months, the second half of this year is unlikely to see a good number for global growth as a whole. However, this does not tell the whole story. For example, is China really a lead indicator for global growth? Will the West follow suit if China’s growth continues to slow? We don’t think so for the reasons below:
· The pandemic has shown a divergence in global growth rates, largely due to the global variance of Covid infection rates and lockdowns etc. Thus, just because China is suffering right now, does not mean that the rest of the world needs to catch a cold, even if it could be bad news for some neighbouring regions, who rely heavily on China’s manufacturing sector for its own growth rates.
· We could see a shift in global manufacturing away from China in the coming months, as the pandemic brought into focus the need to bring some production back to the West. We could see this most clearly in new green technology, and we have already seen electric car manufacturers bring battery production back to Europe, for example Tesla’s battery factory in Berlin. This could lead to a structural shift for China’s manufacturing sector with growth rates continuing to slow in the future.
· In the West, rising inflation rates are down to increasing demand. Although the Bank of England and the Federal Reserve are likely to take steps this week to address soaring inflation rates in the UK and US economies, we do not think that they will choke growth, and there is room for further expansion in the West.
· In contrast, Chinese policy makers have been unwilling to help its economy. Beijing has taken a tough stance on some of the fastest growing sectors of the Chinese economy, for example tech and education, with other sectors also at risk from Beijing’s wrath. Added to this, the PBOC does not seem responsive to the economy’s shortfall in domestic demand, at least not at this stage. These are very China-specific political risks, which do not impact the West, and could boost the West if it leads to companies moving out of China or choosing to invest in the West rather than China in order to avoid the vagaries of Beijing’s economic decisions.
As you can see, we do not think that China’s PMI miss will reverberate around the global financial markets, and that appears to be the case as we start the trading week. At the time of writing, US stock futures are slightly higher after the S&P 500 and the Nasdaq both reached record highs at the end of last week and recorded their best month of the year so far in October. European indices are also pointing to a higher open, suggesting that issues closer to home, rather than China’s slowdown, are the driving forces of Western financial markets right now.
Central bank bonanza
We expect financial markets to be fairly quiet as we lead up to the main events for this week. The Federal Reserve is expected to start tapering asset purchases after its meeting concludes on Wednesday. The market is expecting a formal hawkish slant from the Federal Reserve, which explains the sharp rise in the dollar index last week. If the Fed delivers on this message, then we could see more flows into the dollar this week and more dollar strength in the short-to-medium term, especially against the EUR, with EUR/USD support now at the yearly low below $1.1550. If EUR/USD breaches this level it would be a negative development for the single currency and could herald further losses.
Elsewhere, the Bank of England holds its final Inflation Report of the year on Thursday, and the MPC is widely expected to raise rates by 0.15% to 0.25%. The shift in interest rate expectations and in UK bond yields has been dramatic since the BOE’s September meeting. Due to this, it would be hard for the BOE not to follow through with a rate hike at this stage, and extremely damaging to their credibility if they don’t hike rates. There is also an expectation that the BOE could deliver an extra hawkish surprise and end their bond-buying programme a month early. However, markets will also be looking at what comes next. So far, financial markets are pricing in an extra 1% of rate rises for 2022, and UK asset prices have tolerated this fairly well. However, there is a risk that the MPC will talk down the prospect of such a fast pace of rate increases for next year on the back of fears around consumer strength and strained household finances if mortgage rates rise too quickly. Thus, we think that there is a small chance of a dovish surprise at this week’s MPC meeting when it comes to the future interest rate outlook. This could weigh on GBP this week and it may be one reason why we have seen GBP fall at the start of trading on Monday. So far, $1.3650 is holding as support, but below $1.36, the low from mid-October, is now in sight at key short-term support.