Chinese growth is decent, but could be a lot better

Chinese data for June/Q2 was quite mixed. Regarding upside surprises, we saw: 

(1) real gross domestic product (GDP) growth of 1.1% in Q2 (Consensus: 0.9%); 

(2) industrial production growth picking up to 6.8% in the year to June from 5.8% (Consensus: 5.6%); 

(3) electricity output growth picking up to 4% in the year to June from 2.5%. 

Conversely, downside surprises included:

(a) nominal retail sales growth slowed to 4.8% in the year-to-June from 6.4% (Consensus: 5.3%);

(b) fixed asset investment growth slowed to 2.8% in the year-to-June from 3.7% (Consensus: 3.6%). Softness in consumption and investment meant that net exports did most of the heavy lifting for the economy in Q2.

We believe that the economy is bottoming out in line with leading indicators. Our preferred leading indicator of Chinese activity growth is a financial conditions index (FCI), comprised of the domestic price of money (yield curve), the domestic availability of money (credit impulse), the international price of money (exchange rate valuation), global sentiment, and global uncertainty. We highlight that this FCI is recovering from its lows and now points to annualised growth outcomes around 5%. Against this baseline, electricity output growth is recovering as expected. However, to push the economy into above-trend growth (needed for stronger job creation), further stimulus is required. Importantly, given authorities’ stated objective of boosting consumption, we think that the June/Q2 data set shows room for improvement - especially the if support from the external sector diminishes because of trade tensions, undermining job security and consumer confidence. 

Chinese electricity output and financial conditions

Regarding fixed asset investment, there was some weakness in property data. Growth in residential floor space sold (demand) fell to -8.1% in the year to June from -5.5%, while growth in residential floor space completions (supply) improved to -4.3% from -21.6%. Growth in the ratio of floor space sold to floor space completions dropped to -4% in the year to June from 20.1%, indicating emerging oversupply. Additionally, as floor space sold declined, the housing-inventory-to-sales ratio returned to historically high levels, consistent with weakness in real house prices.

Chinese property demand and supply

Chinese house prices and housing inventory-to-sales ratio

History suggests that the health of the Chinese property market is the primary driver of steel demand and iron ore prices. Indeed, growth in the Chinese property demand-to-supply balance is a powerful leading indicator of iron ore price movements. Recent slippage on this front into marginal oversupply territory could place modest downward pressure on iron ore prices in the coming quarters. That said, we maintain a constructive view on resources stocks for a few reasons.

Iron ore prices and Chinese property demand-to-supply balance

First, we expect that Chinese authorities will at some point stimulate their property sector, even though they do not appear in a rush to do so, as property is key to consumer confidence. Indeed, we highlight that there was talk of a surprise policy meeting to support the property sector a week or so ago. In addition, funding and capital account conditions remain quite conducive to stimulus, China can still borrow U.S. dollars (USDs) more cheaply than the U.S. Treasury, and the yuan remains undervalued and vulnerable to capital inflows (rather than outflows) according to forward pricing. Related to the stimulus piece, we note that recent acceleration in the People’s Bank of China’s (PBoC’s) balance sheet, as well as improvement in the economy’s overall credit impulse, point to better property market outcomes than we saw in June and potentially a better iron ore price outlook than the data suggest.

Chinese USD funding costs

Chinese exchange rate valuation

Chinese property demand-to-supply balance and credit impulse

Iron ore prices and PBoC balance sheet growth

Second, we see commodities as a way of diversifying risk. We believe that bonds, stocks and credit are all becoming quite correlated, forcing investors to look elsewhere for non-correlated returns. Within equities, a contrarian approach to stock picking helps avoid crowded trades, and among the so-called “momentum-reversal” candidates, resource stocks screen very well. More generally, we believe commodities may be a source of inflation in a global growth recovery, with higher commodity prices potentially driving higher bond yields. In other words, if we see weakness in bonds, commodities could well be a driver of, or hedge against, this outcome.

U.S. bond-equity correlation and leading indicator

U.S. bond-commodity correlation and leading indicator