As U.S. companies report fourth quarter earnings, a growing number have cited China’s slowdown as adversely impacting their businesses. The most recent include industry bellwethers such as Apple, Caterpillar, and Nvidia. In prior reports, multinationals such as Alcoa, Coca-Cola, Ford, GE, Harley-Davidson, and Whirlpool stated their earnings were being hit by higher tariffs on imports from China.
This list, moreover, is likely to grow if China slows further and/or tariffs on Chinese imports are increased. However, this begs two questions: (i) Why is China’s economy softening; and (ii) Will the government be able to stabilize growth as it did in 2016?
One of the challenges investors confront is to assess whether China’s slowdown is primarily cyclical or secular. Its growth rate has slowed steadily throughout this this decade, from about 10% in 2010 to 6.6% last year, the lowest in three decades. In dissecting the recent slowdown, investors need to disentangle the effect of higher tariffs on Chinese imports from the impact of structural changes inside China.
There is general agreement that last year’s slowdown coincided with tariffs being imposed on 10% of Chinese goods imported to the U.S. during the first half of 2018. The economy weakened further in the second half, when the list was extended to cover one half of imports from China. Accordingly, investors believe a resolution of the trade dispute is critical to stabilize China’s economy.
Beyond this, China’s potential growth rate is decelerating for structural reasons. The country’s economic miracle was founded on agricultural workers in rural areas migrating to urban areas along the coast with higher-productivity manufacturing jobs. But this process has become more challenging as wages in manufacturing have increased and unit labor costs have surged. Consequently, some economists believe China confronts a “middle income trap.”
Amid declining productivity growth, China’s government has relied increasingly on fiscal stimulus and credit expansion to achieve its growth target of 6.0%-6.5%. But this has also resulted in a doubling of China’s overall debt burden from about 150% of GDP before the GFC in 2008 to 300% currently. The problem with this strategy is it is not viable, as more and more credit is required to support each unit of output. The reason: Much of the credit expansion has gone to SOEs, some of which the IMF labels as “zombies” – or firms that pile on debt but do not contribute positive value added.
Faced with this predicament, China’s policymakers pursued several measures last year to bolster the economy. They included lowering short term interest rates by more than 200 basis points, allowing the yuan/dollar exchange rate to decline by 10%, while also expanding credit and lowering tax rates. Similar actions were undertaken during China’s slowdown in 2015-2016, which proved effective in bolstering the economy.
Thus far, however, their impact is not readily apparent. Auto sales, for example, declined in November by nearly 14% over a year ago, and Apple’s recent public filing indicated softness in consumer spending on electronics. China’s imports plummeted in December, and exports also appear headed for a fall based on recent purchasing manager surveys and weakness in Asia and Europe.
What is clear is China’s policymakers are prepared to take additional actions to keep economic growth above the 6% threshold. The central bank, for example, announced a one percent reduction in reserve requirements, and the government is boosting spending and lowering taxes. What is unclear is whether such action will be as effective as in the past due to the country’s rising debt burden.
The wildcard is whether an agreement on trade can be reached by the March 1 deadline. While both sides wish to do so, the underlying issues are complex. If the disagreement were simply about the size of the bilateral trade imbalance, the issue would be resolved, as China is willing to boost imports from the US and could direct SOEs to do so. However, the more difficult issues relate to violations of intellectual property and subsidization of businesses by the Chinese government, which the US opposes.
The most likely outcome is a temporary truce will be reached, which would bolster world equities for a while. However, because a lasting agreement is harder to achieve, officials may in effect opt to “kick the can down the road.”
The outcome will have an important bearing on global economies. While the US economy has withstood the impact of China’s slowdown thus far, a growing number of US companies are feeling the impact as noted previously. Furthermore, there has been a significant downward revision to earnings expectations by Wall Street analysts over the past six months. They are now calling for S&P 500 EPS growth of 8.1% in 2019 from more than 20% last year. Yet, some observers believe the results will be weaker.
Ultimately, the market’s outcome will depend on whether China’s slowdown can be arrested by policy action. If so, equity markets are likely to rally. If not, they are likely to stay volatile, as the impact of a permanent slowdown has not been priced into markets.
