Is China Becoming The Imminent Threat That Blows Up The Global Economy?

I try not to be an alarmist, but the news coming out of China looks really bad.

If you’ve been following the latest data releases for the U.S. economy, you probably think everything is in pretty good shape. And it is for the most part. For all we hear about how the consumer is getting weaker due to high inflation and interest rates, we just haven’t been seeing it so far.

GDP growth is 2-3%. The unemployment rate is 3.5% and jobless claims, which are closely watched as an early sign of a softening labor market, have actually been declining. Retail sales were actually up 0.7% in July, suggesting that the consumer might actually be strengthening rather than weakening here.

So, overall, the United States is still looking healthy and a potential recession isn’t likely until well into 2024.

China Is In Big Trouble

Not everywhere is like that though. Europe is barely staying out of recession, but it may not be done hiking rates yet. Japan actually might be doing a little too well at the moment. It posted a 1.5% GDP growth rate in the 2nd quarter, but inflation is still above 3% and the Bank of Japan might be forced to tighten very soon.

China, however, is an outright mess.

What a difference a year makes. At the end of 2022, the government was lifting its COVID restrictions and we were talking about a big post-pandemic economic rebound that might save the world from global recession. Not only has the recovery largely been a bust, but the entire economy might be structurally breaking down.

Emerging markets ETFs are performing about how you’d expect. Those with larger exposures to China are getting hit especially hard.

China’s issues, including real estate developer Country Garden missing its latest bond interest payments, have really accelerated in recent weeks, but China stocks have been lagging the emerging markets averages throughout 2023. The iShares MSCI Emerging Markets ETF (EEM) is up 3.5% year-to-date, but the iShares MSCI Emerging Markets ex-China ETF (EMXC) is up more than 8%. Non-China economies, especially those in Latin America right now, are actually holding up pretty well. Growth outlooks are relatively optimistic and rate cuts may be on the horizon. Being able to jettison China from your emerging markets exposure may be the better path.

Why is China such a threat right now? Let’s run down the biggest reasons.

The real estate sector

The Chinese real estate sector might be one of the most unstable segments of the global economy. Its pursuit of growth at all costs has created a ticking time bomb of conditions that might finally be ready to implode. Huge debt and leverage loads, over-construction and a lack of demand have all contributed to this growing problem.

A couple years ago, Evergrande, the country’s 2nd largest real estate developer, began failing to make interest payments on its debts, estimated to be north of $300 billion dollars. Following several more missed interest payments, the company was in crisis mode and looking to sell off assets to service its debt and restructure its debt altogether. The company just recently published its financial statements for 2021 and 2022, reporting a combined loss for those two years of nearly 600 billion yuan.

This was one of the early indicators that the narrative that was being pushed wasn’t real and the sector was in much worse shape than was being led on. Just recently, Country Garden, another big developer, started to repeat Evergrande’s issues - missing debt payments and looking to restructure its massive debt load. The big COVID reopening in China has been a big disappointment and it looks like the Chinese real estate sector might become financial crisis 2.0.

Liquidity issues

Liquidity issues don’t exist just in the country’s real estate market. Three different firms that work with Zhongzhi, which offers banking and wealth management services, say that the company failed to make payments on several high yield investment products. Zhongzhi and companies like it that operate in this space promise big returns to investors and aren’t regulated very closely, so it’s not surprising that something like this could happen (especially in an environment where global interest rates have soared over the past 18 months). A lot of the information coming out is still rumor and speculation, so we don’t yet know the full extent of the situation, but it would be in line with what’s happening elsewhere.

Then, there’s this little nugget…

It sounds like the Chinese government is in damage control mode. They suspended the release of consumer sentiment readings earlier this year and announced this month they would be doing the same to the youth unemployment rate, which has soared to more than 20%.

Any time someone is withholding information, it’s usually not a good thing.

China rate cuts & lack of stimulus

This week, the PBoC unexpectedly cut its one-year medium-term lending facility rate by 15 basis points to 2.5%. While that doesn’t sound like a lot, it’s important to remember that the Chinese central bank tends to move rates in 5 basis point increments, much in the same way that the Fed adjusts in quarter-point steps. The PBoC’s rate cut was the largest single move since the onset of the COVID shutdown and the 2nd such move just this year.

This is an implicit acknowledgement that the Chinese government knows there are big problems here and is beginning to take steps to address it. The one thing that’s missing, however, is a large stimulus package. Minor rate cuts are nice, but ultimately they don’t move the needle a whole lot. The markets are waiting for huge liquidity injections to stop the bleeding.

The question is when (or even if) it will come and in what form. The PBoC has been pretty quiet, so perhaps there’s nothing imminent in the works. China’s debt load is already huge and this may put limitations on what the government can do to help. Either way, there will almost certainly be some type of monetary response sooner rather than later.

Retail sales, industrial activity & fixed investment all disappoint

This week was a bad one for Chinese economic data. The above three categories all missed expectations for July and it’s tough to find silver linings in any of it. The retail sales number shows that the consumer is weakening. Industrial activity shows that manufacturing is also getting weaker. Fixed investment shows that businesses are committing less money to future growth opportunities. Liquidity & structural issues aside, the post-COVID economy, in general, keeps struggling.

Conclusion

In the short-term, I think China equities should probably be avoided in order to stay away from the potential volatility. If you want to maintain emerging markets exposure, going with EMXC over EEM or IEMG is probably a better idea.

Over the medium-term, don’t discount the possibility that a huge government stimulus package could ignite an equity rally. After a 30% decline in the S&P 500 during the initial stages of the COVID lockdowns, stocks did a complete 180 quickly and pushed to new all-time highs within a few months. It’s not out of the question that it could happen again, but major liquidity issues within the banking and real estate sectors are tough to overlook.