We laid out initial takeaways on the Q1 GDP report on Tuesday morning (see link HERE). It was intended as a glass-half-full take, coming from a prior position of a glass-half-empty.
Since the Covid pivot began, we have been cautious on how strong and rapid China’s economic recovery would be. That outlook rested on the view that households, firms and local governments face constraints on spending due to the impact of three years of Covid controls (and debt incurred as a result), the real estate downturn, and an uncertain growth outlook including weakening export demand. We also have emphasized that Beijing, while eager to support a return to normal economic activity, will remain disciplined when it comes to stimulus given concern over financial risks. Taken together, this implies a gradual recovery driven by services and consumption, with fewer spillovers to global growth, and especially hard commodities, than a cycle driven by investment.
In that context, the Q1 and March data look positive, particularly early signs that employment is picking up and translating to an initial recovery in consumption. It isn’t a bout of “revenge spending,” but we have always pushed back on those prospects. Nonetheless, a service-sector fueled rebound is underway and gaining strength.
Chinese assets, which have been range-bound in recent months, barely budged after the GDP report. This likely reflects the conclusion by investors that the report was not so strong as to shift their views about the growth outlook, but not so disappointing as to force Beijing to further loosen policy.
That take seems correct in terms of the policy reaction function. China’s leadership likely views the latest economic data as being, if not stellar, then good enough. 4.5% y/y GDP in Q1 growth puts China well on track to meeting the 2023 target of “around 5%.” Beijing set a conservative growth target out of an awareness that the recovery will be gradual, and out of a desire not to be forced into aggressive stimulus that worsens financial risks to chase an ambitious target. The National Development and Reform Commission, China’s state planner, held its monthly press conference today and did not signal anything new in terms of stimulus measures.
High youth unemployment (19.6%) is a concern for the leadership but is viewed as more of a structural than cyclical problem. The other likely top concern is subdued private investment, which will provide further impetus to efforts by Premier Li Qiang and the new economic team to reassure the private sector about the business environment. Entrepreneurs have yet to fully buy in, partly due to the macro environment (including the weak outlook for global growth) but also doubts about Xi’s willingness to elevate economic pragmatism over his political and geopolitical goals.
Should the recovery show signs of slipping back – which does remain a risk – Beijing will be ready to implement additional stimulus measures, such as increased fiscal spending, but probably not until closer to Q3.
All of this still leaves Chinese equities still looking for major catalysts. Improved earnings will take time, particularly outside of service sector firms, given that the recovery will remain gradual. Geopolitical tensions involving China are unlikely to significantly lower, though we are closely watching for signs that the Biden administration and Beijing are ready to resume high-level engagement in form of a call between Biden and Xi and potential trips to China by Secretary of State Blinken, Treasury Secretary Yellen, and Commerce Secretary Raimondo.
Yellen will deliver a speech on China on Thursday at 10:15 AM in Washington. As always, one audience for this speech is domestic. Hence, we expect Yellen to spend some time defending the Biden administration’s efforts to “de-risk” critical supply chains from China and to boost strategic competition, namely through the CHIPS+ Act (semiconductors) and Inflation Reduction Act (green supply chains). It will be interesting to see if she tries to delineate between these efforts and a broader “decoupling” that she and other economic officials realize is both impossible as a practical matter and also awkward for US economic diplomacy. At the recently concluded Spring meetings in Washington for the World Bank and IMF, a key theme was the economic risks of “global economic fragmentation” (in the IMF’s words). US officials did not appreciate that focus, with its implicit criticism that US industrial policy and protectionism could hurt global growth. So Yellen may seek to present the US as “de-risking” but responsibly.
At the same time, Yellen is likely to advocate for the need for continued bilateral engagement with Beijing, particularly in areas such as debt relief for emerging economies. She and US officials need and want to deepen relationships with a largely new economic team in China, particularly with the recent retirement of vice premier Liu He, a trusted counterpart (see our take on Liu’s legacy HERE).
One of the key hurdles right now in reviving bilateral dialogue is Beijing’s deep cynicism about US intentions. China’s traditional approach has been to favor dialogue as the best way to keep the relationship on track, which the US generally tolerated but often viewed as a self-serving way to confront addressing hard issues. Those tables have turned: rattled by increasingly assertive and public US support for Taiwan, the sweeping controls on advanced semiconductors imposed in October, and furor over the balloon episode, Beijing sees the US as bent on containing China. Traditional pragmatists in Beijing who would normally advocate engagement are on their backfoot.
The Biden administration, recognizing the danger of the current dynamic, has sought to stress the damage to both sides from an accident or miscalculation that creates a crisis. To this end, the administration worked behind the scenes to limit the fallout from President Tsai’s recent transit visit to the US and meeting in California with House speaker McCarthy.
Beijing will eventually reopen high-level communication channels – Xi recognizes the need to manage the relationship – but mutual distrust and highly charged domestic politics in both countries will make it difficult to sustainably bring down tensions.
