Headwinds from the East and West darken the economic outlook

A slew of underwhelming economic data from China released this morning skews risk sentiment to the downside, as investors mull slowing China economic growth, as well as its slumping property market and receding consumer spending.

After a notable risk-on sentiment at the end of last week, which helped curb the dollar’s recent revival, data releases this morning by China and later today in the US, will test that resolve to look past the mounting ‘wall of worry’.

China reported slowing GDP growth in Q3, at 4.9% year-over-year (Q2: 7.9%; Q1: 18.3%), below low-balled market consensus of 5%. Industrial production in September was down 3.1% YoY, a significant miss on market forecasts (4.5%) and the previous quarter (5.3%).

The data shows weakening demand at a time when supply is constrained by power rationing. More significantly, the gap between output and forecasts shows the market has not yet priced in the headwinds posed by China’s energy crunch.

Elsewhere, retail sales were 4.% (Q2: 2.5%), reflecting a very modest beat against forecasts (3.3%), and far below long-term averages at between 7-10%. The rebound was attributed to the service side of the economy after eased delta variant restrictions allowed the service side of the economy to recover.

Crucially, property sales were down, in an anticipated downside risk borne out. China’s property sector represents approximately 29% of the national GDP. Deteriorating property sales not only weakens the outlook for the embattled sector, as many developers fight for survival, but it also poses risks to adjacent sectors. In Q3, there were poor sales for large ticket items (e.g., cars, mobiles, household appliances and furniture).

Markets will remain vigilant to how consumer sentiment responds over time. If property sales remain sluggish or worsen, this can cascade into a broader weakening of China’s economy, which will impact the global economic recovery and Chinese capital flows.  A weakened Chinese economy will strengthen the dollar as investors seek safe-haven harbours.

China’s 8% GDP growth target for 2021 is now at risk, with Q4 GDP expected to be weaker as the energy crunch starts to bite during a seasonal winter pick-up in demand.

Risks ahead for China are skewed to the downside. Markets now exact GDP growth to weaken to around 5.3% in 2022, according to BofA, with risks to this forecast to the downside (e.g., energy crunch, supply chain bottlenecks, regulatory crackdown, property market weakness, slowing consumer spending, and tight credit markets).

However, hope remains amid the worry that policymakers may, mindful of the headwinds, may come to the rescue. For example, there is a simple solution to the extreme funding pressures faced by China’s property developers. The People’s Bank of China (PBOC), China’s central bank, could directly extend funding to property developers, signalling a moderate relaxing of credit controls. However, it is unclear if the political will exists to do this, as it would unwind the deliberate deleveraging efforts across the property sector over the last five years. Still, markets are watching vigilantly for signals.

Later today, US industrial production data for September will be published (EST 14:15). Markets expect a significant drop. “We expect a large drop in output from the automobile sector connected with the global shortage of semiconductors, combined with the disruption to energy production caused by Hurricane Ida, to have resulted in a contraction in industrial production of about 1.3%,” says Paul Ashworth, chief North American economist at Capital Economics.

In the US, while demand is recovering, as the impact of the Delta wave of infections eases, supply faces huge headwinds, both domestically and internationally. On the domestic front, acute labour shortages continue to push up wages in the US. Record job openings across small businesses were left unfilled in September, according to the National Federation of Independent Business. A record number increased offered wages to plug the labour gap, as companies struggle to find workers with the necessary skills. It is a conundrum. “These shortages have developed even though employment is still five million below its pre-pandemic level because of the continuing mass exodus from the labour force, which is down by three million,” says Ashworth.

Back in the Spring, when labour tightening started to emerge, markets suggested the low employment participation was due to fears over the virus, generous government stimulus and childcare priorities. However, six months later, with unemployment benefits now expired and most schools have returned to in-person learning, labour participation has stagnated well below its pre-pandemic level.

Furthermore, while the labour participation rate may lag eased concerns over the Delta wave and childcare priorities, increased gas prices may weigh on workers’ willingness to return to employment which required long-distance commutes, suggested Ashworth.

Supply shortages in China, exacerbated by power rationing in Chinese factories, add to supply headwinds facing US industrial production, which could cause “demand loss” by US corporates, which would weigh on GDP. More broadly, higher wages and higher prices will feed into consumer price inflation across the economy, supporting expectations that the Federal Reserve will start to taper asset purchases in the coming months.

By now, this is already priced in by markets. More likely, the twin drivers of rising inflation and asset tapering will provide a gradual uplift in the dollar’s value over the coming months, with more significant upside risks coming from a possible deterioration in the global economic outlook.

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