China Struggles to Fight the Trend

Stocks Slip Amid Taper Talk

Equity markets slipped last week amid a quiet week of economic data and Fed uncertainty. The S&P 500 declined 1.1% while the Dow Jones Industrial Average fell 1.5%. Stocks pushed lower every day last week but Thursday.

Comments by Federal Reserve Bank of Dallas President Richard Fisher last week indicated that the Fed will start reducing asset purchases in September. Mr. Fisher has been a consistent adversary of the QE program in FOMC meetings, however, which suggests his feelings may not necessarily represent the committee’s broader views. Nonetheless, investors took Mr. Fisher’s comments negatively with little other economic data to digest, contributing to losses on the week.

On Monday, the Institute for Supply Management (ISM) released its non-manufacturing index. Like its better-known sibling, the manufacturing index, which was released last week, the index moved sharply higher and above expectations.

The non-manufacturing index rebounded to 56.0 in July from 52.2 the month prior, boosted by the all-important new orders and business activity components. Each jumped to their highest levels since December 2012. Other measures were less sanguine, however, such as the employment component that softened during the month.

Still, the sharp jump in the non-manufacturing index is a constructive sign for the US economy. The index is at its highest level since February, and indicative of robust growth in the US service economy.

While economic data was quiet in the US, there were a few notable indicators abroad.

In Europe, a composite separately measuring the region’s manufacturing and service activity improved above consensus expectations. The composite rose to 50.5, which is the best reading in nearly two years and a return to expansionary territory. The service index, meanwhile, climbed to 49.8, just under the expansion/contraction line.

Europe’s return to economic expansion is a positive sign for a regional economy that has been struggling through a recession for some time now. Monday’s report raises expectations for the third quarter as it relates to positive GDP growth. Second quarter GDP data is due for release next week.

China also released a number of indicators amid concern that the world’s second largest economy is slowing.

On the manufacturing side, China reported that industrial production increased 9.7% year-over-year in July. This was an increase from 8.9% the month prior and well above consensus expectations. China’s manufacturing output appears to have stabilized around the 10% annual growth level, down slightly from the 12-15% levels witnessed during the initial economic recovery in 2009-2011.

Chinese retail sales were more disappointing, but only modestly so. The measure increased 13.2% from a year prior in July, essentially the same as in June. Analysts had been expecting a 13.5% figure.

Source: Econoday

Overall, July’s China data was mixed, and will do little to persuade observers that China is either improving or deteriorating. Inflation data released during the week indicates a lack of pricing pressure, which is encouraging when compared to the 6%-plus levels seen in 2011.

china struggles to fight the trend

Prior to the global financial crisis, ‘decoupling’ was the word du jour. In the years since the crisis began, however, decoupling has vanished from the everyday lexicon. In recent weeks, the financial media noticed a new form of decoupling, one that shows improving growth prospects in the developed world but slower growth in developing economies. Rightly or otherwise, much of that slowdown is pinned on China and recent data continues to suggest a slower pace of growth than investors became accustomed to in prior decades.

Since 2000, Chinese GDP averaged a 9.7% annual rate, compared to 2.6% for the global economy. Unfortunately, growth in China is gradually trending lower, with the latest reading of 7.5% annualized. Perhaps unexpectedly, investors are seeing improving growth trends across the US and Europe, causing them to become more optimistic on the future of those geographies.

Source: Thomson Reuters

Evidence of this phenomenon can be seen in the performance of MSCI companies with exposure to China and those with exposure to developed markets. Until the middle of last year, companies with exposure to China were vastly outperforming their developed counterparts. Beginning last year, a subtle shift occurred and earlier this year that rotation accelerated.

Source: Thomson Reuters

That trend looks set to continue based on simple measures of manufacturing. China is one of the few economies where manufacturing is sliding over the summer months. Countries like Britain and the US are experiencing a rebound in the manufacturing sector, but the HSBC China Manufacturing PMI slipped to an 11-month low of 47.7.

Source: Markit/HSBC

In the latest week, China finally received some much-needed respite. Inflation came in just below expectations at 2.7% year-over-year and industrial production rose 9.7% year-over-year.

Source: Econoday

The Wall Street Journal recently penned an article entitled “Decoupling Returns to Bite Asia.” They described the slower pace of growth in China and the spillover impact it is having on other developing nations, along with China-dependent countries such as Australia. There is little likelihood those pressures will abate near-term as China attempts to transition from a manufacturing to consumer oriented economy. The period of transition is not always seamless and will continue to pressure developing nations.

The Week Ahead

Economic data picks up significantly this week. Retail sales and the consumer and producer price indices headline the week. Important regional Fed surveys from the Philadelphia and New York Feds also complement the week. Housing starts on Friday will also be scrutinized following a disappointing June figure.

On the central bank front, the Bank of England will release minutes from its most recent policy meeting. Chile and Indonesia also release rate guidance.

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