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With China Facing Deflation, We Expect These Sectors to Win Either Way

Soon after protests erupted in China last November, its government began to loosen the zero-Covid policy in December. This followed many years of lockdowns. However, the robust economic recovery that many expected to unleash turned out to be a whimper rather than a bang.

China’s official growth target for this year is “around 5%”, a number many considered quite conservative at the time it was announced. Growth for the second quarter came in at 6.3% (which sounds ok, but the expectation was to be a full percentage higher).

Property constitutes as much as 30% of China’s economy. In the first six months of this year, property investment fell by a whopping 7.9%. Following years of buoyant growth, the sector hit a credit crisis in the last two years and many developers are carrying way too much debt. Because of excess supply, many housing projects are incomplete. Some buyers even stopped making their mortgage payments while others are reluctant to buy into a market with no price appreciation in the foreseeable future.

Rather than push a consumer-driven economy, China’s central strategy is to boost investment and exports instead. Lately, planners have made several efforts to boost the struggling property market. In addition to extending the due dates on developer loans, commercial banks are now allowed to classify project loans as less risky (which allows them to lend out more to borrowers). However, with bank margins thin and loan demand weak, these policy measures have met a muted reaction from investors that believe more is needed.

Meanwhile, China is the only place in the world on the cusp of price deflation. Producer prices (a leading indicator) collapsed 5.4% in June year-over-year and dropped 0.8% month-over-month. Annual consumer price inflation was dead flat in June. That may not sound so bad if you’re upset about your grocery bill, but price deflation is deadly. Lower prices hurt corporate profits, which causes companies to lay people off, which leads to less production, which creates even more layoffs.

We believe the muted reaction to China’s policy announcements to help the property sector won’t be enough to kickstart the economy and reverse this recent deflationary trend in the data.

Both energy and material stocks are a buy right now. If price deflation gets worse, we expect China to introduce a far more aggressive stimulus package. This is what investors want and will lead to an immediate jump in the price of commodities across the board. If China’s economy picks up on its own, the market narrative will be that China’s post-Covid economic recovery has finally started. Commodities will rally on that news as well.

The Chinese government won’t allow the third option to happen. That option is waiting for this contraction to self-correct. The protests last November led to an immediate reaction from its central government. Astonishingly, the youth unemployment rate is presently 21.3%. If I were running a country that faced protests only 8 months ago, that number would make me very nervous. Civil unrest tends to start very quickly and take on a life of its own.

-Jeff Pollock

DISCLAIMER: The opinions expressed in this publication are for general informational purposes only and are not intended to represent specific advice. The views reflected in this publication are subject to change at any time without notice. Every effort has been made to ensure that the material in this publication is accurate at the time of its posting. However, Schneider & Pollock Wealth Management Inc. will not be held liable under any circumstances to you or any other person for loss or damages caused by reliance of information contained in this publication. You should not use this publication to make any financial decisions and should seek professional advice from someone who is legally authorized to provide investment advice to assess your goals and objectives, personal circumstances, and make an informed suitability assessment.

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