By Carol Liao, China Economist, and Allison Boxer, US Economist
After months of COVID-related disruptions, China’s economy looks to be on the path to normalization. In June, new daily coronavirus case counts stabilized in the low hundreds.
More people are hopping on planes and trains, intercity highway traffic has rebounded to pre-outbreak levels, and city traffic is congested again.
Factory activity in June expanded for the first time since February, as manufacturing hubs emerged from lockdowns, production increased, and supply chains eased. The manufacturing purchasing managers’ index (PMI) crossed the 50 mark into expansionary territory, and industrial production rose 3.9% year-over-year (y/y). In particular, China’s June exports rose at the fastest pace in five months, indicating resilience in the country’s manufacturing supply chain.
The Chinese government has prioritized production and delivery of exports. To be sure, the robustness of China’s supply to the global goods market has been tested repeatedly since 2020, through waves of COVID outbreaks, power outages, and regional geopolitical crises – all without major bottlenecking. As China’s domestic supply chain continues to normalize, supply-side pressures should ease
In addition, soft domestic demand has helped China keep its inflation under control and producer price inflation (PPI) has been moderating in recent months. This, together with the depreciation of the yuan in early 2Q 2022, has resulted in a moderation of China’s export price inflation to the U.S.
Given softening demand in developed markets along with rising recession risks (see our Secular Outlook for details), going forward, we don’t believe the nation’s supply chain poses a major concern for inflation globally, despite ongoing uncertainty over COVID’s trajectory.
Furthermore, while China has stepped up stimulus to support infrastructure spending, the property market outlook remains gloomy, mitigating China’s demand for global commodities. Therefore, it is unlikely to be a dominant factor in global inflation.
Developed market inflation risks are broadening and shifting away from China
in the U.S., supply chain recovery also appears to be underway thanks to a combination of shifting consumer preferences back towards services, slower overall spending, and higher inventory levels. This has resulted in fewer backlogs at ports, increased freight capacity, and declining transport prices. Inventory-to-sales ratios for sectors like general merchandise, home goods, home electronics, and building supply stores, which are the major categories of Chinese exports to the U.S., have normalized. Import price inflation from China has also been moderating in recent months.
Despite these signs of healthier supply chains, U.S. goods inflation has recently reaccelerated (read our latest U.S. CPI blog). The continued acceleration of retail inflation – despite a slower recent pace of spending and this easing in supply chain pressures – suggests that inflation may be more entrenched than previously thought. While we still see reasons to think that goods price inflation will ultimately moderate, we’re also seeing inflation broaden to other categories.
Shelter inflation has risen sharply in recent months and geopolitical risks remain a worry for the commodity price outlook. The net result is that inflation risks appear to have migrated away from being primarily driven by supply chains and disruptions from China, to a broader set of areas that tend to be stickier, less sensitive to Fed policy action, and harder for consumers to substitute away from. This raises the risk that any further upside inflation surprises are also accompanied by a sharper slowdown in consumption.
Implications for investors
In the near term, disruptions to the global supply chain may persist, despite China’s continued recovery. Disruption from the war in Europe and strikes in some major markets could still pose risks to global supply chains. Disrupted food and energy supplies are already spurring global inflation, but growing risks of gas shortages and the associated rationing in Europe could compound supply chain challenges if factories are forced to close to ensure sufficient energy supplies for households. Inflation could remain high, contributing to a higher risk premium.
In the longer term, we see rising risks of deglobalization and more fragmented capital markets (read our latest Secular Outlook here). China’s role in the global supply chain could diminish over time, as the U.S. government seeks to ease America’s reliance on China’s massive manufacturing base for goods, spare parts, and materials of all kinds.
These trends may augment economic inefficiencies and increase inflationary pressures in the years to come, prompting many investors to focus on building resilience in portfolios.