U.S.-China Trade Tensions Have Eased, Will Growth Revive?

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Includes: ADRE, CHN, CN, CXSE, DBEM, DDM, DIA, DOG, DXD, EDBI, EDC, EDZ, EEH, EEM, EET, EEV, EMEM, EMF, EMLB, EPS, EQL, ESGE, EUM, EWEM, FCA, FEM, FEX, FLCH, FLQE, FWDD, FXP, GXC, HEEM, HUSV, IEMG, ISEM, IVV, IWL, IWM, JHML, JKD, KEMP, KGRN, MFEM, MSF, OTPIX, PGJ, PPEM, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RFEM, ROAM, RSP, RWM, RYARX, RYRSX, SCAP, SCHE, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPEM, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TDF, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV, VWO, WCHN, XPP, XSOE, YANG, YAO, YINN, YXI
by: Charles Schwab
Summary

Emerging Market (EM) stocks appear to be pricing in an economic recovery for China and the rest of emerging Asia based on a U.S. trade deal.

There is risk that the real driver of a potential rebound, private-sector loan growth, doesn’t materialize or is insufficient to overcome government austerity.

This year’s rally in Chinese and EM stocks could become vulnerable in the coming months as optimism over a trade deal leads to disappointment over its actual economic and earnings effect.

By Jeffrey Kleintop

The easing of trade tensions between the United States and China appears to have lifted Chinese stocks, which has helped boost overall emerging market (EM) stocks this year. Investors seem optimistic that China's economy will finally begin to recover from the sharp slowdown over the past 12 months and help drive overall EM growth now that a trade deal with the U.S. is near and may include the removal of tariffs. But, there may be confusion over the cause of China's slowdown, and the effect of a trade deal may not be what investors expect.

What economic effect did the tariffs have on China?

The Chinese economy has weakened over the past year. But this may have little to do with the U.S.-China tariffs. While exports to the U.S. have slowed to just 1.9% year-over-year (as of January 2019), China's shipments to the rest of the world have continued to grow at a solid pace. Overall Chinese exports rose at an above average 14% from a year ago in January, lifting the 12-month average to 9%. Growth of exports exceeds the growth in the rest of China's economy, as you can see in the chart below. As a result, it seems that the U.S.-China tariffs was not a key contributor to the slowdown in China.

China's export trade grew faster than the overall economy

China Monthly GDP %, Exports Year-over-Year %

Source: Charles Schwab, Bloomberg data as of 2/26/2019.
Bloomberg calculated monthly GDP estimate.

If it wasn't trade, what caused China's economic downturn?

China's economic slowdown was more likely a lagged response to an intentional tightening of lending by its government. We believe the policy was designed to address the risk from a rising mountain of debt on unproductive assets, which included government-owned "zombie" companies and infrastructure projects tied to "ghost cities" and "bridges to nowhere." As a result, government spending slowed sharply, as you can see in the chart below.

China's government investment has slowed sharply

China Fixed Asset Investment

Source: Charles Schwab, Bloomberg data as of 2/25/2019.

The slowdown in lending and government spending appears to have had a broad impact on China's economy. China's growth in bank assets, a measure of overall lending growth, fell from 16% at the end of 2016 to just 6% at the end of 2018, as you can see in the chart below.

Bank lending has slowed in China

China

Source: Charles Schwab, Bloomberg data as of 3/1/2019.

As a U.S.-China trade deal nears, could China's overall trade growth begin to slow?

While the easing of trade tensions is a positive, it began with the trade truce of December 1. However, economic data in December and January continued to weaken. Asian emerging markets have been a source of strength for China's exports. But the purchasing managers' indexes (PMIs) of China's major trading partners have weakened, with emerging markets in Asia signaling contraction by falling below 50 this year, as you can see in the chart below. In contrast to growth optimism over a U.S. trade deal, a trade slowdown might begin to emerge as the strength in demand from China's Asian trading partners slows.

Asian emerging market PMI slides into contraction

ASEAN Manufacturing PMI

Source: Charles Schwab, Bloomberg data as of 3/1/2019.
ASEAN = Association of Southeast Asian nations which includes Singapore, Malaysia, Thailand, Myanmar, Philippines, Indonesia, Vietnam, Cambodia, Laos, and Brunei.
A reading of 50 marks the threshold between growth and contraction in manufacturing.

It is important to point out that the trade relationship between China and Asian emerging markets is circular. China is a major destination for the exports of Asian emerging market countries, as you can see in the chart below. As China slows, it reinforces the economic trend among emerging markets in the entire region.

China is the largest export destination for many Asian emerging markets

Export Destinations for Asian Emerging Markets

Source: Charles Schwab, Bloomberg data as of 3/1/2019.

What's next for China's economy and EM stocks?

Offering a glimmer of hope, credit growth in China jumped in January (People's Bank of China). China's five cuts to banks' reserve requirements in the past year may lead to increased bank lending to private businesses. This stimulus, combined with tax cuts, could support an improvement in overall economic activity later this year.

However, EM stocks appear to be pricing in an economic recovery in China and the rest of emerging Asia based on a trade deal. There is a risk that the real driver of a potential rebound, private-sector loan growth, doesn't materialize or is insufficient to overcome government austerity. This suggests the rally this year in Chinese and EM stocks could become vulnerable in the coming months as optimism over a trade deal leads to disappointment over its actual economic and earnings effect.