As U.S. companies report fourth-quarter earnings, a growing number have cited China’s slowdown as adversely impacting their businesses.
The most recent include industry bellwethers such as Apple, Caterpillar and Nvidia. In prior reports, multinationals such as Alcoa, Coca-Cola, Ford, GE, Harley-Davidson and Whirlpool stated their earnings were being hit by higher tariffs on imports from China.
{mosads}This list, moreover, is likely to grow if China slows further and/or tariffs on Chinese imports are increased. However, this begs two questions: Why is China’s economy softening; and will the government be able to stabilize growth as it did in 2016?
One of the challenges investors confront is to assess whether China’s slowdown is primarily cyclical or secular. Its growth rate has slowed steadily throughout this decade, from about 10 percent in 2010 to 6.6 percent last year, the lowest in three decades.
In dissecting the recent slowdown, investors need to disentangle the effect of higher tariffs on Chinese imports from the impact of structural changes inside China.
There is general agreement that last year’s slowdown coincided with tariffs being imposed on 10 percent of Chinese goods imported to the U.S. during the first half of 2018.
The economy weakened further in the second half, when the list was extended to cover one-half of imports from China. Accordingly, investors believe a resolution of the trade dispute is critical to stabilizing China’s economy.
Beyond this, China’s potential growth rate is decelerating for structural reasons. The country’s economic miracle was founded on agricultural workers in rural areas migrating to urban areas along the coast with higher-productivity manufacturing jobs.
But this process has become more challenging as wages in manufacturing have increased and unit labor costs have surged. Consequently, some economists believe China confronts a “middle income trap.”
Amid declining productivity growth, China’s government has relied increasingly on fiscal stimulus and credit expansion to achieve its growth target of 6.0-6.5 percent. But this has also resulted in a doubling of China’s overall debt burden from about 150 percent of GDP before the financial crisis in 2008 to 300 percent currently.
The problem with this strategy is it is not viable, as more and more credit is required to support each unit of output. The reason: Much of the credit expansion has gone to state-owned enterprises (SOEs), some of which the International Monetary Fund labels as “zombies” — firms that pile on debt but do not contribute positive value added.
Faced with this predicament, China’s policymakers pursued several measures last year to bolster the economy. These efforts included lowering short-term interest rates by more than 200 basis points, allowing the yuan/dollar exchange rate to decline by 10 percent, while also expanding credit and lowering tax rates.
Similar actions were undertaken during China’s slowdown in 2015-2016, which proved effective in bolstering the economy.
Thus far, however, their impact is not readily apparent. Auto sales, for example, declined in November by nearly 14 percent over a year ago, and Apple’s recent public filing indicated softness in consumer spending on electronics.
China’s imports plummeted in December, and exports also appear headed for a fall based on recent purchasing manager surveys and weakness in Asia and Europe.
What is clear is China’s policymakers are prepared to take additional actions to keep economic growth above the 6-percent threshold. The central bank, for example, announced a 1-percent reduction in reserve requirements, and the government is boosting spending and lowering taxes. What is unclear is whether such action will be as effective as in the past due to the country’s rising debt burden.
The wildcard is whether an agreement on trade can be reached by the March 1 deadline. While both sides wish to do so, the underlying issues are complex.
If the disagreement were simply about the size of the bilateral trade imbalance, the issue would be resolved, as China is willing to boost imports from the U.S. and could direct SOEs to do so. However, the more difficult issues relate to violations of intellectual property and subsidization of businesses by the Chinese government, which the U.S. opposes.
The most likely outcome is that a temporary truce will be reached, which would bolster world equities for a while. However, because a lasting agreement is harder to achieve, officials may in effect opt to “kick the can down the road.”
{mossecondads}The outcome will have an important bearing on global economies. While the U.S. economy has withstood the impact of China’s slowdown thus far, a growing number of U.S. companies are feeling the impact as noted previously.
Furthermore, there has been a significant downward revision to earnings expectations by Wall Street analysts over the past six months. They are now calling for S&P 500 EPS growth of 8.1 percent in 2019 from more than 20 percent last year. Yet, some observers believe the results will be weaker.
Ultimately, the market’s outcome will depend on whether China’s slowdown can be arrested by policy action. If so, equity markets are likely to rally. If not, they are likely to stay volatile, as the impact of a permanent slowdown has not been priced into markets.
Nick Sargen is chief economist at Fort Washington Investment Advisors and a lecturer at the University of Virginia Darden School of Business.