Has the magic dragon run out of puff?

China’s Communist Party recently held its so-called ‘Third Plenum’ at which it outlined future economic policy. Major economic reforms have been the highlight of previous events, such as when Deng Xiaoping used it in 1978 to initiate the reform and opening up of China. However, this time the accompanying underwhelming 5,000-word communique did not contain any specific reforms, but only talked in general terms about building a strong country.

China remains the dominant growth region in the world economy. It has been a manufacturing-driven economy and continues to be so, with the latest hopes placed on dominating the global electric vehicle (EV) market. This has already led the US and EU to impose tariffs on Chinese EVs. Now, China needs to re-focus its economy from manufacturing to consumers. However, Chinese consumer confidence is currently very subdued and has been for a good two years. Many hoped that the exit from harsh pandemic lockdown measures would be the trigger for a consumer spending spree. Unfortunately, consumers look to be scarred by the experience of the pandemic and the end of China’s long housing boom. House prices have continued to fall and in June dropped by another 4.5%, the fastest pace of decline in nine years.

China’s economic growth is likely to fall short of the official 5% target in 2024, which is already well below the 7.7% average annual growth achieved in the decade before the pandemic. China’s central bank recently cut two benchmark interest rates to encourage lending, including trimming the 1-year loan prime rate from 3.95% to 3.85%. However, this looks like a ‘drop in the ocean,’ given the challenges in the property development sector. Markets had been expecting more major fiscal stimulus, but previous measures to artificially prop up lagging trend growth through a succession of fiscal measures, has left the country with an excessive debt burden.

Under President Xi Jinping, China has stepped away from liberalisation and turned towards a more centrally planned economy again. He has also made clear his long-term intentions regarding Taiwan. There is also the ongoing technology ‘Cold War’ with the US and the prospect of further tariffs, particularly if Donald Trump returns to the oval office.

Given this, are the days of China being the engine of global economic growth over?

What have we been watching?

The narrative for global markets shifted last week. Having adapted to ‘higher for longer’ interest rates, markets suffered major turbulence on the latest soft US jobs data and fears that the Federal Reserve (Fed) has left it ‘too late’ to cut interest rates, moving the US economy from a ‘soft landing’ to risk of recession. The US mega-tech stocks were also sold down – Intel fell by 25% after announcing 15,000 job cuts, Apple dropped as Warren Buffet’s Berkshire Hathaway confirmed it had sold half its stake, while AI stocks including Nvidia were hit as a US hedge fund Elliott called the sector over-hyped.

This triggered a domino effect, with Bitcoin falling 11% and NASDAQ down 2.3% with futures suggesting a further 5% fall later today. South Korea, the home of many listed technology stocks, fell by 8%, but the biggest fall was Japan which dropped 6% on Friday and then a further 12% today. Japan’s economy is heavily-skewed towards manufacturing, so it is more vulnerable to recession, but sentiment was not helped by the Bank of Japan’s decision to hike interest rates. This, combined with the likelihood of the US cutting interest rates, has undermined the ‘carry trade’ where global traders borrow cheaply in Japanese Yen to fund market positions. The UK market was also caught up in the global maelstrom, even though the Bank of England voted by a narrow margin to cut interest rates by 0.25%. Even Brent oil fell by over 5% despite the rising tension in the Middle East.

US investment bank Goldman Sachs has increased the chance of a US recession from 15% to 25%, so is this all a bit of an over-reaction from global markets? The problem seems to be that the Fed is not due to meet again until 18^th September -that is a long time – although US interest rate futures are now indicating cuts in interest rates of 1% in the final months of 2024. The yield on 10-year US Treasury bonds dropped from just over 4% to 3.8% – a big move. As for the global tech sell-off, exciting as AI is, markets have felt for a while that valuations were too elevated. Perhaps the biggest shock is the sell-off in Japan. Could it be that the growth of global passive ETF investing has made markets more volatile with everyone trying to bank some cash at the same time creating turbulence? For example, Nvidia has fallen by almost 10% so far this month – which with a valuation of three-trillion dollars has a big impact on global indices!

The Middle East remains a powder-keg. Iran has vowed revenge after a Hamas leader was assassinated in Tehran. The fact that the victim had been the Hamas negotiator in Qatar talks does not bode well. Israel also killed a senior Hezbollah commander in Beirut in retaliation for the recent missile attack on the Golan Heights. Several countries have urged their nationals to leave Lebanon, as fears grow of wider conflict in the Middle East.

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In the UK, Chancellor Rachel Reeves confirmed tax increases in the October Budget. Given income tax, National Insurance and VAT will not increase, this suggests a number of alternative measures. This might include a stealth tax by extending the freeze on tax thresholds, increasing CGT rates, reducing pension tax relief, and raising inheritance tax. Rachel Reeves also announced she is axing the £1.3bn investment planned by the Conservatives in technology and AI projects -not helpful for Labour’s economic growth ambitions! Meanwhile, the Bank of England (BoE) voted 5:4 to cut interest rates by 0.25% to 5%. The BoE is forecasting the UK economy to grow by 1.25% in 2024 and by 1% in 2025 while inflation is expected to drop to 1.7% by mid-2026 and 1.5% by mid-2027. BoE Governor Andrew Bailey was very keen to make it clear that as things stand currently that it needed to ‘be careful not to cut interest rates too quickly or too much.’ This suggests a gradual easing path perhaps with one more 0.25% cut this year.      

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In Europe, there was mixed regional economic data. Germany reported worse than expected GDP numbers, with the economy slipping into contraction in the second quarter. France and Spain were a little better than expected, while Italy was in line. In addition, inflation picked up in Germany in July. Taken together, the uneven growth presents a challenge for the European Central Bank, which has adopted a ‘wait and see’ approach to further interest rate cuts.

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In the US, the Federal Reserve (Fed) left interest rates on hold, and there was initial disappointment that the press statement did not drop any direct hints about lower rates. However, these were dispelled by Fed Chair Jerome Powell, who in his press conference, said that the Fed was ‘getting close’ and that a rate cut could be on the table at the next meeting on 18^th September. US manufacturers would no doubt welcome a cut, as the ISM July manufacturing PMI came in below estimates at 46.8. This was then followed on Friday by extremely soft US jobs data.

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The Bank of Japan increased interest rates from 0.1% to 0.25% and will halve its bond buying as it starts to normalise monetary policy.

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China’s manufacturing sector continued to contract in July with a PMI of 49.4 on soft domestic demand, although exports remain weak.

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Brent oil dropped to $76 despite events in the Middle East taking a turn for the worse as fears of US recession increased.

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Finally, talking about China/Taiwan. A recent ‘war game’ simulation estimated the potential impact on the global economy of a war in the Taiwan Strait at $10trillion or about 10% of global GDP. This would be far worse than either the Great Financial Crisis or pandemic. Taiwan accounts for 60% of global semi-conductor chip shipments and it might take over 5 years to replace the production capacity that would be inevitably damaged. Hopefully common sense prevails, but in his 2024 New Years’ address, President Xi Jinping described Taiwan’s unification as an ‘historical inevitability.’

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Read Last Week’s Alpha Bites – Sinking global trade

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Alpha Portfolio Management is a trading name of R C Brown Investment Management PLC which is authorised and regulated by the Financial Conduct Authority.