China slips further into deflation as the West breathes a sigh of relief

Many have predicted that the next century will belong to China, and the narrative of a rising star in the East has become stronger and stronger since the turn of the millennium. This is not without its basis in reality. Since 1978, China has averaged 9% annual GDP growth and lifted 800 million people out of poverty. However, the pandemic and particularly the CCP's zero-COVID policy have predictably thrown somewhat of a spanner into the works. In 2020, Chinese GDP growth fell to just 2% as international trade dried up amid the global shutdown. But then it shot right up above 8% as western economies reopened before crashing straight back down to 2% in response to the party's draconian citywide lockdowns throughout 2022.

Now, after a period of intense global inflation, something both strange and worrying is happening in China: prices are actually falling. That's right. Following November's consumer price index report that showed a 0.5% year-over-year decline, China is officially experiencing deflation. It might seem like a good thing on the surface, but unchecked deflation is actually the worst kind of price pressure since it prompts people to defer consumption in anticipation of lower prices. So, what are the implications of this likely to be on instrument prices both in China and worldwide?

A long time coming…

China's economic woes didn't emerge in a vacuum, nor were they totally unpredictable. Beyond the effects of zero-COVID, a part has also been played by the long-standing property bear market, youth unemployment, and the government's tech crackdown. These factors were then exacerbated by accelerating foreign capital outflows following the pandemic and a strain in relations with the US over Taiwan. For Chinese tech stocks, the effect has been nigh-on catastrophic. Tencent and Baidu, for example, have both lost close to 50% since late 2021. Meanwhile, the global household name Alibaba has tanked by around 65% over the same period. And with prices now positively falling in key sectors, it's understandable that consumers would avoid purchases where possible, which will only hurt these consumer-focused apps even further.

Even international fuel sources like oil and gas are down significantly year-over-year, and yet Chinese industry is unable to take full advantage due to weaker domestic and international demand. Pressure is mounting on Beijing to take decisive action. As such, all eyes will be fixed on this month's upcoming Politburo and Central Economic Work Conference (CEWC) meetings for confirmation of PBC governor Pan Gongsheng's pledge for more "accommodative" monetary policy aimed at boosting domestic demand and banishing deflation. If the expected CCP support is forthcoming, we could feasibly expect a resumption of growth in these multi-year low Chinese stocks in 2024.

Winners and losers

It's no secret that the West has been suffering economically of late, but here, it's almost a mirror image of China. Inflation has been out of control and still remains significantly above target in both the US and EU, while fuel shortages associated with the geopolitical instability in Eastern Europe have been punishing both industry and ordinary consumers. As a result, the EURO STOXX 50 index has been fairly stagnant, barely gaining 5% over the past two years. Until just a few weeks ago, it was actually down, managing to gain a full 10% in a little over a month. This movement has been reflected almost one-to-one by the S&P 500.

It is believed that this sudden uptick could be attributable to China effectively "exporting" its downward price pressure to the West. Indeed, China represents 20% of all of Europe's imports in a trade relationship that is worth $2.5 billion per day. In sentiments that were later echoed by Societe Generale analyst Albert Edwards, Thierry Wizman from Macquarie wrote, "The longer that China fails to show that it can recover, the likelier that inflation expectations will decline in the West, as fears that China can export its deflation to the rest of the world through international trade will gain ground."

If this trend does continue, we could see an organic normalisation of inflation in the US and EU, which would lead central banks to finally normalise monetary policy and year over yearperhaps even adopt a more dovish stance in 2024. This would, of course, be great news for equities across the West. 

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