MacroscopeChina economy: deflation and sentiment concerns are real, but investors have reason to hold out hope

The upside for Chinese assets is significant, provided Beijing springs a positive surprise with targeted, well-communicated support

While the policy-driven rally of the past fortnight is flagging, it shows there is potential for a meaningful improvement in market sentiment

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A customer buys food at a Beijing market. Sentiment towards China’s economy has soured in recent months, but there is significant upside potential, given the right kind of policy support from the government. Photo: AFP

Published: 10:00pm, 10 Aug 2023Updated: 10:51pm, 10 Aug 2023

Another day, another reminder of the acute problems facing China’s economy as it emerges from three years of self-imposed isolation. Data published on Wednesday showed that consumer prices fell for the first time since February 2021, adding to the deflationary pressures that have become more pronounced since Beijing unexpectedly scrapped its zero-Covid policy at the end of last year.

Only six months after a flurry of warnings that China’s reopening could boost demand to such an extent that it could add fuel to the inflationary fire around the world, the recovery has faltered as confidence among households and businesses has eroded sharply. Domestic consumption, the key catalyst for growth, has slowed as a festering crisis in the all-important property sector and record high youth unemployment crimp spending.

The severity of the downturn and the growing realisation that structural factors – in particular, the abrupt end to the housing boom, the rapid build-up of debt and the diminishing returns of investment-led growth – are mostly to blame have prompted speculation that China is displaying symptoms of Japanese-style stagnation.

Even though these fears are overdone, they have begun to shape the market narrative around China. A cursory glance at the latest research reports from Wall Street banks reveals that “balance sheet recession” and “Japanification” have become key talking points among analysts and investors.

More worryingly, there is significant scepticism over Beijing’s willingness and ability to restore confidence in the economy.

However, while the economic outlook looks grim, the situation in markets is more nuanced. This is mostly because expectations – a crucial determinant of asset prices – were too high at the beginning of this year. The deterioration in sentiment since the reopening rally fizzled out in February stems mainly from disappointment and consternation over the weakness of the recovery.