China Macro:The good and the bad behind the best PMIs in two years

Today’s PMI numbers are much stronger than expected. Both the officialand the Caixin manufacturing PMIs reached a new high in more than twoyears. Specifically, the official PMI rose to 51.2 (previous and consensus:50.4/50.3), while the Caixin PMI also hit 51.2 (previous and consensus: 50.1).

On the bright side, it tells us that the recovery is stronger than market hadexpected. Given the PMI readings, current equity and commodity prices don’tlook very demanding, according to their historical relationship (side charts).

However, today’s PMI data also confirmed that policy would resolutely turn toneutral with no easing to come out in the rest of this year.

The PMI data clearly point to improved confidence. The PMI of smallenterprises rebounded in Oct, following the earlier rise in large enterprises.

Demand is improving, evidenced by the strong sub-index of New Orders (to52.8 from 50.9). One tailwind is of course the policy support. As we discussedin our July data comment, the market was too pessimistic in reading the softdata, which should be a blip given the ramped-up stimulus.

Another tailwind comes from the current reflation trend, which hasboosted corporate earnings and thereby business outlook. Meanwhile,although the recent property tightening has already weighed on home sales, ithas not impacted investment yet. We expect the economy to feel the painfrom the property downturn after the Chinese New Year. That said, the subindexof Export Orders moderated in both PMIs, suggesting that externaldemand remains soft. It’s also in line with what we see in trade data, whoserecent improvement is mostly due to price instead of volume.

Policy shifting to neutral on inflation and financial risk: Today’s PMI dataalso point to rising inflation pressure. Our forecasts on inflation in Oct havesome upside risks (link). While we don’t think inflation would be a major issuesix months later, it’s definitely something to watch for policy makers andinvestors. It’s almost certain that this year’s growth target would be met. Puttogether, the chance for further policy easing in the near term is very low.

Taking stock and looking ahead. We made three out-of-consensus calls atthe beginning of this year. First, while the market feared hard landing risks, wehad forecast China to grow 6.7% in 2016 and each quarter. Today’s PMInumbers further confirm that the economy is on track to another 6.7% GDPgrowth in 4Q16. Second, while the main market concern then was deflation,we had forecast China to enter a reflation cycle this year, which would boostcorporate earnings growth. Today’s data actually suggests that the reflationpressure is turning out to be even stronger than we had expected. Third, whilethe market expected sizeable depreciation, we had forecast a very mild oneby expecting the USD/CNY to end this year at 6.6. The call was largely ontrack until this Oct, when the dollar index strengthened much more than thepast nine months combined, mostly due to what is happening in the UK andEurope. While today’s data leave little surprise for China’s economy in the restof this year, the most interesting thing now is the RMB, which is driven moreby the prevalent depreciation expectation than anything else. The strategyadopted by the PBoC has effectively made the USD/CNY a one-way play.

When, whether and how the PBoC could change such an unpleasant situationremains to be seen in the coming months.