U.S. Services PMIs: Service sector reports strong growth and steeper price pressures in September

The seasonally adjusted S&P Global US Services PMI^® Business Activity Index posted 55.2 in September, down from 55.7 in August but still signaling a marked monthly increase in service sector output at the end of the third quarter, and one that was among the strongest in the past two-and-a-half years.

The latest rise was often linked to success in securing new work, while there were a number of reports that the recent reduction in interest rates had boosted demand in the service sector.

A boost from lower interest rates was also mentioned by those companies that saw new orders increase in September as clients became more willing to commit to new projects.

New order growth was recorded for the fifth month running, with the latest solid expansion only slightly softer than the 14-month high seen in August. Total new business was supported by a modest increase in new business from abroad.

Despite marked expansions of both activity and new business, confidence in the year-ahead outlook dropped sharply during September and was the lowest since October 2022. While lower interest rates and an expected improvement in demand following the Presidential Election supported optimism, sentiment waned amid concerns about a potential slowdown in the economy.

Meanwhile, employment dropped for the second month running, albeit only marginally. Some companies reported lowering staffing levels in a bid to save costs but others reported staff shortages.

Input prices increased rapidly in September, with the rate of inflation the joint-fastest in the past year. Higher input costs were often linked to salary pressures.

Alongside higher staff pay, rising prices paid for manufactured goods led some companies to increase their selling prices markedly during the month. The rate of inflation of prices charged for services quickened to a six-month high.

Rates of increase in both input costs and selling prices were well above the respective pre-pandemic averages.

The aforementioned reduction in staffing levels at a time of solid growth of new orders meant that outstanding business was accumulated during September. Backlogs of work rose for the third time in the past four months, and at the fastest pace since January.

The S&P Global US Composite PMI Output Index posted 54.0 in September, down from 54.6 in August but still signaling a solid monthly improvement in business activity at the end of the third quarter.

Meanwhile, inflationary pressures strengthened, with the increases in input costs and output prices hitting 12- and six month highs respectively.

Chris Williamson, Chief Business Economist at S&P Global Market Intelligence

“US service sector businesses reported a strong end to the third quarter, with output continuing to grow at one of the fastest rates seen over the past two-and-a-half years. After GDP rose at a 3.0% rate in the second quarter, a similar strong performance looks likely in the three months to September.

“Encouragingly, inflows of new business in the service sector grew at a rate only marginally shy of August’s 27-month high. Lower interest rates have already been reported by survey contributors as having buoyed demand, notably for financial services which, alongside healthcare, remains an especially strong performing sector. (…)

The ISM:

• In September, the Services PMI registered 54.9 percent, 3.4 percentage points higher than August’s figure of 51.5 percent.
• The Business Activity Index registered 59.9 percent in September, 6.6 percentage points higher than the 53.3 percent recorded in August, indicating a third month of expansion after a contraction in June.
• The New Orders Index expanded to 59.4 percent in September, 6.4 percentage points higher than August’s figure of 53 percent.
• The Employment Index contracted for the first time in three months; the reading of 48.1 percent is a 2.1-percentage point decrease compared to the 50.2 percent recorded in August.
• The Prices Index registered 59.4 percent in September, a 2.1-percentage point increase from August’s reading of 57.3 percent.
• The Backlog of Orders Index remained in contraction territory for its second consecutive month, registering 48.3 percent in September, a 4.6-percentage point increase from the August reading of 43.7 percent.
• Twelve industries reported growth in September, up two from the 10 industries reporting growth in August.

Few Signs of Slowing Activity in the Services Sector

Wells Fargo’s economists “few signs of slowing” are limited to “increased mention of uncertainty over the upcoming U.S. presidential election in November”. Whatever uncertainty there actually is has zero impact on the willingness to place additional orders:

The strength of the sizable U.S. services sector is keeping the economy humming amid the manufacturing near recession readings:

But S&P Global data says that further manufacturing weakness would normally start to impact services with a 6-month lag.

Lower interest rates and the passage of the U.S. elections should help revive manufacturing demand.

Similarly, strong corporate profits should keep employment reasonably solid as the Ed Yardeni chart suggests:

Ed also illustrates the turnaround in the Citigroup Economic Surprise Index as forecasted here a few weeks ago. Ed thinks the 10Y yield “could rise back to 4.00%–particularly now that oil prices are rebounding and import prices are likely to rise the longer that the dockworkers’ strike lasts.”

Amid all these somewhat conflicting trends, the PMI data wants to drag core inflation right on the Fed’s target;

U.S. Port Workers Agree to End Their Strike Companies sweeten contract offer to a 62% wage increase over 6 years to reopen ports from Maine to Texas

Eurozone industry outlook: the perfect storm continues

There is no sugarcoating it. European industry is going through a deep correction, and it does not look like the end is here yet. Since mid-2022, industrial production has been in steady decline. This represents the strongest downturn in production in more than 30 years without the eurozone economy entering a recession. A strong service sector is keeping the economy afloat, while the manufacturing sector is shrinking.

There is little light at the end of the tunnel right now. Looking at recent data, we hardly find any evidence that a rebound is imminent. Inventories built up during times of high demand and supply-chain disruptions have barely come down. And new orders are not yet picking up, with demand both from within the eurozone and without remaining weak.

Source: Eurostat, ING Research

The perfect storm for manufacturing has multiple drivers. Over the past few years, we have seen that supply-side problems have faded and that (the lack of) demand has quickly become the largest worry for European manufacturers.

Note: the supply category consists of industrial businesses indicating labour and equipment are a factor limiting production.
Source: European Commission DG ECFIN, ING Research calculations

Going through the drivers of weakness, we find that consumer demand for goods remains sluggish due to the real income shock that Europeans experienced when inflation surged. And the economy seems to be stuck in a weak growth environment, which limits the outlook for consumer demand despite a decent recovery in real wages.

Furthermore, weak fixed investment plans are impacting manufacturing significantly. In the eurozone, investment is well below its pre-pandemic trend. This is due to weak domestic demand as well as high interest rates after years of negative rates. And policy uncertainty plays a major role, too.

More structurally perhaps, the energy shock is still keeping energy-intensive production muted, while weak demand outside of the eurozone – think of China for example – is impacting new orders in the manufacturing sector. Chinese export growth to the eurozone, meanwhile, is a sign of additional competition for local producers.

Finally, geopolitical tensions in the Middle East have contributed to longer-than-expected disruption in shipping. As a result, input costs for producers have started to increase again. This makes production more challenging in a weak demand environment in the eurozone.

The eurozone is quite alone in this. Other major economies are not experiencing a similar downturn. Looking at China and the US for example, we see that the US has experienced flatlining production over the past 18 months, while China saw production grow by about 6%.

The eurozone saw production decline by a similar amount. With weak domestic demand in China, it is no surprise that exports surged by 15% over the same period. For the eurozone, exports contracted by close to 5%. So, China has been able to mask weak domestic demand by producing for the rest of the world, which has gained a lot of attention recently as Western economies struggle with China’s excess capacity.

Germany is most often described as the sick man of Europe in terms of manufacturing. But the reality is that while Germany may have experienced a larger contraction in industrial production than most other markets, there are very few shining lights within the eurozone. None of the major eurozone economies now produce more than at the start of 2023. France has performed best but is down 0.4%, while Germany has experienced a downturn of 8.4% based on comparable data from Eurostat.

The inventory cycle is key to the recovery in production. National accounts data has shown a sharp inventory reduction in the first and second quarters of this year. But this comes on the back of far greater increases in the years before. The large buildups raise doubts about how much stocks will have to fall before production picks back up. It could very well be that some sectors will simply maintain higher inventory levels than in the past as a result of supply chain disruptions during the pandemic and the first phase of the war in Ukraine. Currently, a large number of eurozone businesses are still indicating that the stock of finished products is continuing to rise though, leaving us sceptical about an imminent turnaround. (…)

Source: Eurostat

Before the summer, the destocking seemed to coincide with an increase in new orders but since then, overall order books have been deteriorating and that has also been the case for some of the sectors that already dealt with destocking. The transport equipment sector stands out as a prime example of an industry that has not experienced rapid destocking and is seeing a rise in new orders. This is a sector that includes defence equipment. (…)

As a result, new production could return to the eurozone even if inventories remain higher than in previous times. This is because the production process is changing from a “just in time” to a “just in case” model where businesses hold onto larger amounts of inventory than in the 2010s when the world was much more predictable. This could result in a quicker turnaround for eurozone manufacturing than currently expected. (…)

The changing growth model in China is adding to concerns about a structural decline of European industry in certain markets. Exports from China have soared as domestic demand disappoints and production capacity is large. This puts pressure on certain industrial sectors in Europe, the car sector most notably. It is too early to draw conclusions about how much of an existential threat this poses to European industry, because of possible European policy responses or a recovery of Chinese domestic demand for example. But for the foreseeable future, this is piling pressure on eurozone industry. (…)

More competition in the global LNG market or a cold winter could bring back higher prices than before. This limits the recovery that can be expected from energy-intensive sectors. (…)

All in all, it looks like green shoots in the manufacturing outlook are emerging. But eurozone industry continues to be plagued by enough longer-lasting concerns that it would be too optimistic to expect a vibrant recovery in 2025. There is light at the end of the tunnel, but it is very faint right now.

EU to Impose Tariffs Up to 45% on Electric Vehicles From China

The European Union voted on Friday to impose tariffs as high as 45% on electric vehicles from China in a move set to increase trade tensions with Beijing, according to people familiar with the process.

The European Commission, the bloc’s executive arm, can now proceed with implementing the duties, which would last for five years, said the people, who spoke on the condition of anonymity. Ten member states voted in favor of the measure, while Germany and four others voted against and 12 abstained. (…)

The EU and China will continue negotiations to find an alternative to the tariffs. The two sides are exploring whether an agreement can be reached on a mechanism to control prices and volumes of exports in place of the duties. (…)

The new tariff rates will be as high as 35% for EV manufacturers exporting from China. The new duties would be on top of the existing 10% rate.

Chinese EV makers will have to decide whether to absorb the tariffs or raise prices, at a time when slowing demand at home is squeezing their profit margins. The prospect of duties has prompted some Chinese automakers to consider investing in factories in Europe, which might help them dodge tariffs. (…)

The share of electric cars sold in the EU that were made in China climbed from around 3% to more than 20% in the past three years. Chinese brands accounted for around 8% of that market share, as international companies that export from China including Tesla Inc. taking up the rest.

Still, Europe’s tariff hike will have a “minor impact” on Chinese manufacturers because the region accounts for only a fraction of their total sales, according to Daiwa Securities analyst Kevin Lau. Europe contributed between 1% to 3% of overall sales for BYD Co., Zhejiang Geely Holding Group Co. and SAIC Motor Corp. in the first four months of this year, he estimated. (…)

German automakers including Volkswagen AG, Mercedes and BMW would be hit hardest in a trade spat as China accounted for roughly a third of their car sales in 2023.

Elsewhere on Bloomberg:

• Chinese producers have gained an upper hand in EV technology and are overtaking European brands in China, the world’s biggest EV market.
• China’s pricing advantage is striking: The cost of batteries there has dropped to $126 per kilowatt hour on a volume-weighted average basis, while packs are priced 11% higher in the US and 20% higher in Europe, according to BloombergNEF. In the meantime, Chinese manufacturers are already unveiling a new generation of batteries that rely on sodium, which is more abundant than the lithium now used in EV batteries, and less prone to catching fire.

• In Europe, seven new electric models costing less than €25,000 ($27,810) could hit the market this year and next, including a new Renault 5 and Stellantis NV’s Citroën e-C3, according to the Transport & Environment lobby group.
• In that optimistic scenario, EVs could grab as much as 24% of the European market next year, according to T&E, which advocates for clean transport and energy. That would be a big leap from the 12.5% market share for EVs in EU countries over the first seven months of 2024, as measured by the European Automobile Manufacturers’ Association.

What Israel’s potential response could mean for the oil market

ICE Brent is trading more than 8% higher than it was before Iran’s missile attack on Israel. However, the bulk of this move occurred on Thursday after President Biden, when asked if he would support an Israeli strike on Iranian oil infrastructure, responded, “We’re discussing that.”

Depending on the scale of such a response, it could potentially be significant for oil markets. Not only due to the immediate impact of losing Iranian barrels but also due to the fact that this scenario risks spilling over into something more extreme, which could potentially lead to a disruption in Persian Gulf oil and LNG flows through the Strait of Hormuz.

While an attack on downstream oil assets would be significant for the Iranian domestic market, fundamentally, it would be less so for the world market with Iran still able to export. In fact, depending on the nature of the strike, such a move could potentially lead to even stronger crude oil exports. If domestic refining capacity is affected, it would leave more crude oil available to export. Iran might struggle to find willing buyers because of US sanctions. However, this would still likely be bullish for oil prices as it is a step closer to impacting global oil supplies and escalating tensions.

The bigger concern for the global oil market would be strikes that target midstream and upstream assets, as this would impact Iran’s ability to export crude. Under such a scenario, we could see as much as 1.7m b/d of oil supply lost.

The loss of 1.7m b/d of crude oil supply would be enough to push the global market back into a sizeable deficit from 4Q24 through 2025, even when considering that OPEC+ will gradually unwind 2.2m b/d of additional voluntary cuts as currently planned. Such a scenario could see Brent averaging a little over $90/bbl in 2025. 

(…) the key concern, while still extreme, would be that these disruptions spill over to the Strait of Hormuz, affecting Persian Gulf oil flows. Almost a third of global seaborne oil trade moves through the Strait of Hormuz and while some pipeline infrastructure means that a portion of oil flows could be diverted to avoid the Strait, it still leaves in the region of 14m b/d of oil supply at risk. A significant disruption to these flows would be enough to push oil prices to new record highs, surpassing the record high of close to $150/bbl in 2008. (…)

Disruptions would not be isolated to the oil market. It could also potentially lead to disruptions in LNG flows from Qatar, which makes up more than 20% of global LNG trade. This would be a shock to global gas markets, particularly as we move into the northern hemisphere winter, where we see stronger gas demand for heating purposes.

While we are seeing a ramp-up in new LNG export capacity, this still falls well short of Qatari export volumes. Qatar exports a little over 100bcm of LNG annually, while in 2025, roughly 30bcm of new LNG export capacity is expected to start. In addition, a lot of this capacity is slated to start up later in 2025, too late to help with any shortfalls over the 2024/25 winter. (…)

The hope would be that emergency releases would give OPEC+ members time to ramp up supply. While we believe the group would go ahead with unwinding its 2.2m b/d of additional voluntary supply cuts (possibly bringing this supply back quicker than currently planned), there is no guarantee that the group will be quick to respond with increasing supplies beyond this. Saudi Arabia has a fiscal breakeven oil price of above $90/bbl and so would be happy to see prices trading up to these levels. We would likely only see the group start to bring further supply back online if prices move above $100/bbl.

The other issue is that the bulk of spare OPEC production capacity sits within the Persian Gulf. Therefore, in an event where there is a blockade of the Strait of Hormuz or at least a significant disruption to flows via the strait, this spare capacity may be of little help.

AI CORNER

Texas Regulator Wants Data Centers to Build Power Plants New AI centers need their own generation, official says

(…) Gleeson said his agency is telling data center developers they will need to supply some of their own power if they want to connect to the Texas grid within 12 to 15 months. Many of the corporations involved, he said, have among the biggest balance sheets in the world and can afford to fund construction of new power plants.

“We have to look at really the co-location issue as being a new facility coming with its own new generation,” Gleeson said.

Developers, he said, could even opt to “over build” — creating power plants that generate more electricity than their data centers need and selling the rest to the grid. “We’re happy to take it,” Gleeson said.

More on this in Power Play

• AI adoption tracker (Goldman Sachs)

AI adoption by firms remains modest, with only 5.9% of US firms currently using AI to produce goods or services (vs. 4.6% in Q2). Within industries, education and information firms reported the largest increases in adoption rates while transportation, recreation, and manufacturing firms reported a decline. Broadcasting and financial-related firms report the highest expected increase in AI adoption over the next six months. Industry surveys released over the past quarter suggest that a large share of businesses are planning to increase investment in AI and related infrastructure, but many still have concerns over technological infrastructure and ethics and governance.

The US Economy Is Roaring!

On August 20, the BLS revised the number of jobs created over the 12 months ended March 2024 down by 818,000, 30% less than initially reported.

On September 18, having previously refocused on the labor market, the FOMC cut its Fed Funds rate 50bps.

On September 26, as Ed Yardeni explains,

the Bureau of Economic Analysis (BEA) released several very significant upward revisions to real GDP, real GDI, personal income, and personal saving. Collectively, they blew away the hard landing scenario. They didn’t leave much if any room for the soft landing scenario either. (…)

Q2’s level of real GDP was raised by 1.3% to a record high. More importantly, the level of real Gross Domestic Income (GDI) was revised up by 3.6%. The significant tightening of monetary policy from March 2022 through August 2024 did not cause a recession. There has been no landing, and certainly no hard landing. (…)

The personal saving rate was revised up from 3.3% to 5.2% (chart). Last week on Wednesday, September 30, Fed Chair Jerome Powell said at the National Association of Business Economics Annual meeting that the revisions reduced the downside risk to the economy. The higher personal saving rate also reduced the downside risk of consumers retrenching. He acknowledged that productivity growth might be stronger.

Powell and many commentators were worried that the Bureau of Labor Statistics’ recent downward revision of 818,000 in payroll employment over the past 12 months through March meant the economy is on a much weaker footing. The latest BEA revisions put a fork in that theory since the upward revision in real GDP combined with a downward revision in labor input mean productivity growth is stronger. This all confirms our thesis that the US is in the midst of the Roaring 2020s propelled by technology-driven productivity growth.

Last week, the August Personal Income and Outlays release revealed that Americans’ capacity to spend is not diminishing. Wages & Salaries income was up 0.5% MoM in August, +4.9% a.r. in the last 2 months. Labor income is the main driver for expenditures, pointing to ~5% growth in total spending with inflation below 2.5% (2.2% in August and +1.2% annualized in the last 4 months).

The Fed is happy seeing inflation near targets. The risk is that sustained real wage growth is fueling demand which could put unwanted pressure on prices.

Later today we get weekly unemployment claims and the U.S. Services PMIs. Tomorrow, September payrolls.

SERVICES PMI: Eurozone economy suffers fresh contraction at end of third quarter

The HCOB Eurozone Services PMI Business Activity Index signalled an eighth consecutive month of growth at the end of the third quarter. Registering above the 50.0 no-change mark, as has been the case since February, the latest figure indicated sustained growth in services output. However, falling to 51.4 in September, from 52.9 in August, the index pointed to an expansion that was only modest and the weakest for seven months.

Higher business activity levels were achieved despite the level of incoming new work decreasing. This was the first time since February that demand for services has fallen, although the contraction was only marginal. Outstanding orders provided services firms with a means to support activity. Backlogs of work fell for the fourteenth time in the past 15 months, and to the quickest extent since February.

Employment levels continued to rise across the eurozone’s service sector in September. While the rate of job creation was fractionally faster than in August, it was weaker than seen on average since data collection began in July 1998.

Services inflation cooled in the euro area at the end of the third quarter. Notably, rates of increase in input costs and output prices were their softest in 42 and 41 months, respectively.

Finally, expectations for growth over the next 12 months strengthened in September. This marked the first month since May that business confidence has improved. That said, the level of optimism was subdued by historical standards.

The seasonally adjusted HCOB Eurozone Composite PMI Output Index fell into contraction territory in September for the first time since February. Down from August’s three-month high of 51.0 to 49.6, the headline index was indicative of a marginal decrease in private sector business activity at the end of the third quarter. Trends at the sector level worsened in September. Euro area factory production recorded an accelerated decline that was the fastest in the year-to-date, while services growth slowed to a seven-month low.

The big-three economies of the currency bloc – Germany, France and Italy – all registered month-on-month contractions in business activity during September. Germany spear-headed the downturn, with private sector output here falling for a third month in a row and at the fastest pace since February. France suffered a renewed contraction, partly reflecting some payback following August’s boost from the Paris Olympic Games. Italy meanwhile saw its first month of decline in the year-to-date, although the pace of contraction was only marginal. Expansions were seen in the two other countries for which Composite PMI data are available – Spain and Ireland – with the former registering a sharp and accelerated upturn.

According to the latest data, the level of new business received by private sector firms in the euro area shrank for a fourth successive month. Additionally, the pace of decrease quickened to the steepest since January. A renewed (albeit marginal) deterioration in demand for services was accompanied by a rapid drop in new factory orders. Export* sales performances worsened, with the fastest fall in new business from non-domestic customers since last December providing a considerable drag on total order book volumes.

Surveyed businesses in the euro area recorded another monthly fall in their volumes of outstanding workloads, extending the current period of backlog depletion to a year-and-a-half. The rate of decrease was also slightly faster than seen on average over this sequence. Completion rates picked up in both the manufacturing and services sectors in September.
Eurozone firms stepped up headcount reductions at the end of the third quarter. Although the rate of job shedding was marginal, it was the joint-fastest since December 2020 (matching January 2021, as well as November and December 2023).

Lower employment levels were entirely a reflection of the manufacturing economy as factory lay-offs were sufficiently strong to more than offset modest job creation within the service sector.

Meanwhile, euro area business confidence continued to weaken in September, marking a fourth month in a row that firms’ sentiment has deteriorated. Albeit still optimistic overall, 12-month expectations for activity were at their lowest in the year-to-date.

Finally, the HCOB PMI data revealed a further marked easing of cost pressures across the eurozone. Overall, the rate of input cost inflation was the second-slowest November 2020, with July 2023 narrowly undershooting that seen in September. The extent to which euro area companies raised their own prices also eased at the end of the third quarter. Overall output charges increased only modestly and to the weakest extent in just over three-and-a-half years.

Commenting on the PMI data, Dr. Cyrus de la Rubia, Chief Economist at Hamburg Commercial Bank, said:

“At first glance, the services sector in the eurozone seems to be holding up fairly well. It’s still growing, and the slowdown is not too steep just yet.

But when you dig a little deeper and look at individual countries, the picture is not as rosy – except for Spain. Here, we are rubbing our eyes in amazement. Service providers there are booming, with the index shooting up to 57 points. The situation in the other three leading eurozone economies is quite different.

In France, service providers’ business activity slowed down after the Olympics effect and in Germany and Italy, growth almost hit a wall in September. Even if Spain manages to avoid getting pulled down by the struggles of its neighbours, the eurozone’s services sector as a whole seems to be headed for more sluggish growth.

“On the ground, most service sector employees have not really felt the pinch yet. In fact, the hiring rate picked up in Spain and France, and even in Italy, jobs growth only dipped slightly. It is Germany where things look bleakest, with companies there actually cutting staff. This is where the recession in manufacturing is making itself felt, as in this environment the corresponding companies are placing fewer orders with the service sector.

“The situation in the service sector in the eurozone will continue to deteriorate. This is indicated by the decline in new business. For the first time since February, it has fallen in the eurozone compared to the previous month. The development in Germany and France is similar. Factoring in the ongoing contraction in industry, the eurozone economy is likely to have grown only at a marginal rate in the third quarter. Our GDP nowcast model, which takes into account the PMI indicators, also points to only minimal growth.

“On the plus side, operating costs in the services sector saw their slowest rise since early 2021, and inflation in selling prices is also easing off. Given the overall economic weakness, this is a good case for the ECB to cut interest rates in October. And indeed, only recently, ECB president Christine Lagarde did hint at a rate cut this month.”

A Beautiful Deleveraging with Chinese Characteristics? (Ray Dalio)

Last week, China’s leadership—including President Xi Jinping, the Politburo, the CSRC, and the PBoC—clearly 1) announced a reflationary barrage of fiscal and monetary policies and 2) made statements in support of free markets as a big step to end the deflationary deleveraging and to stimulate creative productivity. That happened at the same time as 3) Chinese assets were (and still are) very cheap, so it was a combustible combination of influences that set the markets on fire. It was a big week.

In fact, I think that it was such a big week that it could go down in the market-economic history books as comparable to the week Mario Draghi said that he and the ECB would “do whatever it takes,” if China’s policymakers, in fact, do what it takes, which will require a lot more than what was announced. (…)

In a nutshell, it all depends on whether Chinese policymakers do or don’t simultaneously a) restructure bad debts (thus eliminating zombie conditions of their institutions) and b) lower interest rates below inflation and nominal growth rates, or, if that proves impossible, monetize debt to get the rates below the inflation and nominal growth rates while weakening the currency to devalue the debt.

More specifically, for China’s policymakers to engineer a “beautiful deleveraging,” they have to lower debt burdens by simultaneously

a) doing debt restructurings that clean the bad debts out of the system (which is deflationary) while also

b) creating money and credit (which is stimulative and inflationary) in a balanced way so that debt service burdens are reduced and there is neither unacceptable deflation nor unacceptable inflation.

This beautiful deleveraging can only be done in countries that have most of their bad debts denominated in their own currencies and have most of the debtors and creditors as their own citizens, which is the case for China. Doing a deleveraging in this way not only reduces debts without triggering either unacceptable deflation or unacceptable inflation, but it also allows viable businesses to get back to business unencumbered by their old debts and it eliminates the “pushing on a string” problem of having scared people, companies, and other entities holding cash in safe banks and government debt assets.

It does this by making cash a poorly performing asset class relative to the major alternative asset classes that are doing well because of the reflation. Doing these things starts to rekindle “bottom fishing” and “animal spirits.” We are clearly seeing that happen now.

Also, pro-market and pro-entrepreneurial policies are stimulative and, in this case, especially good because there is such enormous power in President Xi’s policy-indicating statements. In this case, supportive comments came from the highest levels (from President Xi Jinping, the Politburo, the CSRC, and the PBoC) encouraging officials and people to adopt innovative and bold approaches to support the economy, and included President Xi reassuring officials that they would not be punished for well-intentioned mistakes made in the process of implementing new policies. These statements matter a lot.

While there’s no doubt that all of this is bullish for the markets, as part of the beautiful deleveraging there will have to be difficult and painful changes in the following areas:

The debt restructurings will be especially difficult both because they are complex and because they are politically charged because they will have huge effects on people’s wealth. Debts at the local government levels—especially between local governments which paid for their spending through land sales and by borrowings from companies and people in their provinces—are especially difficult situations to handle.

Imagine the situation of a perfectly good company that lent to the local government and/or is dependent on local government spending facing the current situation. Who should do what in what amounts to deal with this situation? Who will determine such things and how? These things are not clear. Because similar problems have been faced and dealt with throughout history (including the 1990s in China with Zhu Rongji and many people helping him who are still alive and lucid) in ways that are both effective and painful, this can be done if the courage and capabilities are mustered, but it will be very difficult.

The tax system for collecting money to spend on shared expenditures and needed remediations and social programs is deeply in need of reform. As things stand, getting and distributing money is highly ineffective at the national, provincial, and local government levels. More specifically there are not effective income taxes, real estate taxes, inheritance taxes, or most other taxes (other than VATs, especially at the production level). This set of conditions makes the last problem I mentioned – the local government debt
and financial problem – more challenging.

Though there was a recent minor change in policy, the demographic problem—especially the early retirement age (on average 53) and relatively late death age (the average 53-year-old dies at 83)—leaves many people with a long time with little income and one child to take care of them. At the same time, the working population is declining rapidly.

So, while last week we saw great actions and words that I am sure will be followed by highly stimulative policies that will help a lot and will support asset prices, I think that there are several important other things to keep an eye on to see how well China’s domestic debt-money-economy challenges will be handled.

Of course, these observations are about just one of the five big forces (the debt-money-economy force) in one of the big countries (China), and it’s important to remember that the other big forces (the internal political conflict force, the external geopolitics conflict force, the acts of nature force, and the technology force) are also affecting China, other nations, and the entire world.

Last week was filled with comparably important developments pertaining to all of these things, and these developments seem, to me, to be broadly tracking the big cycle that will have big impacts on what the changing world order will look like.

Is China Circumventing U.S. Tariffs?

(…) U.S.-China relations have been tense for some time due to diverging strategic priorities and geopolitical differences; however, we can pinpoint the inflection point—at least for trade—as the implementation of Trump-era tariffs and the broader trade war that originated in 2018.

To that point, China’s trade surplus with the United States saw a meaningful dip when tariff rates ramped up over the course of 2019. Successive years have seen China’s trade surplus slip even further, and as of the end of 2023, China’s trade surplus with the United States was essentially half of what it was relative to before the trade war—both in terms of U.S. and China GDP.

Source: IMF and Wells Fargo Economics

We can point to many other metrics to indicate the U.S.-China trade linkage is not as robust as it once was; however, a deeper dive into global trade flows tells an interesting story. One that suggests the overall U.S.-China trade relationship may not necessarily be weakening as much as data suggest. The same global trade data also suggest that China may be circumventing U.S. tariffs, and still benefiting from U.S. demand and the United States as a final export destination. (…)

As far as tariff revenue, at least for the United States, the U.S. is collecting a sizable amount of revenue derived from the tariffs imposed on China. As of mid-2024, the trade-weighted average tariff rate (i.e. tariff revenue as a percent of the total value of U.S. imports from China) on China is ~9.5%, a notable step up from the tariff rate prior to the trade war [<3%]. (…)

As reflected in the narrowing China trade surplus, the U.S. is importing less from China, the United States’ main source of tariff revenue. Instead, the U.S. is sourcing an increased amount of goods from other nations in Asia as well as across Latin America and Europe.

Relative to 2017, the U.S. is importing significantly more goods from countries such as Vietnam, Mexico, South Korea, Turkey, Thailand and India. Essentially, countries not subject to China-style tariffs. At the same time, global trade data reveal that China has also boosted trade relations with those same nations. As of the end of 2023, and relative to before the trade war started, China is exporting more goods to those very same countries.

Source: IMF and Wells Fargo Economics

Coincidence? Probably not.

Take Mexico for example. Mexico is widely considered to be one of the top nearshoring destinations for U.S. corporations looking to shift critical supply chain links out of China. As U.S. multinational corporation interest in nearshoring picked up after tariffs were imposed and surged again after COVID-19, so has Chinese foreign direct investment (FDI) into Mexico. Without knowing for certain, there is a high likelihood China is actively putting infrastructure on the ground in Mexico as an intermediary to accept Chinese made goods before ultimately sending on to the United States.

Source: IMF, NL Analytics and Wells Fargo Economics

Indeed, given the shifting composition of trade flows and China’s increased foreign direct investment activity, we would argue the evidence strongly suggests that a perceptible portion of China-U.S. trade flows are being re-routed via proxy countries. The Biden administration indeed took notice of these tactics, and recently applied tariffs to certain Chinese goods making their way into the U.S. via Mexico.

China using proxy nations as means to avoid U.S. tariffs will likely retain the attention of the current administration and a potential Democratic administration post-elections, but could also be at the core of former President Trump’s proposed “global tariff.”

Should a tariff on all exports to the United States apply to all nations, the ability for China to completely circumvent export duties would be diminished.

While a U.S. global tariff would place downward pressure on global growth and upward pressure on global inflation, as well as potentially damage relations between the U.S. and most trading partners, the genesis of former President Trump’s global tariff proposal could still be aimed at disrupting China’s rise. Combined with Trump’s proposed 60% tariff on exports to the U.S. directly from China, China’s ability to tap U.S. consumer demand could be at risk should U.S. trade policy turn more protectionist in the near future.

With exports propping up China’s economy for the time being, a global tariff alongside tariffs imposed directly on China could have a more severe impact on China’s economy relative to existing tariffs. (…)