China’s Economy Is In Trouble. The Ripples Will Hit the Fed.

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The world’s two largest economies are navigating an increasingly difficult task—the U.S. Federal Reserve is trying to tamp down inflation without a hard landing while Chinese policy makers are looking to repair the damage from their zero-Covid policies.

How policy makers in one country fare could impact the other, adding to the complicated calculus for investors also trying to digest the latest geopolitical escalation as China’s claims the Taiwan Strait that the U.S. Navy regularly transits isn’t international waters.

TS Lombard Chief Economist Freya Beamish says in a client note that China’s policy makers are more likely to keep its economy from going off the tracks rather than “breaking” first. That means the renminbi is unlikely to depreciate sharply and send global stocks and other risk assets into a tailspin in a way that gives the Fed a way out of tightening monetary policy.

In the U.S., Beamish sees a Fed-induced hard landing, with more wealth destruction needed to cool the economy and inflation not dissipating over the course of the year—especially as de-globalization pressures take hold.

That is not to say there isn’t trouble in China. Chinese policy makers are tweaking their harsh zero Covid policies to try to dull the economic pain, including guidelines prohibiting local officials to widen restrictions beyond high and medium-Covid risk areas or quarantine those in low-risk areas. But Beamish cautions that the priority remains zero-Covid and pandemic containment. TS Lombard expects China’s GDP growth to fall to 3.3%—far below the 5.5% growth target Beijing set out.

Though Chinese policy makers have vowed to steady the economy—and most money managers expect them to pull out the stops—there are limitations.

Others also warn that Chinese officials could be hamstrung in their efforts to ease the economic pain. In a note to clients, Gavekal Research’s Wei He writes that fiscal stimulus is more urgent as a result of the Covid-related lockdowns’ hit to an already battered economy. But these lockdowns have also been a drain on revenue and created new spending obligations, and the central government seems reluctant to increase official debt. That leaves local governments possibly raising more hidden debt to prevent a spending crunch—further darkening China’s debt troubles.

That is likely to add to the long-term concerns about China’s debt situation. The economy is getting even closer to needing a full-scale recapitalization of its banking system—or at least major liquidity injections, according to Beamish. Though such a move ahead of the 20^th Party Congress in the fall is unlikely. “Authorities will do all they can to sweep the evidence under the rug, even though there is so much under the rug already that stuff is now being pushed out the other side,” she says.

Against that backdrop,

BlackRock

Investment Institute strategists are neutral on Chinese stocks, and they aren’t rushing to buy despite the biggest year to date losses in U.S. stocks in decades. Among the reasons they outlined in a note to clients: Valuations aren’t that much cheaper when accounting for higher interest rates and a weaker earnings outlook as margins come under pressure. Plus, there is a risk the Fed could raise rates too high—or the market may expect that it will.

BlackRock strategists see a darkening economic outlook, hit by persistently high inflation, the spike in commodities prices and spillovers from a slowdown in China. As a result, the firm is underweight U.S. Treasuries and overweight inflation-linked bonds.

Write to Reshma Kapadia at reshma.kapadia@barrons.com