Chinese Trade Weakness Is an Unpleasant Surprise for the World Economy

 | Aug 08, 2017 | 8:00 AM EDT
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The unpleasant surprise contained in the Chinese trade data released earlier on Tuesday could reverberate across the world, and not just because President Donald Trump will send another angry tweet about the rising Chinese current account surplus.

The reality is that the world's second-largest economy has far more influence on global trade now than before the financial crisis. Investors should brace for a slowdown in the world economy in the second half of the year.

China recorded a trade surplus of $46.74 billion in July, its highest since January. That figure was higher than the $46.08 billion forecast in a Reuters survey and was well above the June surplus of $42.77 billion.

Exports increased more slowly than predicted, by 7.2% versus expectations of a 10.9% increase, and were down from June's 11.3% increase. Imports, however, missed even more, increasing by 11%, their slowest pace of growth since last December. Expectations were for a 16.6% rise in imports; they rose 17.2% in June.

The data are preliminary and subject to revision, but there were other signs that China's economic activity is beginning to cool. The official Purchasing Managers Index for July came in at 51.4, below expectations of 51.6 and down from June's 51.7.

China can kill the recovery in global trade as sure as it has started it. The country is "propelling world trade more so now than ever before," said Vanda Szendrei and Gabriel Sterne of Oxford Economics in recent research.

They found that the correlation between current Chinese activity and global trade three months ahead has been 82% since 2010, approximately twice that of the U.S. and the eurozone. Looking at six months ahead, the correlation is 64% -- 2.5 times that of the U.S. and the eurozone.

This correlation exists even though China accounts for slightly less than 10% of global trade, while the U.S. accounts for 13% and the eurozone 12%.

In a report last May, rating agency Standard & Poor's noted that emerging markets were giving new impetus to world trade as commodity prices recovered and local currencies were appreciating, thus boosting domestic consumption.

Another important factor is that import growth in emerging markets responds more sharply to changes in domestic demand than it does in developed markets. For example, S&P calculated that a 1% rise in domestic demand in Russia boosts imports by 1.68%.

But the tailwinds from the first half of the year are about to turn into headwinds. The Oxford Economics analysts cite a slowdown in new construction and weaker PMIs in China, saying they expect Chinese GDP growth to slow to 6.7% in the third quarter, 6.6% in the fourth quarter and to 6.2% in 2018.

Commodity prices seem to have peaked, at least for now, while fresh sanctions on Russia could put a lid on any recovery there. As for Brazil, the country still is struggling in the grip of its worst economic slowdown and a huge corruption scandal. Elsewhere, inflation rearing its head again could dampen previously strong domestic consumption.

This situation does not mean investors should rush out of emerging markets. The slowdown is likely to be gradual and would affect developed markets, too. With valuations frothy in the U.S. and many parts of Western Europe, retreating to the West is unlikely to yield better results.

A better strategy could be to stop allocating funds to wide-encompassing indexes and funds in emerging markets, because their growth is uncertain if GDP slows. Looking at actual sectors, themes and companies in emerging markets takes time, but could prove to be more rewarding longer term.

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