Current negative sentiment in markets reflects perceived US / Chinese economic divergence. Chinese weakness is widely thought to be intensifying, dragging down global growth, while the US economy is deemed sufficiently solid to keep the Fed on track for an early rate hike. The suggestion is that equity investors face an unappealing combination of softening corporate earnings prospects and a higher discount rate (with real Treasury yields rising recently despite falling nominal rates).

The combination of Chinese economic weakness and US solidity at mid-year had been suggested by narrow money trends at the start of 2015. Six-month growth of US real M1 was rising strongly while the corresponding Chinese measure* had fallen to its lowest level in data extending back to 2000 – see first chart.

Current trends, however, are giving an opposite message. Chinese real M1 growth has revived, with recent policy easing suggesting a further lift, while US growth has fallen sharply, dropping below the Chinese level in July for the first time since 2013.

This suggests that Chinese economic growth will recover by end-2015, if not before, while US strength will fade. A US slowdown may arrive too late to prevent a Fed rate hike but would be likely to push back any follow-up move.

The combination of Chinese economic revival with a Fed back on hold would probably be viewed positively by equity investors.

The risk, of course, is that the US economy slows “too much”, resulting in earnings concerns outweighing relief at Fed tightening being pushed back. To rule out this scenario, it is important that US real money growth stabilises or recovers. Inflation trends should be helpful near term, with recent further commodity price falls suppressing headline consumer prices.

The view here remains that current global economic weakness is being exaggerated and that underlying momentum has recovered since the late spring. While today’s Chinese Markit / Caixin manufacturing PMI survey for August was softer again, Japanese and Eurozone readings strengthened – second chart. Yesterday’s US Philadelphia Fed survey was also solid**. The Chinese Markit PMI undershot the official PMI measure in July and may underrepresent larger companies benefiting from stimulus measures; by contrast, the Market News International business survey improved sharply this month.

*Using ”true” M1, including household as well as corporate demand deposits – see previous post.
**The New York Fed survey was notably weak but this may reflect a large fall in the Canadian dollar, which is an important influence for some state manufacturers.