How China’s capacity cuts could have global macro implications

China has exported disinflation from export-focused capacity growth over the past several years to cushion its own domestic slowdown. This has helped central banks around the world keep inflation from surging even higher.

However, China’s government has announced a series of capacity consolidation measures, labeled its “anti‑involution” strategy, to curb loss‑making for companies in several industries. In recent fixed income policy week meetings, Portfolio Manager Adam Marden was even more animated than usual on the topic, arguing that reductions in China’s export supply capacity could be one of the most important macro factors to affect markets over the coming few years.

Adam recently shared some fascinating details on this landmark pivot in China’s economic policy and its implications for the global economy and markets.

What is China’s government trying to accomplish?
Since Chinese real estate prices collapsed, the country’s government is trying to stimulate growth in other areas. Some segments of the Chinese economy that focus on exports are suffering from production overcapacity, leading to price wars that lower profits. This has been particularly noteworthy in industries related to petrochemicals and various industrial metals. To counter overproduction, China’s government is encouraging consolidation of competing companies to reduce supply and hopefully improve profitability in those segments.

China mounted a similar campaign to rein in oversupply in 2015 for sectors such as coal and steel. However, in 2015 and 2016, China also embarked on heavy demand‑side stimulus measures, which are currently absent from today’s measures.

What are the wider global implications?  
The effort to constrain supply will boost the profitability of Chinese firms that emerge to exercise more pricing power in their industry. But the implications will be much more far-reaching as they extend into the global economy. Why? Disinflation from Chinese exports has been nearly every central bank governor’s best friend, helping them in their struggle to keep inflation under control after the pandemic. But that disinflationary impulse looks ready to wind down.

Where will we see the signs of the supply constraints?
I think you’ll see the stocks that directly benefit from the capacity cutbacks gain, followed by prices of a range of commodities as deflation fades from export-intensive segments of China’s economy. From there, the higher commodities prices will pressure China’s producer price index (PPI) upward.   

How will the weaker disinflationary impulse interact with other macro trends?
The effects will then slowly work their way through economies around the globe via China’s export prices. With U.S. tariffs on China in flux, it’s difficult to say how Chinese export flows will respond. This will determine how strongly the higher prices from China make their way into the economies of different countries.

Of course, there are other macro factors that affect inflation. For example, artificial intelligence (AI) could boost productivity enough to create a disinflationary impulse in the global economy (although it’s difficult to say how much with any precision). Such a productivity boost could conceivably offset the upward price pressure from China’s anti-involution campaign.

“…both long- and short-term inflationary risks abound, which should ultimately help drive yields higher on developed market government bonds.”

As Adam noted, there are many macro factors generating crosscurrents that influence inflationary and disinflationary factors worldwide. And weaker disinflationary forces from China won’t necessarily translate directly into higher inflation elsewhere.  

Overall, however, both long- and short-term inflationary risks abound, which should ultimately help drive yields higher on developed market government bonds. Although trade policy has proven to be highly changeable, U.S. tariffs have kicked off trade wars that are indeed inflationary. Demographics in many developed markets mean a shrinking workforce, which should also push labor costs up. These factors are most acute in the U.S., where limited immigration is constricting labor supply even more.

With a new Fed chair taking over in May, the central bank may become more susceptible to political pressure to lower rates despite inflation consistently running above the Fed’s 2% target. In this environment, less disinflation from Chinese exports looks set to underpin a lengthy list of inflationary impulses. That’s something the market consensus continues to underestimate.