Schroders - China's strong growth, but fragile foundations.

While China has defied the sceptics for now, we do not see much in the data to encourage us about the economy’s future.

China beat City expectations for GDP growth in Q2, posting a 7% year-on-year increase in activity, the same as in Q1. Sequential growth momentum improved, with a 1.7% quarter-on-quarter growth rate, up from 1.3% previously. However, to us this does not look like a recovery built on strong foundations, and there is a parable about the man who built his house upon the sand.

Expectations for Q2 GDP had been lowered thanks to a slew of weak high frequency data, though June recorded one or two improvements. Still, industrial production grew just 0.1% faster, year-on-year, in Q2 compared to Q1. Investment grew at an average pace of 10.3%, down from 13.5%, and retail sales also slowed, to 10.2% growth from 10.5%. Given that Q2 GDP last year was stronger than Q1 – providing a negative base effect – it seems odd that GDP did not slow. Certainly, our in-house model pointed to a consistent growth rate of around 6.3%, down from 6.9% in Q1. Can we reconcile the difference?

While it would be easy to claim this is a classic case of the authorities fudging the numbers, we will resist temptation. The breakdown of GDP provided shows the primary and tertiary sectors accelerated whilst manufacturing slowed. A further breakdown is not available at this stage, but we note that in Q1 a strong performance by the finance industry contributed an estimated additional 0.5% to GDP growth, thanks to brokerage performance on the back of the equity market rally. Although this rally collapsed in mid-June, brokerage incomes likely outperformed again for most of the quarter. Our view is that GDP growth built on an equity market bubble is unsustainable, and with a weaker equity market performance likely in Q3, a repeat GDP shock seems unlikely.

In another echo of Q1, it is likely that net exports once again contributed a sizeable chunk to GDP last quarter. But as in Q1, this is not because of a strong export performance (which contracted in the quarter, year-on-year), but because of a weak import performance, thanks to cheap commodity prices. Again, this is not a sustainable source of growth; a stronger economy will begin to draw in more imports, and commodity prices will not fall forever.

So while China has defied the sceptics for now, we do not see much in the data to encourage us about the economy’s future. The performance in Q2 looks to have been built upon shaky foundations, rather than the solid rock of self-sustaining growth. The biblical house built upon sand ultimately fell with a great crash as the weather turned against it – the same fate may not await China, but all sandcastles ultimately crumble.