Greetings from Shanghai! I am back in China’s commercial center for a two-week visit to conduct economic research. Although it’s hot and humid in Shanghai right now, I still prefer summers over winters here. At night, the streets are packed with people from around the globe.
Despite China’s economic growth rate slowing from 9% to 8%, the economy is still growing rapidly, and it is impossible to get into a good Chinese restaurant — yes, most locals still prefer Chinese food — without a reservation in advance.
The big news from Thursday is the 25 basis-point rate cut from China’s central bank, the People’s Bank of China (PBOC), its first rate cut in more than two years. The new benchmark one-year lending rate of 6.31% is scheduled to take effect on June 8. Deposit rates were also slashed by 25 basis points to 3.25%. I have discussed Beijing’s commitment to avoid a hard landing this year to ensure a smooth political power transition to the next generation of senior leaders—this rate cut is another part of that, and it didn’t come as a surprise.
In the past year, Beijing avoided cutting interest rates because of the inflation risk that move would have posed. Now with global commodity prices hovering near one-year lows and much of Europe sinking into recession, the risk of inflation has gone down significantly. Unlike the U.S., where interest rates are already close to zero, China still has plenty of room for further rate cuts.
News of the rate cut extended Thursday’s rally, spurred by rumors of coordinated central bank efforts to bail out Spain. Although China isn’t playing a leading role in European bailout efforts, the timing of the rally and Beijing’s rate cut seems too much of a coincidence. There is likely some cooperation between China and G7 central banks. The events in the past 36 hours have reversed market psychology and momentum.
A few weeks ago, I discussed that the market’s potential downside would be limited to where it started for the year, at the 1260 level for the S&P 500. On Monday, the S&P 500 traded as low as 1263 and has since gone up in a rip-roaring three-day 400+ point rally. After this powerful run, stocks will probably take a break and move at a slower, more sustainable pace upward. I still expect a range-bound summer, but the momentum has reversed upward for the first time since five weeks ago.
Finally, as you probably recall, in last week’s Dispatch I discussed how China’s transition from an export manufacturing economy to a diversified service economy, much like the transition the U.S. went through during the 1970s and ’80s, makes the country’s weak manufacturing data less meaningful.
On Tuesday, my thesis was confirmed by the latest HSBC China Services Purchasing Managers Index (PMI), which rose to 54.7 in May, the highest reading in 19 months. This figure stands in stark contrast to the weak manufacturing numbers released last week.
Many Chinese factories that depended on a cheap labor force are in trouble as wages rise, while businesses that sell to increasingly affluent Chinese consumers, such as Starbucks (NASDAQ:SBUX), Apple (NASDAQ:AAPL) LVMH, New Oriental Education and Baidu (NASDAQ:BIDU) continue to thrive. That is why we have stayed away from manufacturing and focused on the consumer sector in China.