China’s PMI contracts further, fuels expectations of government stimulus (Part 3)

Continued from Part 2

After a third month falling below the 50 point neutral line, investors are starting to price in government intervention

Aside from the 7.5% GDP growth target for 2013, the China Flash PMI also mentioned that inflation should remain below 3.5%. The government specifically stated that it would support social welfare programs as well as consumer demand.
It seems both factors are moving in a direction that points to stimulus.

China PMI Sub Indices 2013-07-29Enlarge Graph

Deflation slowing down

Both the input and output price indices posted slower declines. Input prices slowed down to 47.8 from 44.9 in June, though the purchased goods index didn’t change. Output prices also decelerated their drop, posting 47.2 from 43.8 in June. The slowdown in descent, though, isn’t supported by higher output, so inflation could be creeping in due to a strengthened U.S. dollar or weaker Chinese yuan.

Nonetheless, inflation is still below the 50 point line, implying contraction. The June consumer price index reading came in at 2.7%, which is far below the 3.5% upper limit, so inflation shouldn’t restrain the government from easing.

Employment continues to fall

To top the cake and ensure that the government does something about the sluggish performance, employment contracted for the fourth time—now at 47.3 from 47.6 in June. Strong employment growth is at the heart of consumer demand growth. If employment continues to fall, then domestic demand will follow.

The main theme behind China’s reforms is moving the economy from a manufacturing- and export-led country to a domestic demand–driven country. For this reason, the government isn’t likely to take the drop in employment lightly.

How will the market react?

At this point, whether or not the Chinese government sticks to its guns or saves face by massaging in a good reason to stimulate, the investor community will continue to price in potential stimulus. The recent remark by Chinese Premier Li Keqiang pointed to a more flexible stance by the government than its position two months ago.

Investors have already started boosting iShares FTSE/Xinhua China 25 (FXI), and will likely continue to do so until a more concrete answer comes from the government. In the short term, the best strategy is likely to buy the rumor and sell the fact.