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What China’s Recovering Supply Chain Means for Global Inflation

Renewed growth in China’s manufacturing activity, coupled with softening developed market demand, should ease some supply-side pressures – but several…

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This article was originally published by Pimco Blog

After months of COVID-related disruptions, China’s economy looks to be on the path to normalization. In June, new daily coronavirus case counts stabilized in the low hundreds. More people are hopping on planes and trains, intercity highway traffic has rebounded to pre-outbreak levels, and city traffic is congested again.

Factory activity in June expanded for the first time since February, as manufacturing hubs emerged from lockdowns, production increased, and supply chains eased. The manufacturing purchasing managers’ index (PMI) crossed the 50 mark into expansionary territory, and industrial production rose 3.9% year-over-year (y/y). In particular, China’s June exports rose at the fastest pace in five months, indicating resilience in the country’s manufacturing supply chain.

The Chinese government has prioritized production and delivery of exports. To be sure, the robustness of China’s supply to the global goods market has been tested repeatedly since 2020, through waves of COVID outbreaks, power outages, and regional geopolitical crises – all without major bottlenecking. As China’s domestic supply chain continues to normalize, supply-side pressures should ease. In addition, soft domestic demand has helped China keep its inflation under control and producer price inflation (PPI) has been moderating in recent months. This, together with the depreciation of the yuan in early 2Q 2022, has resulted in a moderation of China’s export price inflation to the U.S.

Given softening demand in developed markets along with rising recession risks (see our Secular Outlook for details), going forward, we don’t believe the nation’s supply chain poses a major concern for inflation globally, despite ongoing uncertainty over COVID’s trajectory.

Furthermore, while China has stepped up stimulus to support infrastructure spending, the property market outlook remains gloomy, mitigating China’s demand for global commodities. Therefore, it is unlikely to be a dominant factor in global inflation.

Developed market inflation risks are broadening and shifting away from China

In the U.S., supply chain recovery also appears to be underway thanks to a combination of shifting consumer preferences back towards services, slower overall spending, and higher inventory levels. This has resulted in fewer backlogs at ports, increased freight capacity, and declining transport prices. Inventory-to-sales ratios for sectors like general merchandise, home goods, home electronics, and building supply stores, which are the major categories of Chinese exports to the U.S., have normalized. Import price inflation from China has also been moderating in recent months.

Despite these signs of healthier supply chains, U.S. goods inflation has recently reaccelerated (read our latest U.S. CPI blog). The continued acceleration of retail inflation – despite a slower recent pace of spending and this easing in supply chain pressures – suggests that inflation may be more entrenched than previously thought. While we still see reasons to think that goods price inflation will ultimately moderate, we’re also seeing inflation broaden to other categories.

Shelter inflation has risen sharply in recent months and geopolitical risks remain a worry for the commodity price outlook. The net result is that inflation risks appear to have migrated away from being primarily driven by supply chains and disruptions from China, to a broader set of areas that tend to be stickier, less sensitive to Fed policy action, and harder for consumers to substitute away from. This raises the risk that any further upside inflation surprises are also accompanied by a sharper slowdown in consumption.

Implications for investors

In the near term, disruptions to the global supply chain may persist, despite China’s continued recovery. Disruption from the war in Europe and strikes in some major markets could still pose risks to global supply chains. Disrupted food and energy supplies are already spurring global inflation, but growing risks of gas shortages and the associated rationing in Europe could compound supply chain challenges if factories are forced to close to ensure sufficient energy supplies for households. Inflation could remain high, contributing to a higher risk premium.

In the longer term, we see rising risks of deglobalization and more fragmented capital markets (read our latest Secular Outlook here). China’s role in the global supply chain could diminish over time, as the U.S. government seeks to ease America’s reliance on China’s massive manufacturing base for goods, spare parts, and materials of all kinds.

These trends may augment economic inefficiencies and increase inflationary pressures in the years to come, prompting many investors to focus on building resilience in portfolios.

Please visit our Inflation and Interest Rates page for further insights on these key themes for investors.

Carol Liao and Allison Boxer are economists and regular contributors to the PIMCO Blog.

All investments contain risk and may lose value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2022, PIMCO.

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