Perspective on China’s Historic Q1 Contraction

Last Friday, China reported Q1 2020 gross domestic product (GDP, a government-produced measure of economic output) fell -6.8% y/y, its first contraction (negative reading) since the country began reporting quarterly GDP in 1992.^[i] Whilst this is a landmark event, it didn’t shock many. Analysts and economists widely expected a decline, to varying degrees, given the government essentially shut down the economy from late January through February to try to contain COVID-19.^[ii] Some financial news coverage we read pointed out the drop was bigger than analysts anticipated, but those estimates seemed to us more like hugely disparate guesses, so we doubt that means much. Economic commentators we follow are now debating China’s growth prospects for the rest of the year, with most outlooks pessimistic. As many observers rightly point out, other major economies have virus-related restrictions in place now, and until eased, growth globally likely suffers—weighing on demand for Chinese goods. So how should investors view Chinese GDP over the coming quarters? Let us explore the issue.

For historical context, here is a chart showing Chinese GDP growth since 1992.

Exhibit 1: Chinese GDP Quarterly Growth Rate Since 1992

Source: FactSet, as of 17/4/2020. Chinese GDP year-over-year growth rate, quarterly, Q1 1992 – Q1 2020.

All three major economic sectors—agriculture, heavy industry and services—contracted on a year-over-year basis (-3.2%, -9.6% and -5.2%, respectively).^[iii] Of 11 reporting subsectors, just 2 (Finance and Technology) grew.^[iv] To us, it seems fair to say China’s six-week shutdown roiled the economy.

But China began easing restrictions in March, and some widely watched monthly gauges suggest certain parts of the economy were improving on a relative basis. (Note: China routinely combines many January/February monthly data points due to the shifting timing of the week-long Lunar New Year holiday.) Retail sales fell -15.8% y/y in March after plunging -20.5% in January-February, but beneath the headline figure, online sales rose, and spending on communication devices turned positive.^[v] After contracting -13.5% y/y in January-February, industrial production slipped -1.1% y/y in March—still a decline, although at a much slower pace.^[vi] Factories catching up on export orders reportedly boosted the gauge, though this recovery may be fleeting since foreign demand has seemingly dried up due to coronavirus restrictions in America and Europe. Fixed asset investment—a measure of construction and development activity—contracted -16.1% year to date (YTD) through March versus 2019’s first three months.^[vii] This, too, is a slower rate of contraction than the -24.5% YTD year-over-year drop in the January-February period, another signal of recovering economic activity as domestic restrictions eased.^[viii]

Yet these relative improvements may not last, since major Western economies followed China’s lead in March with their own virus-containment policies. Both China’s official and the Caixin purchasing managers’ indexes (PMIs, surveys measuring monthly business activity) show export orders dropped far into contractionary territory in February and March, a sign of flagging overseas demand.^[ix] As many observers have noted, this development will likely weigh on Chinese output in Q2 and potentially beyond. 

Looking ahead, we don’t anticipate a huge rebound in Q2 GDP—perhaps not even in Q3. But this isn’t because we have any special insight into the state of China’s recovery—our opinion stems from the GDP calculation method most reports for China cite. China started reporting seasonally adjusted quarterly GDP (which accounts for normal fluctuations at different points in the year, such as winter weather and holidays) only in 2011, and many observers are sceptical this methodology works well. Hence, financial commentators usually report China’s GDP growth rate on a year-over-year basis—that is to say, the current report compares Q1 2020 to Q1 2019; next quarter’s will compare Q2 2020 to Q2 2019. If Q2 2020 output rebounds rapidly, the change would be very apparent when compared to Q1 2020, when GDP fell swiftly. Yet that improvement will likely be nearly invisible in a Q2 2020 - Q2 2019 comparison, as the GDP base in calculation was higher in the latter. We think this math could obscure even a strong rebound. 

We suggest investors keep these reporting differences in mind as other major economies announce Q1 GDP in the coming weeks. Besides the year-over-year comparison, countries may also report GDP changes on a quarter-over-quarter basis (seasonally adjusted GDP in the current quarter versus the prior). Some also announce annualised growth rates—what the quarter-over-quarter growth rate, compounded, would equate to if it persisted for a full year. The UK and many economies in Europe primarily cite quarter-over-quarter growth whilst the US and Japan use annualised growth rates as their standard. (Hence, European Q1 or Q2 GDP drops may look far smaller than American or Japanese, although they may not be.) Some methods provide more granular detail, but no single reporting method is inherently better than the other, in our view. Instead, we think they reveal different information. But those nuances may get lost in headlines, so prepare yourself now and be careful not to base country-to-country comparisons on mismatched growth rates.