China economy: Are traders overestimating its health?

Judging by the reaction of financial markets, traders seem encouraged by the recent round of Chinese economic data, from gross domestic product and exports to industrial production and retail sales.

But those traders may be leaping to conclusions.

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"In the short term, it reinforces what we've been trying to get investors to listen to — China is not headed for a hard landing. Retail sales witnessing double-digit growth. Housing market looks like it is stabilizing ... indicating that the stimulus put in place by the central bank is starting to work," said Sameer Samana, global quantitative strategist at Wells Fargo Investment Institute.

But Wall Street veterans including Samana caution that investors should not buy into the idea of a Chinese recovery too quickly — turnarounds take time. At least three to four months of consistently good numbers representing a gradual rebound in China's industrial and services sectors will be needed before any seasoned economist will be able to label China as a "turnaround story."

With every statistic we see out of Asia, ex-China, whether it's Taiwan, whether it's Hong Kong and other Asian countries, they're suffering slowdowns from their sensitivity and exposure to China.
Peter Boockvar
managing director, Lindsey Group

Moreover, the earnings of major Chinese corporations would also need to illustrate a rebound in profit and sales growth. According to Shanghai-based financial data firm Wind Information, steel, industrial and energy companies in 2015 posted a 45 percent or greater drop in net profits on average. That's definitely not an encouraging sign, experts say, given how actively the central bank was injecting liquidity into the economy.

Analysts point to something else, as well: Neighboring trading partners of China continue to post dismal numbers, suggesting that the improvement in China's March data may not be accurate.

South Korea reported a double-digit decline in first-quarter exports. Taiwan posted weaker-than-expected March trade data earlier this week, with exports plunging 11.4 percent and imports dropping 17 percent year over year. Growth in Hong Kong's manufacturing sector came in at its lowest level since August. And Japan's latest Tankan Survey indicated further deterioration in business activity and confidence.

A Chinese day trader watches a stock ticker at a local brokerage house in Beijing, China.
Asia markets mixed after China Q1 GDP as expected

"With every statistic we see out of Asia, ex-China, whether it's Taiwan, whether it's Hong Kong and other Asian countries, they're suffering slowdowns from their sensitivity and exposure to China," said Peter Boockvar, managing director of Washington-based economic advisory firm The Lindsey Group.

Markets for years have had a sort of psychological co-dependency on China, given its prevalence, influence and growth in the global economy. But other macroeconomic factors at play — volatility in currencies, rising fears over Japan's economy and the effectiveness of global central bank policy — have attracted some investors' attention and sidelined the awareness they normally give to China.

The yuan: It still matters

Strategists who spoke to CNBC said it will only take another disappointing report from China — or a significant drop in the yuan — for global investors to once again put the world's second-biggest economy at the top of their worry list.

Also important is the talk from Chinese policymakers. President Xi Jinping and central bank Governor Zhou Xiaochuan have expressed an intent to keep the yuan stable. Finance Minister Lou Jiwei has attempted to inspire confidence among global investors, resulting in the offshore yuan gaining ground against a basket of currencies.

Bets against the yuan were popular among hedge fund giants such as David Tepper and Bill Ackman. Yuan appreciation over the last two months has made that trade less tenable. Still, Beijing experts are forecasting a gradual depreciation in the Chinese currency. The question is how global stock markets will respond to a drop in yuan, which hurts foreign companies that do business in China.

"I don't think the Chinese will devalue the yuan in the near term, but if they were to do it, markets would take it negatively. It would reintroduce the threat of competitive devaluation, which could likely feed into other global markets," said Samana.

The IMF, the SDR and the yuan explained

There's growing doubt about whether China will embark on another one-off devaluation. Boockvar said that if China were to take such a daring step, it could ruin its chances of being accepted into the International Monetary Fund's basket of special drawing rights currencies — IMF-issued reserve assets — in October 2016.

The onus is now on the Chinese government to continue rehabilitating itself through aggressive reform, strategists told CNBC. Even then, growth could slow.

William McFadden, head of China macro sales at investment bank North Square Blue Oak, pointed out that "The current plan of industrial restructuring, involving capacity reduction in several key industries, will tend to put a speed limit on overall industrial growth, even if noncapacity challenged sectors do grow more quickly."