[OPINION: The views expressed by Investopedia columnists are those of the author and do not necessarily reflect the views of the website.]

Right now, China is experiencing a financial crisis with communist characteristics. The country is attempting to accomplish the twin goals of permanently downshifting GDP growth and rebalancing economic drivers. But Beijing’s insistence upon maintaining financial and economic stability throughout, effectively transfers deflation risk from the market in the near term, to the real economy over the longer term.

To be clear, what they are attempting to accomplish has never been done before in modern economic history. It is reasonable to assume the glide path down will be less linear than Beijing hopes. As such, we reiterate our bearish bias on the “Old China” economy with respect to the intermediate term. We suspect that the nascent deceleration highlighted by the Q2 GDP data will morph into a full-blown negative trend over the next few months.

A slowdown in China should also help perpetuate another leg down in commodity-oriented reflation over the intermediate term. Investors should avoid Energy (XLE) and Metals and Mining (XME) stocks domestically and emerging market commodity producers internationally, such as Brazil (EWZ) and Russia (RSX).

Last week we received the balance of Chinese growth data for Q2. Headlined by another comically static GDP report (+6.9% YoY vs. +6.9% prior; hovering within a convenient 30 basis point range since the start of 2015, despite having a meaningful drawdown and subsequent recovery in both high-frequency economic data and financial markets over that time period, but I digress.)

It should be noted that sequential growth momentum throughout the mainland Chinese economy was broadly positive in the month June.

Here are some highlights:

  • Consumption Growth: Real Retail Sales: +10% year-over-year versus +9.5% prior
  • Manufacturing Growth: Industrial Production: +7.6% YoY versus +6.5% prior
  • International Trade: USD Exports: 11.3% YoY versus +8.7% prior
  • Credit Growth: Total Social Financing: +1.78 trillion Chinese yuan month-over-month versus +1.07 trillion CNY prior
  • Property Sector: Funds Available for Real Estate Development: +11.2% YoY vs. +9.9% prior

While it may certainly seem that all is well in China (for now), we continue to sound the alarm bell on the “Old China” economy in particular with respect to the second half of 2017 and beyond.

Specifically, far and away the most important development in the recent GDP release is the fact that the nominal growth rate of China’s manufacturing sector decelerated from a cycle-peak of +14.2% year-over-year in the first quarter of 2017 to +12.7% YoY in the second quarter of 2017. While that may not seem like much of a pullback, it does mark the first sequential deceleration since nominal growth in this sector bottomed at +0.9% YoY in the third quarter of 2015.

Moreover, Chinese heavy industry’s trailing twelve month contribution to the country’s broader economic growth remains overextended at a historically unsustainable rate of 46.5%.

As we’ve said before, the 2016 “recovery” in the Chinese economy was predicated on the growth rate of heavy industry and this was perpetuated by a significant amount of fiscal and monetary stimulus.

Contributing to the aforementioned negative inflection is the ongoing tightening of monetary policy throughout the year-to-date.

Case in point, already in 2017, the People’s Bank of China has pulled back significantly. PBoC Open Market Operations are down -246% year-over-year in 2017 versus an increase of +689% year-over-year by this time last year. For the full year of 2016, the PBoC pumped a staggering net 1.727 trillion Chinese yuan into mainland financial markets.

The key takeaway for investors here is that the monetary policy impulse in China is negative on both a trending and year-over-year basis, which is something that should weigh on growth within the credit-sensitive manufacturing sector of the Chinese economy. Much like it was on the positive side throughout 2016, we are keen to call investors’ attention to this factor as a leading indicator for broad-based economic softness going forward.

The investment implications of a slowdown in the Chinese economy are important to understand. Consistent with our #ReflationsRollover theme, the slowing Chinese economy should help perpetuate another leg down in commodity-oriented reflation over the intermediate term.

To underscore this point, China represents roughly half of global demand for major base metals, according to the IMF. China has also become the largest importer of metals, with its share increasing from less than 10% to 46% from 2002 to 2014. The country actually consumes about half the world’s production of refined copper, iron ore, aluminum and smelted and refined nickel.

All told, we reiterate our bearish bias on the “Old China” economy with respect to the intermediate term and suspect that the nascent deceleration highlighted by the Q2 GDP data will morph into a full-blown negative trend over the next few months.

Darius Dale is a senior analyst on the Global Macro team and a core contributor to the firm’s economic outlook and associated investment strategy views. Hedgeye is an independent, conflict-free investment research and online financial media company.

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