China's factory activity cools in May as US tariffs hit

China's factory activity contracted in May for the first time in eight months, with the Caixin/S&P Global manufacturing PMI falling to 48.3, signaling that U.S. tariffs are starting to negatively impact Chinese manufacturing. New export orders shrank for the second consecutive month at the fastest pace since July 2023, with producers citing U.S. tariffs as a restraint on global demand, while output prices have fallen for six straight months due to intense market competition and supply-demand imbalances continue to fuel deflation.

Analysis

China's manufacturing sector experienced a contraction in May, with the Caixin/S&P Global manufacturing Purchasing Managers' Index (PMI) falling to 48.3 from 50.4 in April, marking its first decline in eight months and the lowest reading in 32 months, indicating U.S. tariffs are exerting direct pressure. This private-sector survey result aligns with official PMI data showing a second consecutive month of falling factory activity. The detrimental impact of tariffs is further evidenced by new export orders shrinking for the second straight month in May, at the fastest pace since July 2023, dragging overall new orders to their lowest level since September 2022. Consequently, factory output contracted for the first time since October 2023, and employment in the manufacturing sector declined at the sharpest pace since the start of the current year due to headcount reductions. Deflationary pressures persist, with output prices falling for six consecutive months driven by intense market competition, exemplified by the price war in the auto industry; Morgan Stanley's Chief China Economist, Robin Xing, noted that supply-demand imbalances continue to fuel deflation and that reflation is likely to remain elusive. The situation is exacerbated by U.S.-China trade talks being described as "a bit stalled" and the temporary reinstatement of sweeping U.S. tariffs by a federal appeals court. In response, China's Premier Li Qiang indicated the country is considering new policy tools, including "unconventional measures." Paradoxically, amid these challenges, export charges rose for the first time in nine months, reportedly achieving the fastest growth since July 2024 due to rising logistics costs and tariffs, and business optimism regarding future output improved on expectations of an improving trade environment.

Key Decisions for Investors

• Investors should exercise caution regarding investments directly exposed to Chinese manufacturing and closely monitor leading economic indicators from China, given the PMI contraction and the stated impact of U.S. tariffs.
• Pay close attention to any announcements of 'unconventional measures' by the Chinese government, as these could significantly influence market direction and economic recovery prospects.
• Re-evaluate exposure to sectors heavily reliant on U.S.-China trade and global supply chains, considering the risks posed by stalled trade negotiations, reinstated tariffs, and persistent deflationary pressures in China, despite some business optimism for future output.
• Monitor developments in the U.S.-China trade relationship for potential escalations or de-escalations, as these will likely have a substantial impact on affected industries and overall market sentiment.