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Deflation is the latest risk for China’s struggling stock market

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The CSI 300 Index just capped its worst week since March after a drop in consumer and producer prices added to signs of deterioration in the economy. The benchmark of onshore Chinese shares has now erased more than half of the gains spurred by the Politburo’s policy vows in late July. Hopes that earnings will offer fresh catalysts are giving way to fears that companies may lose pricing power.

Foreign investors, who snapped up onshore Chinese stocks for two weeks amid the optimism spurred by the Politburo meeting, sold each day this week, withdrawing a net 25.5 billion yuan ($3.5 billion) in all. That was the most for any week since October.

While few expect China to experience the decades-long deflationary spell that has haunted Japan, Beijing’s reluctance to deploy forceful stimulus in the face of weak consumption and a property market slump can keep prices muted for longer. Without a healthy dose of inflation, which generally helps buoy corporate revenue and profits, the stock market risks being stuck in the doldrums.

“Lack of inflation means lack of pricing power,” said Mohammed Zaidi, investment director at Nikko Asset Management. “Investors should re-calibrate their earnings expectations for slower growth.”

China’s economy has shown increasing strains in recent weeks, with a sharp deterioration in July imports underscoring how domestic demand remains sluggish despite Beijing’s efforts to restore confidence. The nation’s banks extended the smallest amount of monthly loans since 2009, data showed on Friday, adding to signs that recovery in the world’s second-largest economy is faltering.

That suggests a turnaround in earnings may take longer than thought, with early readings of the second-quarter results already having painted a bleak picture.

Some companies have already been forced to reduce prices to survive against the weak macro backdrop. Analysts warn that businesses may fall into a vicious cycle should consumers choose to defer purchases on expectations of more price cuts, prompting companies to sacrifice profits to woo buyers.

Forward earnings estimates for firms on the MSCI China Index are edging lower again in August after rising for the first month this year in July, data compiled by Bloomberg show.

“There is a risk of corporate earnings being revised downward,” said Wilfred Sit, chief investment officer at Hang Seng Investment Management. “What we need to see now is whether the government is able to come up with some kind of effective policies to boost the economy.”

It’s also not the first time that China has experienced deflation. Consumer and producer prices fell in tandem in 2009 and 2020. Stock performances back then have been mixed — the MSCI China Index rebounded during the earlier bout of deflation, but entered a downward spiral shortly after the latter period.

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