(Bloomberg) -- China’s economic malaise extended into the third quarter, drawing renewed attention to the need for more fiscal stimulus as domestic demand falters under a prolonged housing downturn.

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A surprise slowdown in fixed-asset investment to 3.6% in the first seven months of the year was among the biggest takeaways from data released on Thursday. Retail sales beat expectations largely on a seasonal uptick — boosting China’s stock market — though they remained far below pre-pandemic growth. Industrial production softened slightly even as it continued to outpace consumption. The offshore yuan held onto early losses after the data.

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The latest snapshot of China’s $17 trillion economy points to an overall loss of dynamism and signs of deterioration as consumers and businesses turn increasingly pessimistic. Recent government efforts — including interest-rate cuts — to stimulate consumption and investment are barely moving the needle, as the world’s No. 2 economy continues to lean on manufacturing to power growth.

“The economy’s momentum slowed,” said Ding Shuang, chief economist for Greater China and North Asia at Standard Chartered Plc. “This has posed more challenges to the goal of achieving around 5% growth this year, and policymakers would see this too.”

Among the slew of data, equity traders reacted positively to the bump in retail sales. The onshore benchmark CSI 300 Index finished up 1.2% at the mid-day break, heading for its best session in two weeks. A gauge of Chinese shares listed in Hong Kong also advanced, erasing early losses.

While the figures were “pretty much in line with expectations,” markets may be somewhat relieved that there seem to be some early signs of stabilization in retail sales and home prices, all of which have been the weak spots in recent months, said Marvin Chen, a strategist with Bloomberg Intelligence.

President Xi Jinping’s government is targeting growth of about 5% this year, as policymakers try to shake off a post-pandemic slump. Economists are calling on the government to accelerate spending on infrastructure and other programs to revive demand, if that target is to be realized.

Fiscal support for the economy has been weak this year, as Beijing restrains from unleashing big stimulus. Public expenditure contracted in the first half, while authorities have been raising money for infrastructure projects via bond sales at a slow pace until recently.

The housing slump showed little sign of reversing, even though the pace of its fall stabilized. Home prices dropped at a largely unchanged rate on a month-on-month basis but declined faster in annual terms. New home starts continued to plunge at a clip of around 20% from a year ago.

Overall investment expanded 1.9% in July from a year ago, worse than the 3.7% gain in the previous month, according to Goldman Sachs Group Inc. calculations.

A breakdown of the figures shows a deceleration in infrastructure investment expansion in the January-July period from the first six months of the year. Private firms’ investment also deteriorated and posted no change from a year ago.

Infrastructure investment has been one of the major drivers of domestic demand, which has been trailing production this year, said David Qu of Bloomberg Economics, adding the slowdown there posed a warning sign.

“That means an engine of China’s economy on the demand side is also moderating and losing steam,” he added. “It tells us that maybe one day, the weakness in the demand-side will return to bite the other side.”

Concerns over a prolonged decline in confidence and prices are mounting after China reported the first contraction of loans to the real economy in nearly two decades.

That reignited debate over whether China could fall into the same kind of decades-long stagnation Japan stumbled into in the early 1990s, or repeat its “balance-sheet recession” as families and businesses focused on clearing debts and stopped spending in the economy.

“We believe the economy faces a significant threat from self-fulfilling deflation expectations,” according to Serena Zhou, senior China economist at Mizuho Securities Asia Ltd. “The government’s top priority should be to break this downward spiral early with more assertive measures.”

The NBS in a statement acknowledged headwinds to economic growth, citing “an increasing negative impact from the changing external environment, while domestic demand remains insufficient.” “The switch from old to new growth drivers is causing temporary pains,” it said.

China’s leaders are betting on high-tech manufacturing to propel the economy as they try to deflate a bubble in the real estate market, where households store the bulk of their wealth. While that has hit consumer confidence, economists expect Beijing to do just enough to meet its target of around 5%.

One hurdle is that authorities are finding it difficult to use all the money they raised from bonds because of a lack of qualified construction projects, according to Ding at Standard Chartered. The government needs to expand the use of such funds into other areas such as the equipment upgrade program, he said.

“More flexible use of the money raised from the bonds can help fiscal policies make a greater impact on consumption and investment,” Ding said.

Although the People’s Bank of China is expected to cut interest rates again this year, its moves will likely be too moderate to help lift sentiment.

The central bank’s room to ease policy further is also constrained by worries over the yuan, as well as the need to stem a bond rally that could deliver a financial shock to the economy if it unwinds in a disorderly manner.

Bond yields fluctuated in recent days, whipsawed by a wide range of intervention measures and stronger demand for haven assets.

The economy’s performance marked “a weak start” to the second half, said Xing Zhaopeng, senior China strategist at Australia & New Zealand Banking Group Ltd. “Demand side weakness remains stubborn.”

--With assistance from Iris Ouyang, Zhu Lin and Shikhar Balwani.

(Updates throughout.)

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