The US has so far skirted what was once a widely predicted recession. China's economic slowdown could change that.
New data out Tuesday showed China's service sector activity hit an eight-month low in August. The slowdown in the world's second-largest economy could become a headwind for what's been an otherwise resilient US economy, according to economists at EY.
"While there is growing optimism about a ‘soft landing’ for the US economy, global challenges still cloud the horizon with China's economic turmoil emerging as a top risk," EY chief economist Greg Daco and EY senior economist Lydia Boussour wrote in a note on Tuesday.
"Economic activity in China has weakened significantly in recent months and stress in the property sector has resurfaced, posing downside risks to the macro and business outlook."
After a massive increase over the last several decades, China's annual economic growth slowed to a 2% annual rate in 2022, its lowest rate since 1976. Many thought that would change in 2023, as COVID restrictions were expected to subside. But the reopening has been slower than expected.
In the second quarter, China's GDP grew at a 6.3% annual rate, missing Wall Street's expectations due to a slowdown in property investment and shrinking consumer confidence. The weaker-than-expected growth prompted Wall Street firms to lower their expectations for overall growth this year.
Overall, the US economy's trade exposure to China is a small percentage of GDP.
Recent research from Wells Fargo showed a "hard landing" in China, where economic growth slows substantially, would only have a "modest" impact on US growth. In the scenario Wells Fargo explored using a model from Oxford Economics, it predicted flat growth for the Chinese economy in 2024 and a contraction of 2.6% in 2025 before a rebound to an annual growth rate of 2.7% in 2026.
This notable "growth shock" for the Chinese economy would only reduce US GDP by 0.1 of a percentage point in 2024 and 0.2 of a percentage point in 2025, according to Wells Fargo.
"The estimated effects on GDP growth rates in the Eurozone and Japan are a bit larger, but by no means would we characterize them as significant," Wells Fargo chief economist Jay Bryson wrote on August 25.
EY's team of economists also acknowledge that the US economy's direct trade exposure to China is "rather small."
But "a potential tightening in global financial conditions associated with a 'China growth scare' would significantly magnify the impact," EY's economists wrote.
The tightening financial conditions could create a feedback loop where depressed stock prices are met with surging bond yields, contributing to market volatility amid weak business and consumer confidence, per the economists. This environment typically leads to consumers preferring to save rather than spend and therefore slows economic growth.
"For now, the US economy continues to display resilience," EY's economists wrote. "But economic activity will likely become increasingly sensitive to external shocks as domestic demand slows further and provides less of a growth buffer."
Josh Schafer is a reporter for Yahoo Finance.
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