Pace of contraction in business activity eases for the first time in 3 months

Facts
Although Hong Kong's headline PMI stayed below the 50-neutral mark for the third straight month in October, it also improved for the first time during the same period, printing 49.0 compared to 45.9 previously (long-term average: 51.7; 2008/09 bottom: 38.7). It also rose above the third quarter's average reading of 48.4.

All the key activity sub-indices improved by a material margin as well. Although the new orders sub- index fell below 50, it jumped by 4.8ppt to 49.3 from 44.5 a month earlier (long-term average: 51.7; 2008/09 bottom: 30.3). This was driven in part by the new China business sub-index, which stepped up to 51.1 from 50.5 the month before (long-term average: 52.4; 2008/09 bottom: 32.4). As expected, Mainland demand is finally picking back up and increasing its counterbalance against the impact of weakening Western demand. Having slowed for the previous two months, new orders from China is back on the increase. With the Beijing government now in a selective easing policy mode, Mainland growth should stabilize though the end of this year, backed by sustained income growth and on-going infrastructure investment.

Output therefore contracted at its slowest pace in three months, rising to 48.4 from 43.7 previously (long-term average: 51.9; 2008/09 bottom: 33.1). Within the survey, businesses flagged that they are still finding credit conditions relatively tight (most likely due to the spillover impact of China's ytd monetary policy moves) and macro conditions challenging.

The sub-index staffing levels in Hong Kong almost broke even in October, rising to a three-month high of 49.1 from 47.5 previously. Survey respondents attributed this to both lower order volumes and voluntary staff resignations, but interestingly, not to higher staffing costs. Employment costs stayed above their long-run average (of 52.8) for the fifteenth month running, expanding with a print of 54.9 versus 53.4 previously. The resilience of the local job market clearly has yet to be toppled by on-going global economic and financial market turbulence, further supporting our view that the strength of Hong Kong's domestic economy should provide the city with a strong buffer against external economic uncertainty.

Cost-wise, both the input and output cost sub-indices stayed above their long-term average, with the sub-index printing 59.1 and 54.4 respectively (long-term averages: 54.1 and 50.7 respectively). Although the output sub-index inched up for the first time in three months, it was only by a slight margin (up from 53.8 in September). Moreover, the substantial easing of input cost inflation, the reading for which dropped steeply by more than 4 ppts from 63.4) suggests that with pipeline price pressures still easing, CPI inflation should be close to peaking soon (if it has not already).

Though still moderating, the improvement in October's PMI signals that private business activity in Hong Kong could be back on the mend, supported in part by the recent stabilization of Mainland demand. While it's too early to assume that demand from China alone will be sufficient to eliminate all downside risks from slowing Western demand in the coming months, with China's manufacturing and service sectors now both back in expansion mode, local job creation still happening (unemployment rate remains at a 13-year low of 3.2%) and cash registers still ringing (retail sales grew by almost 20% on an annualized sequential basis in 3Q11), the city should be able to narrowly skirt recession in 2011.

Bottom-line: The weight of slowing Western demand has yet to lift from Hong Kong's economic growth, but the counter-balance provided by China is strengthening. With Mainland growth expected to stabilize through year-end, business activity in Hong Kong should be relatively more sheltered this time from uncertainty in Western markets. With slower growth already starting to lessen pipeline price pressures, inflationary pressures in the city should be in decline by year-end.