Tariffs Are Just Tip of the Iceberg for China. These Are the Bigger Problems.

Investors have been waiting for Chinese officials to change their tack on stimulus efforts, but those moves have been incremental. Here: shipping containers at a port in Nanjing, China. (AFP / Getty Images)

As the U.S. and China extend their tariff truce, and appear to be in a de-escalatory lull for now, there’s another risk brewing in China for investors to focus on: Beijing’s efforts to curtail deflationary forces spreading through the world’s second-largest economy.

Chinese stocks have been a standout this year, with the MSCI China up 26%, trouncing the 9% gain in the S&P 500 . Those returns were sparked in part by the excitement over DeepSeek’s artificial-intelligence models that put a spotlight on the innovation bubbling up in China.

But beneath the excitement about the technology sector is a persistent economic rout. Economists think China’s growth is under the 5% target Beijing has set for this year and headed lower. The property market is four years into a slump. Gradual efforts to stabilize the economy have done little to lift consumer spending in a sustained way. Businesses are still hesitant to spend, even more so as deflation has gripped the economy.

Investors have been waiting for officials to change their tack on stimulus efforts, but those moves have been incremental, creating spurts of growth that quickly lose momentum. Beijing has leaned on stimulus only when necessary—and lately things aren’t that bad.

That was reinforced in this week’s Politburo meeting, where officials left the door open for incremental and targeted measures but led economists to think measures may be smaller than some expected. The U.S. and China dialed back trade-related tensions in recent weeks, and analysts expect a detente to pave the way for an in-person meeting President Donald Trump wants with China’s Xi Jinping this fall. That has taken further pressure off China to act.

Indeed, on a recent trip to China, Michael Hirson, head of China research for 22V Research, found confidence in China’s ability to navigate the trade situation.

That confidence is twofold: China’s demonstration that it indeed has leverage with its control of rare earths such as critical magnets used by U.S. auto makers, industrials, and for defense purposes; and Chinese exporters’ ability to mitigate the tariff impact by shifting production and selling to other markets.

Also helping exporters: the Chinese yuan’s weakness against the euro and other nondollar currencies. There are still risks, including the U.S. penalizing China for its purchase of Russian oil, as it just did with India. Policymakers are turning their attention to deflation, a byproduct of years of aggressive manufacturing investment that has fueled the one bright spot in the economy—exports—but created intense competition and pricing pressures in industries such as electric vehicles, solar panels and e-commerce.

TS Lombard’s head of China research, Rory Green, expects Beijing to focus efforts to curb overcapacity on traditional heavy industry—steel, cement, and copper. While EVs and other areas of technology could see increased scrutiny on pricing, Green says those might be offset with some sort of policy support.

Officials so far have leaned toward enforcing existing regulations to limit capacity rather than implementing a batch of new rules or mass closures of facilities.

Green expects that to continue, and for Beijing to offset some of the impact with investments in infrastructure and spurts of other stimulus. But there is the risk that Beijing goes too far in curtailing manufacturing investment, resulting in a more pronounced economic slowdown.

The improvement in U.S.-China relations may buffer the stock market for a while, as could the view that Beijing’s efforts to cut capacity will help profits, Green says.

But the economic problems will eventually catch up with the market—especially if Beijing stays on this course in its approach to stimulus.

Write to Reshma Kapadia at reshma.kapadia@barrons.com