AI resilience meets domestic headwinds

CHINA’S economy slowed more than expected to 4.3% year-on-year (y-o-y), or 0.9% quarter-on-quarter on a seasonally adjusted basis, in the second quarter of 2026 (2Q26) from 5% in 1Q26.

Nevertheless, gross domestic product (GDP) growth averaged 4.7% y-o-y in the first half of 2026 (1H26), remaining within the government’s 4.5%–5% growth target.

One encouraging development was the continued reflation of the economy. Nominal GDP growth accelerated to 5.9% y-o-y in 2Q26 from 4.9% in 1Q26, while China’s GDP deflator turned positive for the first time since March 2023, signalling that deflationary pressures are gradually easing.

Limited impact from Iran war

There is little evidence that the 2Q26 slowdown was primarily driven by the Iran conflict. According to the National Bureau of Statistics, most sectors continued to operate normally, with disruptions largely confined to the petrochemical industry.

In fact, China may have benefitted indirectly from the conflict. Elevated energy prices accelerated the global energy transition and reinforced demand for China’s renewable energy products.

Automobile exports surged 69.6% y-o-y in June, highlighting China’s strengthening competitiveness in advanced manufacturing, particularly electric vehicles.

Our estimates suggest that capital formation was the largest contributor to the downside surprise, while net exports remained supportive.

Fixed asset investment contracted 5.7% y-o-y in the 1H26, reflecting weakness across both property and infrastructure investment.

The property sector remained the biggest headwind, with real estate investment declining 18% y-o-y. The prolonged property downturn continued to weigh on construction-related industries, including cement, steel, furniture and other upstream manufacturing sectors.

Infrastructure investment also lost momentum.

Growth slowed to -2.4% y-o-y in the 1H26 from 4.3% during January–April, suggesting that the boost from front-loaded fiscal funding and concentrated project launches in the 1Q26 has gradually faded.

More importantly, physical construction activity appears to have slowed meaningfully since the beginning of the 2Q26.

Structural growth engine

Exports continue to be the brightest spot in the economy. June exports rose 27% y-o-y, accelerating from 19.4% in May.

For the 1H26, cumulative exports expanded 17.6% y-o-y, far exceeding market expectations at the start of the year and marking the fastest pace of growth since the post-pandemic rebound in 2021.

Imports also strengthened, with growth accelerating to 36% y-o-y from 27.4% previously.

Consequently, China’s merchandise trade surplus narrowed only marginally to US$577.3bil in the 1H26 from US$583.4bil a year earlier, while remaining historically elevated.

Artificial intelligence (AI)-related products remain one of the key drivers of export performance. China’s AI exports are concentrated mainly in intermediate goods, particularly semiconductors and computing hardware.

Integrated circuit (IC) exports surged 121.9% y-o-y in June, extending this year’s record-breaking momentum.

During the 1H26, ICs and automatic data processing (ADP) equipment together accounted for 14.8% of total exports, up from 10.7% in 2025, while their combined exports grew 67.5% y-o-y.

On the import side, IC imports also reached another monthly record, rising 72.3% y-o-y, highlighting strong upstream semiconductor demand.

Robust growth in both IC exports and imports suggests continued expansion across China’s AI supply chain, reinforcing our view that AI-related exports will remain an important pillar supporting China’s external sector over the coming quarters.

More policy support for consumption likely

Household consumption remains the weakest component of domestic demand. Retail sales of consumer goods grew only 1.3% y-o-y in the 1H26.

Against this backdrop, the State Council officially approved the Expanding Consumption “15th Five-Year Plan” (2026–2030), which targets total retail sales of consumer goods reaching 60 trillion yuan by 2030.

The target implies average nominal retail sales growth of around 3.7% per year over the next five years – a relatively modest objective.

It is below this year’s implied nominal GDP growth and also below our expectation for nominal GDP growth over the medium term.

In our view, Beijing deliberately adopted a conservative target. Unlike infrastructure investment or industrial production, household consumption cannot be directly engineered through administrative measures.

Ageing demographics, elevated precautionary savings, lingering property wealth effect and an incomplete social safety net continue to constrain household spending.

The decision is consistent with Beijing’s broader preference for setting achievable policy targets, similar to its removal of the five-year cumulative urban employment target from the latest Five-Year Plan.

Nevertheless, with retail sales growth still substantially below the implied medium-term target, we expect policymakers to announce additional consumption-support measures, particularly to stimulate durable goods consumption.

At the same time, policymakers are placing increasing emphasis on services consumption, which is not fully captured by traditional retail sales data.

According to the NBS, retail sales of services grew 5.3% y-o-y in the 1H26, 4.2 percentage points faster than goods retail sales. Tourism- and leisure-related spending remained particularly strong, with tourism consultation and rental services, and culture, sports and leisure services expanding 11.3% and 10.4% y-o-y, respectively.

The new Five-Year Plan explicitly identifies services consumption as a separate policy priority. Since household final consumption in the national accounts tends to grow faster than goods retail sales alone, policymakers may also unveil further initiatives aimed at boosting services consumption.

Outlook: 2Q26 may mark cyclical trough

Looking ahead, infrastructure investment is likely to remain the government’s primary policy lever to stabilise growth.

The key question is whether fiscal resources can be translated into sustained physical construction activity and whether new initiatives, including the “Six Networks” strategy, can gradually offset the structural slowdown in traditional property- and municipal-related infrastructure investment.

While AI-related manufacturing and exports continue to provide an important structural tailwind, persistent weakness in household consumption, property, manufacturing investment and infrastructure spending suggests that domestic demand remains fragile.

That said, we believe 2Q26 likely marked the cyclical trough. With additional policy easing and consumption-support measures expected, growth should improve gradually during the 2H26.

We therefore continue to expect China to achieve its official growth target, although full-year GDP growth will likely finish towards the lower end of the 4.5%–5% target range, rather than the midpoint.

We have downgraded China’s growth forecast for this year to 4.6% from 4.7% previously.