The Middle East energy shock has helped China exit its deflationary cycle

• China’s April 2026 inflation data showed meaningful improvement, with CPI rising 1.2% YoY and PPI rebounding 2.8% YoY after 41 consecutive months of decline.

• Higher energy prices from the Middle East conflict helped China exit the deflationary cycle, while core CPI and May Day holiday spending data suggest domestic consumption is also gradually recovering.

• Beijing’s “anti-involution” policies, including solar industry production cuts and lower export rebates, aim to reduce destructive price competition and improve corporate profitability.

• China’s exports surged 14.1% YoY in April, driven by AI-related manufacturing demand, shipbuilding orders, and continued strength in EV and green energy exports.

• Despite improving macroeconomic conditions, Chinese equities remain attractively valued. The MSCI China Index is projected to reach HKD 97 by FY2028, with roughly 20% upside potential as of FY2028.

For more than three years, China’s economic narrative was dominated by persistent deflation - a prolonged cycle of falling factory prices, weak consumer confidence, and cautious household spending. In April 2026, the story began to change.

China’s CPI rose 1.2% YoY in April, up from 1.0% in March. More importantly, producer prices showed a much firmer recovery, with PPI rising 2.8% YoY after 41 consecutive months of decline (Figure 1). The turnaround marks one of the clearest signs yet that China may finally be emerging from its deflationary environment.

Figure 1: China’s inflation data showed improving price momentum

A major catalyst behind the rebound was the surge in global energy prices following the Middle East conflict. Higher oil and transportation costs filtered through both consumer and industrial prices. Transportation costs within CPI accelerated to 4.6% YoY from just 0.9% in March as fuels for transport facilities accelerated to 17.4% YoY from 3.4% in the previous month. On the production side, the input costs for raw materials, fuel and power have risen 4.4% YoY, resulting in output raw material prices increasing 7.1% YoY.

While most major economies are worried about inflation overheating, China’s situation is fundamentally different. After years of weak price growth, China entered the energy shock from an exceptionally low inflation base. In many ways, China has effectively “imported” inflation at a time when the economy arguably needed it most.

Will the inflation momentum continue?

Although the US and Iran have entered a ceasefire phase, the Strait of Hormuz remains effectively disrupted, keeping global oil supply tight. Crude oil prices have stayed elevated near the USD 100 per barrel range, suggesting imported inflation could continue feeding into China’s economy over the coming months.

That said, Beijing has attempted to manage the impact carefully to avoid burdening households or destabilising growth. China’s National Development and Reform Commission (NDRC) limited the pass-through of global fuel price increases by capping domestic gasoline and diesel price hikes, while also instructing refiners to temporarily reduce fuel exports to safeguard domestic supply and keep local prices manageable.

More importantly, the recent inflation improvement is not solely energy driven. China’s core CPI, which excludes volatile food and energy prices, also rose 1.2% YoY in April, indicating that domestic demand is gradually stabilising. Consumption recovery remains slow, but the direction is improving.

The latest May Day holiday data reinforced this trend. According to China’s Ministry of Culture and Tourism, domestic trips during the five-day holiday reached approximately 325 million, up 3.6% YoY, while tourism spending rose 2.9% YoY to CNY185.5 billion. Meanwhile, hotel operator H World Group, which manages more than 12,700 properties across China, reported a 13.6% YoY increase in room nights.

The volume growth is encouraging. However, we also noticed that spending per trip slipped modestly from CNY574 to CNY571. This suggests Chinese consumers are increasingly willing to spend on experiences such as travel and leisure but remain highly value-conscious and selective when it comes to discretionary or big-ticket purchases. In other words, consumption recovery is improving, but not aggressively. Inflation is therefore likely to rise gradually rather than accelerate sharply.

Importantly, China’s producer price pressures had already begun improving even before the Middle East conflict escalated. Beijing’s ongoing “anti-involution” campaign, aimed at curbing excessive capacity expansion and destructive price competition in sectors such as solar panels and automobile manufacturing, has started to gain traction.

For example, major Chinese solar manufacturers have reportedly agreed to reduce production quotas in an effort to rebalance supply and demand conditions across the industry. In addition, starting from 1 April 2026, China removed the 9% value-added tax export rebate on solar modules, cells, and inverters, while cutting the export rebate for battery products from 9% to 6%. The policy shift is expected to raise global solar panel prices by roughly 10–15%, signalling that Beijing is increasingly prioritising value-driven growth and healthier industry profitability over pure volume expansion fuelled by aggressive price competition. Over the longer term, the measures could help stabilise margins across China’s renewable energy supply chain and further moderate producer price deflation.

AI demand and Middle East tension support export orders

China’s exports surged 14.1% YoY in April, significantly exceeding market expectations of 7.9%. The strength was largely driven by the ongoing global AI manufacturing boom. Companies worldwide have continued replenishing inventories of electronics, semiconductors, servers, and industrial components, while the Middle East conflict further accelerated stockpiling activity amid fears of rising input costs and supply disruptions.

In the first four months of 2026, mechanical and electrical products accounted for 63.5% of China’s total exports, rising 21.1% YoY in USD terms. High-tech product exports grew even faster at 31.4% YoY, highlighting the continued strength of China’s position within the global AI and advanced manufacturing supply chain. As the global AI investment cycle remains intact, China’s export momentum is likely to remain resilient in the coming quarters.

A second major beneficiary has been China’s shipbuilding industry. With shipping routes around the Strait of Hormuz disrupted and global freight flows increasingly rerouted, demand for tankers, LNG carriers, and container ships has surged. As the world’s dominant shipbuilder, China stands to benefit significantly from this shift. Ship exports rose 24.9% YoY to USD19.8 billion as of April 2026. Recent orders further underscore the trend, with Switzerland-based Advantage Tankers and Mercuria both placing orders for Very Large Crude Carriers with Dalian Shipbuilding Industry Group.

Third, China’s electric vehicle and green energy supply chains continue to provide strong structural support. The disruption in global oil flows has reinforced energy security concerns among heavily import-dependent economies, accelerating the push toward electrification and renewable energy adoption. This is likely to create additional demand for Chinese EVs, batteries, and renewable energy products, a structural tailwind that tariffs alone are unlikely to offset. The export data already reflects this momentum. In the first quarter of 2026, China’s exports of plug-in hybrid electric passenger vehicles surged 130.9% YoY, while non-plug-in hybrid passenger vehicle exports rose 94.2% YoY. Battery electric vehicle exports also increased 64.1% YoY over the same period.

One of the biggest surprises in April’s trade data was the rebound in exports to the US, which rose 11.3% YoY despite elevated tariffs. Part of the increase was likely due to favourable base effects, as April 2025 marked the peak impact period of the “Liberation Day” tariff measures, creating a weaker comparison base. At the same time, US importers may have accelerated purchases ahead of the high-stakes summit between Chinese President Xi Jinping and US President Donald Trump scheduled for 14–15 May 2026. Businesses likely frontloaded shipments to hedge against the risk of fresh tariff announcements or additional trade restrictions.

Our base case remains that both leaders have strong incentives to preserve stable bilateral relations, particularly amid heightened Middle East tensions and the approaching US mid-term election cycle. We see the most likely outcome as an extension of the current trade truce, while politically sensitive issues such as Taiwan and advanced technology exports are likely to remain unresolved in the near term. More practical agreements, including investment commitments or increased agricultural purchases, could still emerge depending on the tone of the discussions.

Overall, both sides appear motivated to prevent a further deterioration in relations.

China does not need to tame inflation via policy tools

External demand has been one of China’s key growth engines over the past several years, and this trend appears likely to continue in 2026. Export momentum, particularly in AI-related manufacturing and industrial supply chains, should remain supportive over the coming quarters.

At the same time, domestic consumption data, while still relatively soft, suggests that recent stimulus and stabilisation efforts are gradually gaining traction. This should provide modest support to underlying inflation.

Compared to regional peers, China also faces far less pressure to tighten policy aggressively. In Japan, policymakers have had to contend with significantly stronger import inflation and a weaker yen, prompting expectations for tighter monetary policy. Similarly, Singapore recently tightened the slope of its S$NEER policy band to manage imported inflation pressures.

China, by contrast, remains in a far more comfortable position. Current inflation levels are still relatively moderate, giving policymakers considerably more flexibility. While the People's Bank of China does not have the urgency to lower Loan Prime Rate or Reserve Requirement Ratio in the immediate term due to data support, these tools remain available should growth weaken again later this year.

Chinese equities remain attractively valued despite improving fundamentals

Despite improving macroeconomic conditions, Chinese equities have continued to lag. The MSCI China Index has declined 2.5% year-to-date and remains roughly 7% below its late-January peak. Yet valuations have become increasingly compelling. The index is currently trading at approximately 11.0X forward P/E — slightly below its 10-year average of 11.4X and significantly below the roughly 22X peak reached during the 2020 technology rally.

For investors, this valuation gap provides a meaningful margin of safety, particularly in an environment still characterised by elevated geopolitical uncertainty.

We continue to recommend adding Chinese equities on market weakness. The MSCI China Index is projected to deliver nearly 20% upside with a potential target of HKD 97 by FY2028, offering attractive capital appreciation potential.

Investors seeking diversified exposure may consider the iShares Core MSCI China ETF (HKEX: 2801) for broad based Chinese equity exposure or the Fidelity China Focus A-SGD, which has historically demonstrated relatively strong risk management characteristics during volatile market environments.

Table 1: Projections for the MSCI China Index

	2025	2026E	2027E	2028E
PE Ratio	13.2	12.1	10.8	10.0
Earnings Growth	2.8%	8.7%	12.0%	8.0%
EPS	6.15	6.69	7.49	8.09
Dividend Yield	2.1%	2.2%	2.2%	2.3%
Projected Fair Price (Based on fair PE ratio of 12X)				97
Upside				19.9%
Source: Bloomberg Finance L.P., iFAST Estimates. Data as of 11 May 2026.

Figure 2: Share price vs. EPS chart for the MSCI China Index

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.