China's growth performance in May was a mixed bag. Official industrial production (IP) and nominal retail sales growth were a bit better than in April. Growth in fixed asset investment (FAI) and real retail sales slowed further. We see no concrete evidence that the economy has bottomed out.

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We maintain our call that actual activity growth is likely to slow further in Q3. This is what the two main leading indicators we like – housing sales and credit growth – are telling us. Policy is already being loosened gradually, but more broad-based easing is still needed. Such measures could include reserve requirement ratio (RRR) cuts, more stimulus to the housing market, more credit availability for local government investment vehicles (LGIVs), and more fiscal action. As Premier Li Keqiang indicated recently, achieving the official 7.5 percent GDP growth target in 2014 is still politically important. We look for official prints of 7.4 percent for Q2 and 7.5 percent in Q3, but believe these numbers will flatter actual activity. We currently think Q4 is the most likely time for activity to bottom out and begin to firm.

The worst is not yet over, we believe

Official IP growth seems to have stabilized for now, at 8.8 percent year-on-year in May. Electricity production growth, which may be a more reliable indicator of production, also picked up, to 5.9 percent year-on-year from 4.4 percent. Our gauges of the manufacturing inventory cycle (the ratio of new and backlogged orders to inventories of raw and finished goods) and producer confidence (the ratio of raw-material purchases to the average of production and backlogged orders) both suggest that manufacturing momentum improved a little.

However, it is still tough out there. FAI growth continued to slow, in real terms, to 16.4 percent year-on-year in May from an average of 17.4 percent in February-April. Manufacturing and real estate are the biggest drags, offsetting the acceleration in infrastructure investment. There is evidence that central government investment using official budget funds is accelerating, but local government investment remains sluggish, partly due to limited financing.