Marcuard’s Market update by GaveKal Research
Chinese corporate profits have clearly decoupled from the wider economy. Unfortunately it has been the wrong sort of separation. Profits at industrial firms slumped -2.2% YoY during 1H12, down from 29% growth in the same period last year. Worryingly, sectors such as steel, which have benefitted from China’s investment-driven boom, have seen profits entirely evaporate. By contrast, the wider economy chugs along with steady if unspectacular growth; fixed asset investment held steady in July, although industrial production growth eased back to 9.2%. So what gives?
China bears will point to weakening profit growth as an indicator of a more pronounced economic slowdown than revealed by official data. We do not hold to that view, but would concede that Chinese equities face headwinds during a period of economic re-balancing . The reason to buy them is more prosaic—after a severe inventory adjustment equities should benefit from a normal cyclical recovery during the latter part of the year.
Chinese industrial profits plunged because of a rapid normalization of growth following the 2008/09 stimulus-induced boom. The result has been an inventory build-up and falling prices in many industrial categories. Manufacturers suffered an intense margin squeeze because input prices were slower to adjust. And even though final demand weakened through 2011, manufacturing investment rose by more than 30%. This was largely the result of credit being readily available via the shadow finance system even though the central bank executed a substantial monetary tightening throughout the period. The come-down has been harsh, with heavy industry seeing profits especially mauled.
Our relative optimism stems from the fact that the necessary correction in activity is well advanced. Earlier this year, the cost of inputs such as raw materials and labor were rising by more than two percentage points above top line growth. Today, input price rises have moderated resulting in the gap easing to less than 0.5pp. Should this trend continue, which is likely after a lengthy process of inventory reduction, then cost pressure should, by late this year, cease to be a drag on operating profits.
Chinese companies should also benefit from credit easing measures since the authorities are starting to rely on conventional monetary tools, such as interest rate adjustments, to fine tune policy. A reliance on monetary tools such as loan quotas and RRR adjustments is no longer working since the weaker growth environment means the object of policy is not to ration credit growth—but, instead, stimulate its use. This was shown by today’s announcement of weaker than expected loan growth in July. While the effect of demand stimulus has yet to be seen, company financing costs grew by 35% YoY in 1H12, so easier credit conditions will clearly give a boost to operating profits. We would expect the interest rate cuts announced in June and July to register on the corporate bottom line in 2H12.
Our point is not that Chinese industrials will quickly return to double-digit profit growth. After all, Beijing’s Keynesian policies have their limits and, in our view, the economy is going through a major structural change. However, the valuation compression of cyclical stocks appears overdone, certainly relative to highly valued sectors such as consumer staples. Hence, for those investors who believe that economic growth can muddle along over the next few years, then clear value opportunities are present.
Disclaimer: This information may not be construed as advice and in particular not as investment, legal or tax advice. Depending on your particular circumstances you must obtain advice from your respective professional advisors. Investment involves risk. The value of investments may go down as well as up. Past performance is no guarantee for future performance. Investments in foreign currencies are subject to exchange rate fluctuations. Marcuard Cyprus Ltd is regulated by the Cyprus Securities and Exchange Commission (CySec) under License no. 131/11.
