China Market Strategy Hao Hong, CFA The Reflation Trade Is...

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07 March 2017

China Market Strategy Hao Hong, CFA

[email protected]

The Reflation Trade Is Over; Get Set for Defensive Rotation.

Summary: China’s reflation trade, as measured by the relative performance of cyclical vs. defensive, has peaked last summer. At

the time, the intensity of upstream commodity restocking also rolled over. For China, the reflation trade has long been over –

contrary to consensus. Further, PPI inflation is surging globally, and cannot be explained by the supply-side reform in China.

When Chinese cyclical’s relative performance and upstream commodity inventory cycle peaked historically, it means fading

momentum in the upward thrust of commodities, China’s 10-year treasury yield and US cyclical’s relative performance, rising

real interest rate, as well as peaking Chinese property cycle. And the cyclical recovery that consensus is raving about will lose

steam in the coming months. Indeed, defensive rotation in overseas markets will likely be concurrent with volatility surge, but

may or may not correspond to the market’s final peak. Together with buoyant expectation, Chinese markets are vulnerable to a

contagion.

------------------------------

Where will the reflation trade go from here? Since our special presentation titled “A Price Revolution” at the West Lake Hedge

Fund Summit on November 7, 2016, global inflation has surged back in earnest, together with commodities and stocks (please

refer to “A Price Revolution” on 20161114). Our view is that productivity gain outpacing labor wage growth has helped keep

inflation in check in the past three decades. But wage growth recently has been faster than productivity gain. Inflation will be

back globally. At a recent cyclical strategy summit graciously hosted by one of China’s largest brokerage houses, we took the

opportunity to reflect upon the reflation trade so far, and pondered on its future direction. What follows is a summary of our

thoughts shared at the summit. We have plenty of contrarian findings.

Inflation is a global phenomenon.

Inflation surge is a global phenomenon; China’s supply-side reform and infrastructure spending cannot explain this

phenomenon in full. Consensus cites China’s supply-side reform as the reason for the commodity rally. However, we note that

the surge in PPI is a global phenomenon. Spain, for instance, is seeing its PPI surging to 7%, without any supply-side reform - a

level even higher than that of China (Focus Chart 1). Even with China’s ambitious supply-side reform to reduce steel capacity

significantly, China’s steel output reached historical high in 2016, hinting at the elasticity of capacity utilization that will not

automatically disappear with the supply-side reform, as well as the broken relationship between the reform and commodity

prices. The soaring global trade, a consistent leading indicator of PPI, augurs for further PPI inflation ahead globally (Focus Chart

1).

http://researchreport.bocomgroup.com/Strategy-161114e.pdf


China Market Strategy 07 March 2017


2

Focus Chart 1: PPI soaring globally; Chinese PPI approaching the 2009 recovery high.

Source: Bloomberg, Bank of Communications (Int’l)

Meanwhile, China’s Two-Session’s economic targets for 2017 over the weekend underwhelmed. GDP is targeted at around 6.5%,

inflation 3%, M2 12%, TSF 12%, and railroad and road investment mostly flat Y/Y at 800bn and 1.8tn, respectively. And fiscal

deficit is planned at 2.38tn. These figures are below consensus’ heightened expectation for large deficit spending. And the

monetary target suggests more prudent policy than hoped. The government will continue to rein in property bubble, while

pushing 3/4-tier cities to destock their housing inventories. It would be difficult to derive outright bullish conclusions regarding

commodity prices and a cyclical recovery.

China’s upstream inventory cycle is a consistent global long leading indicator.

China’s upstream inventory cycle is a long leading indicator for asset prices. And it’s peaking again. Our research shows that

China’s upstream inventory cycle is a long leading indicator of the cycle in the US dollar and China’s real interest rate by about

three to six months, China’s stock market by up to twelve months, and Chinese property even longer. Unlike some pundits’

subjective interpretation of China inventory cycle, the upstream inventory cycle in China we observed can be shown clearly and

graphically (Focus Chart 2). It has been in place consistently for well over a decade, and demonstrated a consistent property of

leading the cycles in other asset classes. Its lead over the other asset classes is even longer than China’s real interest rate cycle, a

leading indicator we have discussed for a few times in our previous report. (Please refer to “Sweet and Sour Hog Cycle”

20160418. This report marked a significant local peak in China’s iron ore and rebar prices).

Intuitively, upstream inventory is the most sensitive to the changes in the economy. Such sensitivity gives the upstream

inventory cycle its property as a long leading economic indicator. As producers and merchants expect an economic upturn, they

express their expectation by replenishing inventory. Their restocking activities can then set the tone for other interest parties in

the economy, and initiate a virtuous cycle as the upstream restocking effects flow through unto mid and down stream industries,

and vice versa.

Real interest rate has bottomed; property cycle peaked; stocks upside limited. China’s upstream inventory cycle is peaking

soon. If history is a guide, we believe China’s real interest rate has bottomed, and monetary conditions will be tighter in the

coming months. Record-low and falling real interest rate is the real determinant of the rise in asset prices. As interest rates fail

to keep pace with inflation surge, lower real interest rate means higher asset prices. It is the case globally. As liquidity

becomes less abundant on the margin, how China’s stock market performs will depend on the pace of earnings revision relative

to the speed of valuation shrinkage in a tighter liquidity environment. As the momentum in earnings revision fades, stocks’

upward thrust will likely wane in the coming months. We will discuss later how earnings revision has soared, and it is a reflection

of market buoyancy. Meanwhile, the property cycle has clearly peaked, and will likely decelerate further in the coming months,

as property curbs press on (Focus Chart 2).




3

Focus Chart 2: Cycles in various asset classes in China intertwining across time, with upstream inventory cycle leading


Upstream inventory exhibits strong seasonality; likely peaking around mid March: We have also found strong seasonality in

rebar inventory cycle – it tends to build up during the first quarter of every year, and then gradually depletes for the rest of the

year (Focus Chart 3). Importantly, of the ten restocking cycles in the past decade, only the cycles in 2007, 2009, 2011 and most

recently 2016 did not completely deplete the inventory accumulated during the year by year end. Before 2016, these inventory

cycles tended to be two years apart, denoting the length of the cycle completion. Each of these heightened inventory cycles in

Focus Chart 3 corresponds to the peak years seen in Focus Chart 2. The upstream inventory cycle in 2009 is most unusual, with

significant excess inventory left at year end – most likely the aftermath of the 4-trillion stimulus pact.

Focus Chart 3: The strong seasonality in upstream commodity cycle - it is peaking again in mid March.


2016 again experienced a restocking frenzy, after five years of dormancy. Some investors asked whether the 5-year hibernation

would mean a stronger and longer restocking cycle. But we note that iron ore inventory at ports has reached new historic high.

Even if inventory level can continue to pile up, its speed of rising will decelerate, and the strong momentum in commodities will

likely wane consequently (Focus Chart 4).



4

Focus Chart 4: PPI highly correlated with commodity prices, of which overall price momentum is likely to wane soon.


China’s cyclical relative strength has long faded.

China’s cyclical relative performance peaked last summer; it consistently leads US cyclical and Chinese long yields. While the

heated debate about the reflation trade continues, China’s cyclical sectors’ relative performance had already peaked last

summer – at roughly the same time when the upstream inventory cycle peaked in 2016. This observation contradicts the general

sense in the market that cyclical sectors have outperformed. Given the close correlation of cyclical sectors’ relative strength with

the economic cycle, this observation also suggests that the so-called “cyclical recovery” is probably a chimera, and the

momentum in the current recovery is about to roll over in the coming months.

Focus Chart 5: Relative performance of Chinese cyclical leads China’s 10y and US cyclical relative performance by ~9m.


Surprisingly, our research reveals that the relative performance of China’s cyclical tends to lead US cyclical sectors’ relative

strength and China’s 10-year yield by around nine months (Focus Chart 5). The length of the lead time is consistent with the lead

time of China’s upstream inventory cycle over the other asset price cycles as aforementioned in Focus Chart 2. The relative

strength in Chinese cyclical over defensive measures the embedded investor expectation regarding growth outlook. It leads

economic growth by around nine months as well (Focus Chart 6). As growth outlook dims, bond yields and foreign cyclical



5

should fall, as China’s cyclical upturn fades. We believe that the momentum in the current cyclical upswing will wane soon. And

so will the upward thrust in China’s 10-year yield.

Focus Chart 6: The relative performance of Chinese cyclical is a long leading economic indicator.

Source: Bloomberg, Bank of Communications (Int’l).

The Chinese economy is stuck between reflation and stagflation; L-shaped since 2012. Focus Chart 7 outlines different phases

in the economic cycle that China has navigated through since the 2009 recovery. However, since 2012, the Chinese economy

appears to be stuck between reflation and stagflation, as highlighted in the red rectangle in Focus Chart 11. The path that the

Chinese economy has traversed since 2012 resembles the “L-Shaped” growth phase that has been discussed by the

“Authoritative Figure”.

These two economic phases hold different implications for asset allocation. When in reflation, the economy tends to see falling

interest rate, rising stock and commodity prices. But when in stagflation, falling FX reserve, tighter money and falling property

prices are more commonly observed. Recall in the past four years, China has indeed shown all of these symptoms. This empirical

evidence confirms the growth outlook implied by the relative performance of China’s cyclical sectors. Consequently, Chinese

equities have been stuck in a wide trading range, with bouts of volatility periodically.



6

Focus Chart 7: The Chinese economy L-shaped since 2012, and stuck between reflation and stagflation.

03/‘09

04/’09

05‘09

06/’09

07/‘09

08/’09

09/‘09

10/’09

11/‘09

12/’09

01/‘10

03/’10

04/‘10

06/‘10

05/’10

07/’10

08/‘1009/’10

10/‘10 11/’10

12/‘1001/’11

03/’11

05/’1106/‘11

07/’11

09/’1108/‘1110/‘11

11/’1112/‘11

01/’12

02/‘12

03/’1212/'12

03/'14

01/'13

09/'13

06/'14

07/'13

12/'13

01/'14

09/'12

09/'14

10/'14

12/'14

01/'15

04/'15

09/'15

06/'15

12/'15

03/'15

03/'16

04/'1609/'16

01/'17

10/'16

(2.0)

(1.5)

(1.0)

(0.5)

0.0

0.5

1.0

1.5

2.0

2.5

(3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0

Falling interest

Rate

Recovery Overheat

StagflationReflation

tighter money

Falling Property Price

Rising Property Price

Rising Interest Rate

Falling Stock Price

Falling

Commodity

Price

Falling Forex ReserveRising Stock Price

Rising

Commodity

Price

Rising Forex Reserve

Easier Money

Low

Growth

11/‘14

1st interest rate

cut; Bull market

kicked off

04/‘11 CRB

Index peaked

10/’10

1st interest

rate raised

01/’10

1st RRR

raised

08/‘09

IPO re-opened

06/‘13

Interbank

liquidity crisis

11/‘15

Commodity rebound

12/‘10

2nd time RRR and

interest rate raised

Low

Inflation

"L shape" economy

High

Inflation

High

Growth

Source: Bloomberg, Bank of Communications (Int’l).

Market expectation already revised up significantly; buoyant analyst sentiment.

Bottom-up analyst expectation soaring; cost pressure passing through from upstream to mid/down stream. We have

aggregated the earning estimates of more than 2000 listed companies, and categorized them into up, mid and downstream. We

find that while top-line expectation has been revised up, costs revision is even faster and higher, with upstream costs having

already risen, and midstream surging and starting to pass through to downstream (Focus Chart 8). Such cost pressure suggests

that inflation will eventually pass from producers to consumers, contrary to the consensus that CPI will diverge from the surging

PPI. Already, the non-food CPI has soared back to the highest level since 2011.



7

Focus Chart 8: Cost pressure pass-through from upstream accelerating unto mid/down stream

-30%

-10%

10%

30%

50%

70%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Market Upstream

Midstream Downstream

2016 Q4 ERevenue，yoy

Upstream

Midstream

Downstream

-30%

-10%

10%

30%

50%

70%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Market Upstream

Midstream Downstream

2016 Q4 ECOGS，yoy

Upstream

Midstream

Downstream

70%

75%

80%

85%

90%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

MarketUpstreamMidstreamDownstream

COGS/Revenue

Midstream

Downstream

Upstream

Market

2016 Q4 E

Source: Wind, Bank of Communications (Int’l)).



8

The observation that cost pressure is now with up and midstream, and will soon be passed onto downstream is consistent with

the PMI inventory indices. The PMI index of raw materials inventory, as well as that of non-manufacturing goods, has risen,

while finished goods inventory stays low (Focus Chart 9). Note that PMI is a survey-based measure, and thus a sentiment

indicator regarding the inventory outlook of line managers included in the survey. It is conceivable that once merchants start

restocking finished goods, prices of these goods will rise, and cost pressure will be passed through.

Focus Chart 9: Downstream inventory is low, but historically corresponded to stock market highs.

11/2008 7/2010 6/2011

12/2011

6/2012

10/2010 11/2009

40

42

44

46

48

50

52

54

Jan/05 Jan/06 Jan/07 Jan/08 Jan/09 Jan/10 Jan/11 Jan/12 Jan/13 Jan/14 Jan/15 Jan/16 Jan/17

Finished Goods Inventory

成品库存

Raw Materials Inventory

原材料库存

Source: wind, Bloomberg, Bank of Communications (Int’l)).

Overall market’s earnings estimate has surged back to the levels coinciding with previous market highs; cyclical estimates

revision stronger. The aggregated earnings estimate for the overall market has also surged, to a level similar to or higher than

those seen at various market peaks in the past (Focus Chart 10). Further, we note that cyclical sectors’ earning estimates have

been revised more than those of defensive sectors (Focus Chart 11). Surging revision of market earning estimates, as well as

stronger cyclical earning revision, hints at buoyant market sentiment. Should the reporting season turn out to be disappointing,

the market will be vulnerable to a fall.

Focus Chart 10: Market earnings expectation has surged to highs which previously corresponded to market peaks.

2000/1/31

2007/11/30 2009/8/31

2015/5/31

2016/9/30

2001/9/30

2005/6/30

2008/10/31

2011/9/30

2017/2/28

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Market 3-Mth Avg

Asian Crisis/

Russian Default

Global Financial

Crisis

European

Crisis

Source: FactSet, Bank of Communications (Int’l).



9

Focus Chart 11: Earnings expectation in cyclical surging faster than non-cyclical.

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Industrials 3-Mth Avg

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Materials 3-Mth Avg

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Information Technology

3-Mth Avg

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Consumer Discretionary

3-Mth Avg

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Real Estate 3-Mth Avg

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

9596 97 98 9900 01 02 0304 05 06 0708 09 1011 12 13 1415 16 17

Financials 3-Mth Avg

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Telecommunication Services

3-Mth Avg

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Health Care 3-Mth Avg

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

Utilities 3-Mth Avg

Source: FactSet, Bank of Communications (Int’l).

Focus Chart 12: The Shanghai comp likely trading range =3300+/-500 in 2017, 2/3 scenarios below 3300.


Note: valuation date was Dec 05, 2016. Please refer to our 2017 outlook report《High-wire Act》on Dec 06, 2016




10

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11

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