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China’s PPI peaks, but lopsided recovery continues

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Chi LO
 

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Pressure appears to be building for the People’s Bank of China (PBoC) to shift its tighter policy rates stance to an easing bias in coming months.

The rational for this includes:

  • The ongoing lopsided economic recovery (with tepid demand growth)
  • Financial stress with corporate defaults expected to rise due to Beijing’s deleveraging drive and the tightening of regulatory measures
  • Producer price inflation (PPI) is peaking on the back of muted consumer price inflation.

Such a shift in the PBoC’s policy stance is not yet a consensus view.

Lopsided recovery continues

The latest macroeconomic indicators for May 2021 show that China’s economic growth remains uneven, with the recovery of the demand side of the economy (e.g., retail sales) still lagging the production side (industrial output).

A still resilient property market, which Beijing has vowed to slow down, and robust export growth, as production in the rest of the world still lags China’s, have supported much of the fixed-asset investment growth.

Adjusting for the Covid-19 effect by comparing May 2021 with May 2019, all major indicators were weaker than the May year-on-year (YoY) headline growth rates (see Exhibit 1).

Exhibit 1 - Growth of China's key macro indicators - lopsided recovery continues

PPI not filtering down to CPI

Meanwhile, the PPI surged by 9.0% YoY in May while CPI only rose by 1.3%, with core CPI at just 0.9%. This implies that margins continued to have been squeezed at Chinese companies. [1]

This appears to have been manageable. In our view, the fact that despite the profit squeeze, Chinese stocks have been range-trading since the Chinese New Year instead of falling (see Exhibit 2) shows that companies have been able to offset the effects of the lower margins by improving operating efficiency.

Exhibit 2 - Chinese stocks have been trading sideways since the Chinese New Year

Supply-side competitiveness does not solely determine profitability. Demand also plays a crucial role. During the pandemic, demand for consumer staples, healthcare, IT, etc. was strong and less elastic, giving these sectors more pricing power than sectors such as cars, food and beverage, and travel, which saw demand plunge.

Companies with strong pricing power under China’s inflation conundrum should continue to outperform the market.

Analysts expect PPI inflation to peak soon due to a fading base effect and some normalisation in commodity prices as the global supply chains improves.

Meanwhile, consumer price inflation is expected to remain muted, at 1.4% YoY by my forecast for this year, due to a sluggish recovery in consumption.

Consumer spending has been hurt by rising financial stress stemming from Beijing’s deleveraging and structural reform policies that are pushing default rates higher and creating uncertainty about income growth.

Implications for stocks and bonds

The pass-through of higher production costs to consumers has been, and will likely remain, limited in China as there are no demand-pull inflationary pressures. So if the market is right about PPI peaking this summer, the squeeze on company profits should ease, creating a benign environment in the second half of 2021 for Chinese stocks.

If our expectation of a PBoC policy shift towards an easing bias also plays out in coming months, conditions for Chinese stocks should improve further on the back of a boost to liquidity. This should translate into lower bond yields later this year after a near-term rise due to rising financial stress from the expected defaults.

The unfolding economic trends favour an easing bias for monetary policy over the current tightening bias. We see no grounds for monetary tightening.

[1] See “Chi Time: China in the Global Inflation Scare”, 25 May 2021.


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