Submitted by Gordon Johnson of The Vertical Research Group
QUICK TAKE:In short, our thesis is that city-level and regional macroprudential tightening policies in China currently will render economic growth in 2Q18, but more importantly 2H18, dismal; we believe this will spread to emerging markets, rendering the “global coordinated growth” bulls out of sync with reality. This, we believe, in turn, will weigh on metals prices, pushing many of the commodity pundits (i.e., Jeffery Gundlach) to reassess their bullishness. As this happens, we expect steel/bulk exports out of China to rise (as profitability domestically falls with weakening domestic demand) pushing global bulk commodities prices lower.
Exhibit 1: China Total Credit Growth versus Bank Asset Growth, %Y/Y
Source: Peoples’ Bank of China (PBOC), Vertical Group.
Exhibit 2: It Appears Emerging Markets are no Longer “Feeling the China Love”
So how do things look at this juncture? Well, below we highlight the key takeaways from China’s April 2018 data dump. However, in short, looking at the below data in aggregate, we believe our thesis remains firmly intact; furthermore, in checks “on the ground” in China this week, we learned that the Consensus among domestic traders is that steel prices in China have “peaked” for the year as of this week.
GROWTH INTERNALS. As detailed below, while Y/Y industrial production growth edged higher to +6.9% in April 2018 (from +6.8% in March 2018), the all-importantFixed Asset Investment metric in China hit lows not seen in nearly two decades (at +7.0% Y/Y for April 2018 vs. +7.5% Y/Y in March 2018), while retail sales also dipped lower in the month of April at +9.4% Y/Y (vs. +10.1% Y/Y in March 2018). At risk of stating the obvious, at the margin, this suggests to us that China’s key growth internals are indeed slowing.
Exhibit 3: Growth Internals – China (FAI, Industrial Production, & Retail Sales)
CONSTRUCTION ACTIVITY. Taking a closer look under the hood, we notice real estate floor area sales slowed incrementally in April 2018 up just +1.3% YTD (vs. +3.6% YTD Y/Y in March 2018), and fell a concerning -4.1% Y/Y for the month of April 2018.
Exhibit 4: China Residential + Commercial + Office Space Sold
However, when looking to new starts, while growth did slow to +7.3% Y/Y in April 2018 from +9.7% Y/Y in March, this rate of progress remains comfortably above the +2.9% Y/Y growth seen in Feb. 2018 (although, with credit growth in China on the decline, we see this metric disappointing throughout the remainder of 2018).
Exhibit 5: China Residential + Commercial + Office Construction Starts
Total floor area under construction saw YTD Y/Y growth edge higher to +1.6% from +1.5% in March 2018. However, we feel this metric will move towards 0% by year end (floor area under construction typically follows sales growth; and sales growth is currently consolidating at an accelerated clip – Exhibit 4).
Exhibit 6: China Residential + Commercial + Office Space Under Construction
What is the culprit for this slowing? Well, as our readers know, in addition to weakening overall credit growth (Exhibit 1), city-level and regional macroprudential policies have tempered mortgage lending in the world’s second largest economy – this tends to bode ill for overall real estate activity.
Exhibit 7: Household Loans, Y/Y%
More to the above, first tier cities are in a slow melt while lower tiers are growing at sustainable levels; so from the PBoC’s perspective, there’s really no real reason to shift policy either way yet; and if it comes, adjustment will much more likely be the removal of local lending restrictions than interest rate cuts.
The third key signal is deficit spending, and especially infrastructure. You’ll see lots of announcements from the National Development and Reform Commission (“NDRC”) and spikes in credit drivers… not in bank or shadow-bank lending, but the bond markets. So how are the bond market fairing? Well, China government bond issuance saw growth slow to +23.0% Y/Y in April vs. +24.0% Y/Y in March, and China corporate bond issuance fell from -1.7% Y/Y to -3.9% Y/Y over the same timeframe.
Exhibit 8: Chinese Bond Issuance, Y/Y%
What about Open-Belt-Open-Road (“OBOR”)? Well, here’s a look at infrastructure investment, where it seems China has really slowed things down (manufacturing and real estate are not fairing that well either).
Exhibit 9: China Fixed Asset Investment, Y/Y%
OTHER INDICATORS. On the positive side, it seems construction activity did indeed pickup in April (albeit, Y/Y growth slowed from the records seen last April – April marks the peak of China’s construction season, so this data point could be a bit backward looking).
Exhibit 10: China Construction Vehicle Sales, Y/Y%
What about the other data points?
Exhibit 11: Evidence of Seasonality in China’s Manufacturing PMI Survey
Exhibit 12: Industrial Output Volumes, Y/Y% (cement lagging + steel leading = potential for steel price correction)
Exhibit 13: China Li Keqiang Index
Note: Chinese Premier Li Keqiang once remarked to a U.S. diplomat that China’s GDP data was “man made”. To track growth he preferred to look at change in bank lending, rail freight, and electricity consumption. This ticker takes a weighted average of annual growth rates in outstanding bank loans CNLNTTLY Index DES <GO> (40%), electricity production CZINELEC Index DES <GO> (40%), and rail freight volume CHTPFR1Y Index DES <GO> (20%). Electricity production is used rather than electricity consumption as they are conceptually similar and a longer historical series exists for electricity production. Source: CEIC, Vertical Group.
Exhibit 14: Inflation Gauge – Consumer & Producer Price Indexes
Exhibit 15: Average Price Change of New Residential Buildings, by Tiered-Cities, Y/Y%
Exhibit 16: JPM Global PMI – just off Mar. ’18 five month low
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CONCLUSION: China will likely continue to slow, yet it seems the PBoC has a good handle on its targeted slowdown, making the need to rush in with “bazooka” stimulus unnecessary right now (in our view, that is). Will it happen? Based on history, of course it will (as it always does). But are we there yet? We think not. Translation… more pain to come before Xi Jinping “rides to the rescue of bulk commodity bulls”, meaning as the summer slow-down sets in, steel/iron-ore prices likely have acute downside risk (this is not Consensus at the moment – see Jeffery Gundlach’s comments from the Sohn conference several weeks ago).