"It Appears China Has Sent The World A Prodigious False Reflation Signal"

Some material observations on China's latest inflation data from Axiom's Gordon Johnson.

QUICK THOUGHT: Overnight, China released CPI (a measure of the prices consumers are paying) and PPI (a measure of the prices producers, or the guys that make the stuff the consumers buy, are paying). In short, China’s PPI soared to +7.8% y/y (vs. +6.5% y/y last month), while CPI cratered to just +0.8% y/y, following last month’s +2.5% y/y growth.

OUR VIEW: As we have espoused for some time now, we believe the strength in China’s metals prices (which also drive global metals prices) has been driven by speculation at all levels to include steel/iron-ore mills, traders, and port stockers, all of whom are sitting on/near record levels of inventory at present (due to both hopes around Trump pushing global demand for metals [we firmly believe this view is wrong as China, not the US, is the majority consumer of many of the metals the define our coverage universe], and a reflation trade in China taking hold). We also believe a number of supply-side policy errors in China (see coking coal prices) have contributed to the rise in commodity prices – evidenced by comments from the NDRC earlier this week, where they stated that they will not re-impose the 276 day production limits that caused coking coal prices to spike last year, it appears that the technocrats in the ruling Chinese communist party see the error in their supply side efforts from last year.

Yet, as evidenced by the sharp contraction in China’s y/y PPI growth in Feb. ’17 (down to JUST +0.8%, from +2.5% in Jan. ’17), it appears that there is virtually no price pass through anywhere in the production chain in China. At risk of stating the obvious, this is not sustainable, as the people who actually sell the stuff that requires the steel, iron ore, coking coal, copper, etc. are seeing their margins squeezed as a result of rampant speculation in commodity markets (fueled by excess liquidity “sloshing” around), NOT END MARKET DEMAND.

This also suggests, as evidenced by China’s release of its Total Social Financing for Feb. ’17 this morning (where the actual number of CNY1.150tn missed the Consensus estimate of CNY1.450tn), further hopes for credit impulses from the PBoC will prove futile – credit is the life’s blood of China’s economy.

In short, we believe this year’s playbook is the opposite of last year. That is, last year, in the first three months of the year, the bears (us included) were calling for further declines in industrial/commodity stocks, after they had been annihilated in 2H15, ignoring the many loosening efforts that had been put in place in China starting in Sep. ’15. Contrastingly, however, in Sep. ’16 China began to tighten everything from housing to futures trading, and even more recently put restrictions on Wealth Management Products (“WMPs”) and, in an unprecedented move, the asset management industry (link). Still, today, investors are ignoring these measures, which we did last year, causing us to miss the trade of the decade (i.e., being long everything tied to commodities); thus, this year, we are not ignoring these signals from the Chinese government; net, net we feel this year is going to be defined by a massive destocking of inventory across a number of metals in China (steel, iron ore, copper, coking coal, etc.) creating the potential shorting opportunity of the decade – China, NOT THE US/Trump, is what matters for global steel and mining/industrial stocks (we feel many investors have lost focus of this fact).

HOW TO PLAY THIS THEME? On this theme, we think now is the time to be putting money to work shorting Rio Tinto (RIO; SELL) Fortescue (FMG: SELL), Cliffs Natural Resources (CLF; SELL), Caterpillar (CAT; SELL), US Steel (X; SELL), United Rentals (URI; SELL), GATX (GATX; SELL), and Trinity (TRN; SELL). We believe many still expect reflation to define this year; however, as the DATA today in China suggests, we believe these views are going to be met with a harsh reality. Caveat emptor. 

Exhibit 1: China CPI vs. China PPI – rarely, since 2008, has CPI exceeded PPI

Source: China National Bureau of Statistics, Axiom Capital research.

Exhibit 2: Components China CPI

Source: Macrobusiness, China National Bureau of Statistics, Axiom Capital research.

Exhibit 3: Components China PPI


Source: Macrobusiness, China National Bureau of Statistics, Axiom Capital research.