It All Begins And Ends With China: "Is The Global Reflation Cycle Ending?"

Submitted by Gordon Johnson of Vertical Research Group


Last night, China released factory inflation numbers (i.e., PPI), which slowed for a fifth straight month in Mar. ’18… marking the slowest Y/Y growth rate since Oct. ’16 (Exhibit 1). Similarly, the Mar. ’18 consumer price index (“CPI”) retreated from the four-year high set in Feb. ’18 (Exhibit 1).

Interestingly, we note that the Mar. ‘18  +2.1% Y/Y growth in China’s PPI missed Consensus’ expectation of +2.6% Y/Y growth, while the Mar. ’18 +3.1% Y/Y growth in China’s PPI also missed Consensus’ forecast of +3.3% Y/Y growth.

Exhibit 1: China’s Inflation Gauge – CPI vs. PPI Indexes

Source: National Bureau of Statistics, Vertical Group.

WHAT’S DRIVING COMMODITY-PRICE DEFLATION IN CHINA? As we’ve argued before, and as noted in Exhibit 2 below, it appears the swift collapse in China’s credit impulse (i.e., a fancy way of saying China is issuing less debt as a % of GDP) is driving a correction in China’s commodity consumption. Why does this matter? Well,  in our view, steel price strength in 2017 was due to China’s steel exports falling 33.4Mmt, or the second largest decline ever, trailing only that seen in 2009 (Exhibit 5) – China produces roughly half of world’s steel, meaning when they export less, global prices rally. While the driver in 2009 was the global financial crisis (“GFC”), the driver in 2017 was a record credit stimulus in China (i.e., $4.9tn in new credit issued) driving domestic demand, and thus boosting domestic Chinese steel prices. So, in general, while in most years China’s steel prices lag the rest of the world, in 2017 they were much higher; this, in turn, pushed mills in China to ship more domestically vs. to other countries, and thus drove up global steel prices –given China was >50% of global steel production in 2017, this had a big impact on global steel prices. However, this dynamic is now in reverse (Exhibit 6), which we believe forebodes risk to global steel prices.

Exhibit 2: China's Credit Impulse Y/Y% vs. Metals Commodity Index

Note: Credit impulse = (total social financing [net of non-financial equity] + local government debt issuance) ÷ nominal GDP; all metrics are trailing 12-month. Source: People's Bank of China, National Bureau of Statistics, Bloomberg, Vertical Group.

Furthermore, as it relates to the “synchronous recovery” meme, after falling in both Jan. ’18 and Feb. ’18, the JPM Global PMI plunged  by -0.7% Y/Y in Mar. ’18, dropping by the most in any single month since 1Q16’s global growth scare (Exhibit 3). While, admittedly, some of the weakness in Mar. ‘18’s global growth could prove temporary, with such a broad-based weakening across a number of countries, we surmise that global growth has indeed peaked (this is not Consensus).

Exhibit 3: JPM Global PMI - 5 month low in Mar. '18

Source: JPM, Bloomberg Vertical Group.

CONCLUSION. When analyzing China’s Mar. ’18 PPI internals, looking to see what drove such weakness in China’s factory inflation numbers (Exhibit 7), it becomes clear that price deflation across the raw material and basic industrial complex was among the key drivers. Consequently, given China’s PPI is an excellent leading indicator into how China’s industrial economy is fairing, and also considering China’s Mar. ’18 Caixin Manufacturing PMI missed Consensus’ estimate (i.e., 51.0 vs. Consensus’ 51.7), we believe the 2018 “China slowdown” meme is firmly intact (we remind our readers that China consumes the bulk of the worlds commodity-metal output). Consequently, while China’s Mar. ’18 excavator sales growth rate of +78.9% Y/Y got a lot of people excited this weekend (we received a number of inbound emails asking our opinion on this surprisingly strong number), China’s loader sales fell -50.3% Y/Y in Mar. ’18 (i.e., the weakest growth in any single month since 4Q15’s global growth scare) and China’s Mar. ’18 crane sales growth fell to -12.8% Y/Y, or the weakest rate of growth in 17 months.

As such, while China’s Mar. ’18 excavator sales numbers were admittedly strong, as displayed in Exhibit  4 below, given virtually all the prior spikes (and collapses) in excavator + crane + loader sales happened in unison, we feel the Mar. ’18 excavator strength is likely the outlier given acute weakness in both China’s crane and loader Mar. ’18 segment sales.

On the back of this data we would be adding to metals/mining and industrial shorts. The reason is simple… i.e., a growing slowdown in China’s industrial economy is likely to push commodity prices lower through 2018 (the data continues to support this view). Caveat emptor.

Exhibit 4: China Construction Vehicle Sales - %Y/Y

Source: Hong Kong Teng Yuan Co. Ltd., Vertical Group.

Exhibit 5: Chinese Steel Exports

Source: China customs general administration, Vertical Group.

Exhibit 6: Chinese Steel Prices – Rebar, HRC, and Billet

Source: China customs general administration, Vertical Group.

Exhibit 7: China Mar. ’18 PPI Internals