China: Q2 Early Look Brief
Second Quarter 2017
By Leland Miller and the staff at China Beige Book
Executive Overview
So far, 2017 has played out as a
best-case scenario for China’s economy. The remarkable absence of both domestic
(more foolish financial policies) and foreign (Trump tariffs) shocks has
created the stable environment corporates need to outperform most expectations,
including ours.
This fortuitous run continued for
at least one more quarter. China
Beige Book’s new Q2 results show an economy that improved again, compared
to both last quarter and a year ago, with retail and services each bouncing
back from underwhelming Q1 performances. Manufacturing’s rally has now
surpassed the one-year mark. Commodities surprised to the upside, despite
significant price volatility in April. All this outmatched a slowdown in
property and enabled hiring to improve almost across the board.
Three developments are worth extra
emphasis. Any worries the leadership had about the labor market prior to the
Party Congress have likely evaporated, with hiring improving on an already
solid Q1 – both nationally and in all the major sectors. Claims of fading
Chinese manufacturing turn out to have been premature, and new orders say at
least another quarter of solid expansion is coming. And, while it’s only one quarter, it was all
accomplished despite the initial signs of deleveraging – interest
rates spiked and borrowing edged down. Facing the challenge of a very poor
start to 2016, the Party has turned the economy back in the right direction,
with time to spare.
Even in Beijing, though, there is
no free lunch. Companies across the economy understand that 2017 needs to be a
strong year economically and are storing problems away for the future.
Literally – inventories hit their highest levels in the history of CBB data,
both nationally and in every sector. The
same companies who report solid results on most indicators also continue to
show cash flow in the red – corporate health has not yet responded to better
growth. And property continues to make investors nervous. As we
predicted last quarter, the sector as a whole weakened noticeably despite a
major turnaround in residential construction.
The credit market is also a source
of heartburn. Firms did not report higher borrowing costs in Q1, but they
certainly did so in Q2. Either firms expect the spike to be temporary or they
are bearing up under the strain temporarily for political reasons. Either way,
China has not yet even begun to face the pain from deleveraging, so the
commitment to do so remains very much in question. It remains true that either
rates have to come plunging back down, as the NDRC recently called for, or the
present level of corporate activity is headed for a cliff. Today’s feast may
have been bought with tomorrow’s lunch money. But for now, we toast the solid
quarter.
Key Themes
Goldilocks Still Skipping
Along.
For the economy, this may be as
good as it gets for a while, but right now it’s pretty good. Policy support, no foreign shocks, no
one wanting to rock the boat ahead of the Party Congress. The
economy a year ago was much weaker than commonly thought, so merely on-year
gains wouldn’t be impressive. But the economy a quarter ago was fairly active
and this quarter is more so, on multiple dimensions. Revenue growth accelerated
(though see inventories). Sales price gains eased fears of deflation harming
growth. Most important, hiring strengthened again. This might be politically
influenced, and thus temporary, but it already constitutes a political success.
Moreover, with the labor force shrinking, a drop-off from the current hiring
pace wouldn’t be a concern. On the whole, the second quarter is a very nice
baseline for Beijing to be working from.
Why Rebalance When You Can
Have Both?
The second quarter saw minimal
progress in moving away from manufacturing toward services leadership in the
economy. This was an
excellent failure, however, since services performed well and manufacturing
almost as well. Manufacturing tapered but extended its powerful
rally since the first half of 2016. Revenue, hiring, and new orders were all
higher on-quarter and sharply higher on-year. Still, services outperformed
manufacturing in revenue and profits. Hiring in services has been uneven, but
Q2 was solid.
Commodities Surprises to the
Upside.
Defying early signs of a slowdown,
our biggest Q2 surprise was another robust performance in commodities. Make no
mistake, the warning signs look like Times Square: the second quarter saw huge
across-the-board jumps in inventory, sliding sales price growth in three of
four sub-sectors, and rising input costs. Yet, more firms again saw rising
sales prices than input cost hikes, sales
volumes accelerated, and cash flow moved from red to black, bolstering balance
sheets.
Away from Markets’ Gaze,
Aluminum Shines.
Commodities’ unsung hero: aluminum.
CBB data show aluminum
firms wildly outperforming the current market narrative, seeing
broad Q2 gains in revenues, profits, volumes, output, and new orders, as well
as cash flow, which jumped into the black for the first time in our survey’s history.
The why is less
clear than the what, but
one obvious possibility is aluminum is the latest recipient of some of China’s
excess liquidity. The #moneyball may have struck again.
Property Slows Off its Q1
Peak.
As we forecast last quarter, the
property sector weakened, growth slowing in three of five sub-sectors.
Transportation construction drove the deterioration with commercial realty and
construction piling on. The extent of the pain may have been masked by better
results on the residential side. Overall revenues and profits plunged in Tier 1
cities, with the slowdown concentrated primarily in the Beijing and Shanghai
regions. Hiring stagnated, while cash flow worsened across the board. It is the credit picture, however, that
looks most daunting. Borrowing completely cratered outside of
residential construction, as rejections jumped and shadow banks suddenly
refused (or were ordered not) to backstop the sector. Reflecting this disfavor,
the relatively few property firms that were able to issue bonds this quarter
paid through the nose – the highest yields ever seen in the CBB survey.
Inventory Levels Notch
All-Time High.
The single most worrisome
development is the level of inventories, which hit an all-time CBB high
nationwide in the second quarter. The
three sectors tracked– manufacturing, retail, and commodities – also each saw
all-time highs. Inventories can stay elevated in China’s mixed
economy for far longer than market economies, but they still represent either
more waste and debt or a painful hangover that will drag down future growth.
No Fun in Shanghai.
Two high-profile regions marked a
comeback after several quarters of lackluster performance. Guangdong turned in
the strongest revenue and profit result while Beijing posted the largest
on-quarter improvement in each. Shanghai
missed the dragon boat, turning in the lowest growth figures nationwide. Inland
provinces at least matched Q1, with the Center in particular reporting faster
revenue growth. Even with its stellar results, though, Guangdong probably isn’t
celebrating too loudly: companies in the region are China’s most sophisticated
in terms of accounting practices and they report the country’s worst
deterioration in cash flow.
The Right Kind of Inflation.
Unlike cash flow, the inflation
picture has tilted away from stress toward health. The main reason is retail,
which had the largest gains of any major sector in revenue, profits, and
hiring. The hiring contributed to the strength economy-wide that pushed up wage
payments by firms. In light of stated goals of reducing inequality and boosting
consumption, this is a clearly positive development. Another element of good
inflation is directly connected to retail: sales price increases continued in
Q2, a sharp contrast to the weakness in 2014-15. Retail results show people are still
buying despite rising prices. Higher input costs are harder to
explain but were concentrated mostly in property. Input cost inflation was mild
in retail and services and nearly invisible in manufacturing.
Borrowers Comforted by “Party
Congress Put.”
China’s attempt at deleveraging has
been discussed to no end, but its implications are not well understood. In Q1,
corporate reporting to CBB showed credit tightening was limited to interbank
markets. In Q2, it hit firms: bond yields and rates at shadow banks touched the
highest levels in the history of our survey, and bank rates their highest since
2014. So why did borrowing not collapse, denting the broader economy? One
reason is what we call the “Party Congress Put.” While borrowing did see a mild
drop for the third straight quarter, companies’ six-month revenue expectations
remain robust in every sector save property. Companies assume deleveraging is
transient, likely because they are skeptical the Party will allow economic pain
in 2017. It will not be
until 2018 when we find out whether deleveraging is genuine – because it won’t
be until 2018 that it will actually hurt.
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