China Macro-Thoughts on earnings cycle:A new start

Further good news from the NBS, which released the 1Q & March financialresults for China’s industrial companies today. After six disappointing quarters,the growth of industrial earnings jumped to 7.4% yoy in 1Q16 from -3.6% in4Q15 (Fig 1). In March alone, industrial earnings increased by 11% yoy. As ahigh-frequency proxy for listcos, today’s data suggest that China equities wouldsee improved earnings growth for 1Q16 (Fig 2) (detailed breakdown on p2). Butit could tell us more.

Why did industrial earnings rebound in 1Q16?

The question can be answered at different levels. At face value, the rebound isdriven by accelerated sales growth (1Q16: 2% yoy vs. 4Q15: 0%). It’s not thatsurprising as a company’s top line is driven by nominal GDP growth (1Q16: 7.2%yoy vs. 4Q15: 6.0%), which in turn is decided by eased PPI deflation (1Q16: -4.8%yoy vs. 4Q15: -5.9%), and a pick-up in investment demand on infrastructure(1Q16: 19% vs. 4Q15: 16%) and property (1Q16: 6% vs. 4Q15: -3%). SinceChina’s industrial companies tend to have high operating leverage, the rebound inthe top line boosted the bottom line growth in 1Q16.

From a longer-term perspective, today’s industrial earnings might be thebeginning of another stage of earnings growth. Looking back, 3Q14 is awatershed moment when the Chinese economy was hit by adverse shocks bothinternally and externally. Internally, the property sector, which is the mostimportant industry in China, just began a downturn which only bottomed in 4Q15(Fig 3). Externally, as the Fed exited QE3, China’s FX reserves peaked in June2014 and the oil price started to collapse at the same time (Fig 6). Together, thisled to a prolonged inventory destocking cycle which is still dragging on (Fig 4).

Indeed, the previous downturn was so grudging that cyclical stocks lost favourfor a long time.

A blip or a new trend?Given the earnings rebound in 1Q16, now the question is whether the currentearnings recovery can sustain or not. In other words, whether we will have a fewquarters ahead in a row with positive industrial earnings growing? There aresome positive signs: (1) Property investment growth seems to have bottomed in4Q15 (Fig 3). If new starts grow 5% for the whole year (+19% yoy in 1Q16),annual property investment could reach +7% (+1% in 2015). (2) This March, PPIsaw positive month-on-month growth for the first time since Dec 13 (Fig 5). (3)While the inventory destocking since 3Q14 is continuing, it could reverse anytime soon on improved demand and higher prices. (4) Globally, oil prices arerising amid the weak dollar lately. China’s oil companies still lost money in 1Q16due to the 40% yoy drop in oil prices. However, if oil prices stay at the currentlevel of US$46, the yoy comparison would become flattish in 2H16 (Fig 6).

Risks: Oil price and property.

Risks are from both the upside and downside. Externally, the swing factor is theoil price. Internally, the game changer is the property sector. Event risks may notbe negligible as well, as shocks like the “credit crunch” in June 2013 and theunexpected depreciation last Aug would significantly increase the uncertaintyfaced by corporates and impact negatively on their investment decisions.