China's deflationary growth threatens profit
HONG KONG (MarketWatch) -- China may have reassured investors it has avoided a collapse in growth, but corporate profits and prices are increasingly taking the strain.
There was some relief as GDP growth came in at 7.6% in the second quarter, but the economy is showing new signs of falling into deflation. Some analysts argue China will now need much more aggressive interest-rate cuts.
In April, China's producer price index (PPI) quietly slipped negative, and this contraction has since gathered pace. In June, prices fell 2.1% year-on-year, suggesting a large part of the economy is already in deflation.
This is turning a number of brokers downbeat on earnings prospects.
Jefferies warns in a new strategy note that China is on course for a "hard landing" for corporate profits.
As a general rule, falling prices at the factory gate are bad for profits, especially when consumer prices are outpacing producer prices. China's consumer price index (CPI) inflation has been slowing, with the CPI rising 2.2% in June, down from 3% in May. At the same time, wages for factory workers have been rising at close to 20%.
Credit Suisse also flagged the impact of deflationary worries on corporate earnings. They reported quickening erosion in companies' pricing power as demand weakens, as well as a rapid deterioration in accounts receivables. This all means that the slowdown in the economy will put much greater pressure on company profits than on GDP growth.
One predictable cause of deflation in the Chinese economy is over-investment in industrial capacity. There was more evidence of this last week, with reports that coal mines in Shandong province had announced cuts in production, while both steel makers and coal manufacturers have also been cutting prices.
The other big swing factor in the deflation equation is the property market. This accounts for as much as 15% of GDP and also has huge linkages to steel, other construction materials and household furnishings. If the property market did continue to decline, we could yet see much wider deflationary pressures.
The flip side of falling prices, however, is that we can expect authorities to be more aggressive in cutting interest rates.
Jefferies says investors have been looking at CPI numbers, when it is really the PPI numbers that will be important for setting the interest-rate outlook.
Further, a rate-cut is justified because it helps ensure that companies do not face rising real interest rates on their debt burden. Otherwise, in situations of falling prices causing revenues to contract, companies could quickly see financing pressures escalate.
So this makes further rate cuts from the People's Bank of China more likely to follow after the two already made in the past two months. Jefferies says the base rate could be cut by a further 100 basis points. Credit Suisse is calling for cuts in both interest rates and banks' reserve ratio requirements.
Another reason the central bank may need to be more aggressive cutting rates is because China's shadow banking system has blunted the effectiveness of this key policy tool. Until recently at least, yield can be twice as large as on banks deposits.
Meanwhile, some more bearish commentators already predict that China is facing a debt deflation trap. In this case, China's central bank may become the latest to drop interest rates to the floor in an attempt to reflate away its debt burden.
A sharply lower interest-rate outlook has various implications for corporates and investors.
For investors of course, lower rates are typically seen as a positive, although rate cuts so far have not lifted equity markets. If rate cuts continue, there could be a shift of money by Chinese mainlanders from lower-yielding deposits into equities.
Yet Jefferies say it is still too early to return to equities. Instead, the best time to invest is when interest rates have already hit rock bottom and deflationary pressures are abating. They argue that we are still some way from that point.
On a wider level, there are always winners and losers from a period of lower rates and deflation. Traditionally, companies that can maintain pricing power -- such as consumer staples -- are favored, as well those able to benefit from the operational leverage on funding costs.
Lower rates should help companies with high working-capital requirements, which is common in China. As well as helping cash flow, this can boost profit margins. Lower energy prices and commodities can also give a boost to margins, which could give some relief to the industrial sector.
If China is going to drive rates substantially lower, then mainland Chinese property developers should also benefit, despite repeated government assurances that they do not want to revive a property bubble. Ultimately, it could be a familiar story, as authorities have created such a debt overhang, they have little choice left.