Goldman Delivers A ‘Real’ity Check On China

“Hard” data versus “soft” data.

Among those of us who care about such things, that’s one of the most talked about juxtapositions. Basically it amounts to: “hope” as expressed via sentiment and “reality” as reflected in hard economic data.

The disconnect between hope and reality as defined above is readily apparent in the US. Have a look (right pane):

DB

(Deutsche Bank)

To be sure, there’s nothing wrong with a little “hope.” Indeed, there’s nothing wrong with a whole lot of “hope” (just ask Shepard Fairey).

The problem comes in when that “hope” starts to manifest itself in asset prices but doesn’t pan out. Because then what you’re left with is sand castles in the sky. That’s the worry for US stocks.

Similarly, there’s a risk that the market is paying too much attention to “soft” data out of China. The “hope” is that “hope” (an no, there are no misprints there) will eventually morph into reality via a kind of virtuous circle where stronger sentiment leads to looser financial conditions which in turn feeds through to stronger real activity. Meanwhile, the outlook for Chinese banks could improve in lockstep as reflation serves as a kind of pressure valve for NPLs.

But that whole dynamic is tenuous. And as Goldman writes on Sunday evening, “higher PPI inflation in China isn’t likely to boost real growth significantly further from here.” Throw in the the PBoC’s tightening bias and the Politburo’s push to rein in overcapacity sectors and you’ve got a recipe for disappointment.

Via Goldman

China’s industrial sector has been reflating strongly, with PPI running at over a 10% annualized pace. This has driven nominal growth higher and contributed to the recent surge in industrial profits.

GSChina

Thus far, the reflation benefits have been largely concentrated in upstream industries, where pricing power and profits have been sharply boosted by restrained supply. Downstream industries’ profit growth has been modest and roughly stable.

GSChinaUpstream

Given the skewed reflation payoffs, potential upside to industrial capex looks moderate at this point: For upstream industries, while profits have improved, over-capacity curbs may constrain their ability to invest; for downstream industries, there has yet to be a clear profit-driven impulse, although firmer business sentiment could increase investment.

The rise in upstream prices has likely pushed up the cost of fixed investment (even as the impact on consumer goods prices has been limited so far), implying that financing each real unit of fixed investment will require more credit in the future. This diminishes the commonly perceived relief impact of inflation on the economy’s overall debt burden. As such, we also expect the authorities to rein in leverage further on any major upside growth surprise, dampening any “animal spirits” effect and putting a speed limit on growth. 

The PBOC has shifted to a more hawkish policy stance since autumn 2016 and further stepped up its tightening bias in recent weeks with greater tolerance for higher volatility and levels of interbank rates. There is also prospective strengthening in prudential requirements, which could add further pressure on financing conditions. Underlying the PBOC’s tightening is the continued structural fragility of high leverage (both in the real economy and within the financial system).

GSUpstream2Profits

In sum, we view the reflation as helpful in reducing NPL pressure in upstream industries and supporting headline profit growth. However, while we expect solid growth momentum to continue in the near term, we don’t think higher PPI inflation is likely to boost real growth significantly further from here.

The potential for banks’ improved asset quality to ease credit supply and hence boost overall activity (via the “financial accelerator” channel) is also unlikely to be a strong growth driver, in our view. Any increased tendency of banks to supply credit is likely to be dampened by a more hawkish policy and regulatory stance that together are intended to slow the debt buildup. We forecast real activity growth to peak in the first half of 2017 and decelerate gradually in the second half. Upside risk to our baseline view on real growth seems more likely to come from “exogenous” factors such as government-driven infrastructure and PPP investment and the global trade cycle, than from the ongoing reflation process, in our view.

 

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