Economic indicators fell short of market expectation in previous months. The manufacturing Purchasing Managers’ Index (PMI) in April was 51.4%, which experienced a 0.1% fallback from March1. Indeed, the figure was recorded at 50.3% in February, which was the lowest in the past 19 months1. The anxiety of investors on the potential slowdown of industrial economy has suppressed market sentiments in a certain extent, whereas cyclical stocks have been plagued in particular.
Our observation on the ground leads us to think that there has been a mini-destocking cycle happening in China, which led to the marginally weaker economic data-points. On the supply side, as 2017 was a great year for China corporates, they were expecting strong domestic demand in 2018 and decided to stock up on inventories starting in in late 2017 before the prices of raw materials and commodity rose further. However, the start of 2018 was met with weaker demand caused by the mild slowdown in production and investment, and in some cases, over stringent enforcement of environmental directives. A few “one-off” factors have contributed to softer production and investment growth in March, such as a late Chinese New Year which affected the number of effective working days in March and the longest “Two Sessions” – the annual meetings of the national legislature and the top political advisory body – in history (traditionally economic activities soften during these major meetings because of policy uncertainty and environmental considerations), and colder weather in the north also dampened construction in March. The above resulted in an imbalance of supply and demand in some sectors, which were expressed through weaker economic figures.
However, we have noticed that the destocking cycle of some industries is nearing the end. For instance, the total rebar stock and hot-rolled steel coil stock have been declining since late-March2. We expect that the stocks stacked up last year are likely to be fully digested around June to July this year. As a matter of fact, our viewpoint that the mini-destocking cycle is coming to an end has been supported by the economic data in May. May NBS manufacturing PMI recovered to 51.9% from 51.4 in April, slightly higher than the market consensus3. New Orders Index picked up to 53.8% from 52.9%3. Meanwhile, high-frequency data showed stronger price momentum in raw material prices such as coal and oil in May3.
Finally, a transformation in the nature of cyclical industries has been taking place in recent years. In the past, corporates tend to increase capacity in good times. Excess capacity then caused raw materials prices to drop, leading to constant and vigorous fluctuations in corporate profits. Since the implementation of supply-side reform, the phenomenon of unconstrained capacity expansion has rarely occurred. Up-stream prices have been stabilized in general, whereas profits have been steadily improving. Corporates in cyclical industries will not spend excessively on capital expenditure. Hence, profits for these corporates will no longer fluctuate as wildly as before, and it is expected that their balance sheets will show improvements in two years’ time, accompanying a higher chance of dividend payout and higher dividend yield. We believe cyclical stocks will likely undergo a re-rating in the near future.
[1] Source: The Wall Street Journal, as of May 2018
[2] Source: Bloomberg, as of May 2018
[3] Source: CICC Research, as of May 2018
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document and are subject to change without notice.
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