China: GDP Growth Vs. Corporate Profits Vs. Wages

Chinese GDP growth will never be negative well into the foreseeable future, but corporate profits are already shrinking.

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Corporate profits for A-share listed companies are declining, and that the contraction is broad-based across many sectors. Our EM strategist believe that the earnings of listed Chinese companies will remain under pressure as corporate price deflation is still accompanied by rising wage demands.

At a time when corporate nominal revenue growth is at a record low and corporate prices are deflating, wages cannot grow much, and profits certainly cannot expand simultaneously. While we concur that there have been numerous positive developments surrounding Chinese consumers and the broader service sector, the question is how industrial and other companies can raise wages meaningfully and deliver positive profit growth at a time when their selling prices are weak and volumes are lackluster.

Barring an unlikely dramatic turnaround in the economy, either corporate profits will continue to shrink or wages/employment will contract in the next 12-18 months.

Bottom Line: We would not be surprised to see China’s growth stabilize or even marginally improve over the next couple of months, given the large fiscal push and strong credit origination lately. However, our EM strategists doubt that a mild and fleeting growth amelioration will be sufficient reverse the contraction in corporate profits of Chinese companies and foreign companies that sell to China.

U.S. Equities: Beware Unrealistic Expectations

Don’t bet on better profits.

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A broad-based EPS contraction has already caused havoc in the overall market in recent months, but a more painful downturn has been averted because nominal GDP growth has managed to stay above long-term Treasury yields. However, leading economic indicators remain bearish, and the slide in the monetary base warns that the path of least resistance for GDP growth is lower. History shows that once GDP growth dips below the level of 10-year Treasury yields, a prolonged slump in stocks typically ensues.

To be sure, U.S. profits key off the state of the global economy, not just domestic trends. According to our Global Leading Economic Indicator (GLEI), growth is also too weak outside the U.S. to expect a profit turnaround. The GLEI is correlated with U.S. net earnings revisions, which are currently deeply negative following several consecutive quarters of poor operating profits across the corporate sector.

This outlook contrasts starkly with current expectations. The Chart above shows that an aggressive recovery in S&P 500 earnings is expected this year.

Importantly, these expectations are not simply a reflection of hopes for a recovery in resource prices, but are broad-based across sectors. That is wildly optimistic, underscoring that disappointment will remain a key risk.

It is too ambitious to expect equity risk premiums to narrow given such a large gap between reality and expectations. Our U.S. equity strategists remain comfortable with a defensive sector portfolio structure, and caution against chasing the recent bounce in the bulk of cyclical sectors.

Reprieve, Albeit Temporary

According to our U.S. Investment Strategy service, similarities with 2015 argue for a reprieve from deflationary tail risks. This reprieve should prove temporary and we intend to sell on strength in risk assets.

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Roughly a year ago, violent oil and dollar moves gave way to a period of market calm, without much fundamental improvement. The Chart above shows that oil plunged and the dollar (shown inverted) surged in the second half of 2014 and early 2015. Not surprisingly, equities became more volatile and bond yields fell sharply during this period. As soon as oil and the dollar stabilized, equities and bond yields moved higher.

A similar dynamic may be playing out this time around. The 13-week rates of change for both Brent crude and the trade-weighted dollar hit extremes in January, after which they have steadily eased. Soon afterwards, Treasury yields bottomed and the S&P 500 moved higher.

Also supporting a relief rally, volatility and the flight from risk assets had become overdone. Implied option volatilities for a range of major markets spiked in the past few months. The spike was nothing like 2008 or 1998. Still, it was clear that market positioning already had shifted towards fear and away from greed.

Meanwhile, several of our favorite risk barometers have stopped deteriorating – please see the next Insight, (Part II) Reprieve, Albeit Temporary.

Euro Area Stocks: Still Relatively Attractive

Standard valuation metrics show that European equities have a valuation-advantage versus other major equity markets. But these do not always compare apples to apples.

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One problem is that different stock markets can offer very different underlying sector exposures. In this particular case, a crucial difference is that the high-growth Technology and Healthcare sectors account for 30% of the S&P500 but just 15% of the Eurostoxx 600 and Nikkei 225. Clearly, the S&P500 deserves a significant valuation premium over the other two indices.

There are also differences in accounting methods and reliability – which despite a concerted drive to U.S. GAAP standards – do still create significant distortions in cross-sectional analysis between markets.

To get around these problems, our European strategists evaluate equity prices relative to their own history. A valuation-metric that is undistorted by the cycle or structural changes is optimal; the asset-based Tobin Q ratio meets these requirements better than other valuation-metrics.

In relative terms, Europe appears the “least ugly”, but is only slightly ahead of the U.S.

On an absolute basis, no major equity market looks outright attractive. In an environment of low growth and Fed tightening, headwinds remain in place.

Why Are Global Inflation Expectations Still So Low?

The plunge in global oil prices has widely been considered to be the main cause of the rapid fall in global inflation expectations since 2014. However, it was always odd that there should be such a strong link between the level of oil prices and a rate-of-change concept like inflation expectations, especially since the correlation between the two was not very stable prior to the 2014 peak in oil prices.

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A more realistic explanation is that inflation expectations have been falling as a belated response to the plunge in realized global inflation over the past few years, which is a direct response to the much slower pace of economic growth in China and the rest of the Emerging world. Under this interpretation, weak oil prices are not causing inflation expectations to fall, but rather both are reflecting a sluggish global economy.

A near-unanimous opinion expressed to our global fixed income strategists by clients over the past several months is that owning inflation protection of some kind would be a winning trade when global oil prices finally begin to recover. That could work out, although there could be a moment where that assumption is challenged, if oil prices were to begin moving higher in the latter half of the year (as our Commodity strategists expect) but inflation expectations were slow to respond.

If the true cause of low inflation expectations is weak global growth and excess capacity driving down corporate pricing power in many industries – and not just depressed global oil prices – then central bankers could be facing a serious challenge to their credibility in the months ahead, as both realized inflation and inflation expectations could take even longer to return to target.