China: Has Policy Reflation Lost Momentum?

After exhibiting improvement since late last year, the most recent Chinese economic data have deteriorated on the margin. This is largely due to changes in policy stance. Policies implemented late last year induced a quick growth acceleration, which are now prompting the authorities to switch back to focusing on “supply-side” reforms.


The Chinese authorities are struggling to perform a difficult balancing act. Through their reflationary policies, they are trying to push overall growth close to potential. However, at the same time, policymakers want to avoid “lifting all boats”.

Case in point is the steelmakers. Widely viewed as a sector with a hopeless excess capacity problem that urgently needs to be consolidated, steelmakers have witnessed a sudden bounce in profitability since late last year when Chinese reflation began to gain momentum. The authorities are concerned that policy reflation will simply prolong the lives of these supposed “zombie” firms, and the tough decision to cut their lifelines will still need to be made in the coming years once the current round of policy reflation runs its course. Worse still, if these sectors continue to expand capacity with the latest policy help, it will further worsen the situation when the day of reckoning finally arrives.

In other words, as “cutting overcapacity” is one of the key objectives of Xi Jinping’s “supply side reforms”, aggressive cyclical policy reflation appears to be in conflict with this longer-term consideration. In this vein, it may be comforting for the “supply-siders” that the sudden rebound in steelmakers and some other sectors such as construction materials and earth-digging machines have quickly rolled over. This should at least ease concerns over bailing out “zombie” companies.

Looking forward, our China strategists continue to argue against any policy tightening and major growth disappointment, but investors should also curb their enthusiasm in assessing China’s demand-side countercyclical initiatives.

U.S. Equities: Margin Optimism Is Not Justified

U.S. corporate profit margins are already narrowing, but bottom up forecasts are looking for an aggressive move out to new highs in the coming quarters.


Given U.S. labor cost inflation, revenues need to snapback from their current contraction to achieve even modest margin expansion. The growth backdrop is not conducive to such a development. The yield curve, which is an excellent business cycle indicator and a leading signal for profit margins, continues to flatten relentlessly.

Fewer than 50% of the non-financial and non-utility industry groups are currently expanding profit margins. Yet 8 out of 10 sectors are expected to grow margins according to analyst earnings estimates.

Specifically, cyclical sectors such as industrials, materials, energy and technology are slated to show broad-based improvement in profitability. That would not be farfetched if the world were on the cusp of a V-shaped, post-recession type of acceleration and the U.S. dollar were set to weaken significantly, i.e. more than 10%. After all, cyclical sector profit margins are very depressed.

However, deleveraging and the global credit contraction warn that global growth is not about to rebound. As such, our U.S. equity strategists remain skeptical that the macro backdrop will validate upbeat analyst forecasts, rendering the broad market vulnerable.

The ECB Is Done For Now

The ECB will remain on the sidelines for the foreseeable future as the eurozone’s economic recovery continues and inflation accelerates.


The eurozone is experiencing moderately above-trend GDP growth and headline inflation has most likely bottomed. Our models indicate that growth will continue at about 1.75% for the remainder of the year (remember, trend growth in the euro area is barely 1%). The ECB’s updated forecasts expect this pace of GDP growth to persist for the next few years. Meanwhile, the recovery in oil prices and low base effects from last year will begin to push headline inflation higher in the second half of 2016.

Having just announced additional easing measures in March, the ECB is now in a wait-and-see mode. Corporate bond purchases will begin on June 8 and the first new TLTRO auction is scheduled for June 22. Before considering any further policy steps, the ECB will need to evaluate the economic impact of its most recent measures.

If the eurozone economy performs reasonably well and inflation keeps edging higher, then the ECB will remain on the sidelines for the foreseeable future. This means that the downside pressure on the euro stemming from the ECB’s accommodative policies has most probably abated. Therefore, EUR/USD will be more beholden to the Fed. The hawkish minutes from the April FOMC meeting knocked the euro down from its recent high near 1.15. Further euro weakness will hinge on the Fed following through with rate hikes.

U.S. Equities: A Growth Scare Ahead?

An economic growth reacceleration is vital to sustaining the U.S. equity rally and P/E expansion from the February lows. So far, no such confirmation has materialized. Instead, the U.S. appears to be edging closer to a growth scare according to our equity strategists.


Now that U.S. profit margins are narrowing more rapidly and top-line growth remains non-existent, there is a more urgent need for companies to retrench. As seen in the chart above, leading indicators warn that consumption, investment, manufacturing and employment all have the capacity to disappoint in the second half of the year.

Ominously for equity markets, the Fed continues to harbor a deep desire to lift interest rates from what it still considers to be emergency levels at a time when the economy is nearing full employment. Consequently, financial conditions could tighten anew, exacerbating an already challenging profit outlook.

As discussed in the next Insight, several market indicators suggest that the Fed is too complacent about the downside risks to growth.

Is The Latest Equity Market Euphoria Justified?

Stocks have breathed a sigh of relief following earnings season. Nevertheless, cracks are spreading beneath the surface. The chart shows a compilation of nonconventional indicators that are waving a yellow flag. Breadth is thinning, as evidenced by the downtrend in the NYSE A/D line. Sentiment is also poor, with bullish investors throwing in the towel at an accelerating pace (second panel). Rather than view this contrarily, it can often be a sign that selling may accelerate. Moreover, once vibrant M&A activity is cooling rapidly (top panel), and the news has been recently dominated not by deal making, but by deal break ups. This may reflect increased trepidation about further adding debt to already bloated corporate sector balance sheets (third panel). Bottom Line: Resist the temptation to deplete cash balances, and continue to favor defensives over deep cyclicals. A capital preservation mindset is still warranted.

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