Steel stocks reported the biggest quantum of positive earnings surprise this year but have been amongst the worst stock market performers. Recent data points suggest that steel is on the verge of a global destocking cycle as the effects of China’s 2016 stimulus wear off. Just as last year, improvements in the steel industry heralded a pick-up in global industrial production, we believe these negative developments will result in a wider slowdown. This same stimulus resulted in a turnaround in global inflation with China exporting reflation rather than deflation. However, if last year’s reflationary impulse was just a one year global economic restock caused by a Chinese investment splurge which is now already on the wane then this might lead to a further reassessment of all reflation trades as the year progresses and momentum fades.
Investing in cyclical stocks is often more lucrative in the travelling rather than arriving phase. As such, earnings momentum – the direction of travel – is usually a superior buy or sell indicator to a static valuation methodology given that the earnings number is, like the Roman Empire, either expanding or contracting but never standing still. However, the persistence of earnings momentum is still subject to doubt around the duration of the business cycle: stocks can de-rate despite positive revisions. One of the most striking features of the recent generally buoyant European Q1 earnings season is that many of the companies, particularly in the materials sector, who reported the biggest quantum of earnings beats have been amongst the worst stock market performers. When cyclical stocks stop being rewarded for positive earnings revisions it may be a red flag that all is not well with the business cycle.
Outokumpu is one of the most cyclical industrial stocks in Europe. The Finnish stainless steel company has often swung from losses to profitability and its volatile share price has generally been correlated to industrial inventory cycles as well as the supply and demand dynamics of global commodity markets. Reporting a 40% beat of consensus Q1 earnings, the stock initially traded up 5%, only to finish the day down 10%. Reports from other steel companies such as industry giant Mittal have induced the same stock market reaction. We might conclude that the market judged the quantum of the earnings beats as immaterial and instead concluded that the prospects for steel had already peaked: was this the Outokumpu moment, marking the top of the cycle? We think these doubts around the duration of the cycle are likely to spread to other cyclical sectors including banks as the year evolves.
We now seem to be on the verge of a global steel destocking cycle led by China. Global carbon steel prices have begun to soften: iron ore prices have plummeted as Chinese record inventories are reduced. In stainless steel, we have seen base prices in Europe starting to decline despite the buoyant economy and have also witnessed steep falls in ferrochrome and nickel which is usually a catalyst for customer destocking. Just as the positive reassessment of steel names early last year was an early indicator of a global industrial restocking cycle, we think that the weakness in steel is likely to feed through to a slowdown in global industrial production. Moreover, we think it is now clearer that that the origin of 2016’s reflationary impulse lay in a Chinese fixed asset investment splurge in which the steel industry was one of the earliest beneficiaries. So just as steel was an early indicator of reflation in 2016, it’s possible that the downturn in the steel cycle will not only lead to a waning of the reflationary trade but fears over deflation re-emerging.
Figure 1: Chinese PPI. China exporting deflation and inflation
Source: Argonaut Capital Partners, Bloomberg, 31/05/2017
Despite the focus on the US economy and President Trump, China, not the US, has been the dominant influence on global price levels. At the beginning of 2016 the Chinese economy was in a downward deflationary spiral with Producer Price Inflation (PPI) running at -7% YoY (See Figure 1: Chinese PPI. China exporting deflation and reflation) and Chinese corporates were seeming vulnerable to a Fed tightening cycle given large dollar debt issuance and the reluctance of the Chinese authorities to break the currency peg to the greenback. Although there have been some notable supply side reforms in China, with the benefit of hindsight the turning point in arresting the global deflation trend was China unleashing another splurge of fixed asset investment, on a par with the great infrastructure stimulus of 2009. This was a catalyst for the beginning of an industrial restocking cycle, initially in steel (and its associated commodities) before broadening out to industrial production globally.
As China began to export inflation rather than deflation (with Chinese PPI rising to +8% from -7%) this subsequently led to a pick-up in expectations for global interest rates and a reassessment of the outlook for interest rate sensitive sectors, in particular banking. The sequencing of global reflation last year, given its origin in China, indicates that the investment rationale for buying a Eurozone bank in the hope that the ECB may adopt a more hawkish monetary policy may also necessitate a bullish view on the sustainability of Chinese commodity demand, least inflationary pressures fade as Chinese PPI decelerates and possibly turns negative again. Therefore, should this prove to be just a one-year global economic restock, sequencing on the downside and subsequent correlation of interest rate sensitive sectors is likely to mirror that witnessed last year.
Figure 2: Contributions to Global Credit Impulse (market GDP-weighted)
Source: Argonaut Capital Partners, UBS, May 2017
The past few weeks has witnessed typically opaque policy announcements from China on tightening monetary policy. This has immediately corresponded to falling commodity prices (as speculative positions are reduced) and the beginning of a destocking cycle in steel, as record high inventories are run down, which will hit the real demand for steel related commodities. Given the importance of China in global industrial production this, if sustained, will precipitate a global inventory destock. It is worth pointing out that since 2014, China has accounted for all the growth in global credit (See Figure 2: Contributions to Global Credit Impulse) and two-thirds of the growth in global industrial production (See Figure 3: Contributions to Global Industrial Production). Credit growth in China has recently gone into reverse. As such, the chances of a significant loss of momentum in the global economy, albeit with a lag effect, is increasing. Although European macro indicators are currently very robust, suggesting an above trend growth rate of over 2%, we should remember that Europe is traditionally late cycle and that there is little to suggest that there has been any structural pick up in long-term economic growth expectations for the continent. To adopt the old adage about the US, if China sneezes the rest of the world is likely to catch a cold, at least as far as reflation trades are concerned.
Figure 3: Contributions to Global Industrial Production
Source: Argonaut Capital Partners, UBS, May 2017
Whether the 2016 reflation was a one-off stimulus effect or the beginning of a longer-term pick-up in inflation remains a key debate. Economic cycles create opportunities for macro managers but short duration cycles are both uncommon and fraught with danger. By the time a macro trade has been established and stocks selected which might benefit from the inflection point, the cycle is already mature: when the bottom-up earnings surprise confirms the macro trend Mr. Market decides it’s time to fade the cycle. Hence macro-driven managers find themselves constantly befuddled by rapid sector rotation and frustrated by not being rewarded for identifying trends and in terms of individual stocks, cyclical earnings upgrades. In such an environment where inflection points are not illusory but instead temporary, it is perhaps not surprising that strategies which do not attempt to play the cycle (especially passive) have prospered whilst previously well regarded macro managers historically able to profit from macro inflection points have (at least temporarily) turned into investment dunces. Certainly, having spent most of the last year repositioning for global reflation, the pain trade now would undoubtedly be a return to global deflation if we have witnessed just a one-year economic restock.
Given the recent loss of momentum in the reflation trade, the onus is now on the ECB (June 8th) and the Fed (June 14th) to come up with a hawkish surprise. We expect the Fed to hike, but see a likely flattening of the yield curve and as such, the outcome will not be supportive to the reflation trade or the earnings profile of US banks. All recent communications from Draghi suggest monetary accommodation must remain: that QE will be slowly tapered and the deposit rate will only be used as a tightening policy tool once asset purchases have ended. This is at odds with investors in Eurozone bank equity, who seem convinced that we are at the beginning of an inevitable normalisation of interest rates back to positive territory which progressively support bank earnings even though money market futures are currently pricing in only relatively modest expectations of a deposit rate of -10bps by the end of 2019 compared with -40bps today. Expectations of an earnings upgrade cycle based on a normalisation of rates could, therefore, be vulnerable to doubts about both the pace and the quantum of hikes: if the ECB are not willing to raise the deposit rate toward zero now when the threat of global deflation seems to have been (at least temporarily) conquered and with the Eurozone economy growing above trend, just how certain are we that this process will begin sometime next year when economic activity is likely to have decelerated and inflation expectations peaked?
Just like commodity producers, banks are price takers (dependent on interest rates set by central banks and nominal economic growth) devoid of any significant competitive advantage. In an economic environment devoid of inflationary pressures, there is limited pressure on central banks to tighten monetary policy. As such it is quite possible for innovation, productivity and globalisation to drive a long period of economic expansion without inflationary pressures such as that seen at the end of the nineteenth century (1870-1900), particularly in the UK and the USA. In such an environment, companies in industries at the centre of innovation or with competitive advantages have an ability to grow revenues which simply does not exist for the price taking industries (oil, materials, banks, power utilities) who are almost wholly dependent on a rise in the general pricing level. Little wonder then that in a period of economic expansion without inflationary pressures, banks and commodities become value traps and that 2016’s reflationary impulse saw a dramatic reappraisal of their growth prospects. It also follows that if the reflationary impulse is only temporary then these stocks will revert to their value trap status.
In comparison to the recent past, we are therefore struck by the current exuberance for owning Eurozone bank shares after a significant re-rating to historically rich valuations when the global reflationary impulse is now clearly on the wane. Although the process of balance sheet repair is now largely complete, the potential for a rebound in profits remains limited: provision charges for bad loans are already at a cyclical low with no bounce back potential; there is no appetite for consolidation which might drive cost reduction; whilst new lending growth, even in the current buoyant environment struggles to replace maturing loans. Revenue derived from lending money can only start to grow again with a somewhat unlikely sustainable combination of both rate hikes and lending growth. Yet the reflationary impulse has created something of a blind faith in a pull to book value of low-quality banks: there would, for example, now appear to be tribes in the Amazon who believe that Italian behemoth Unicredito is “cheap” and will continue to re-rate despite it being stuck in structural low-return markets with little prospect of structurally revenue growth or improving its return on assets to an acceptable level. If reflation wanes and deflation returns, book value will return to being a poor indicator of value.
When the global deflation outlook gets too grim it is always possible, just as in Q1 2016 that the Chinese authorities embark on another infrastructure splurge to prevent a global deflationary shock. However, it is worth noting that the Chinese authorities have historically only acted when the fundamental outlook is more desperate than it is today. Furthermore, future injections of liquidity stimulus may not necessarily be so easily passed on in the form of credit expansion (and economic growth) in view of the increased regulation of the off-balance sheet assets of Chinese banks. When China decides to get itself out of a hole by implementing further monetary stimulus for infrastructure spending, the hole doesn’t disappear but in fact becomes deeper. The recent Moody’s downgrade of China was significant only in the sense that the loss of face from the trick of further leverage is now more apparent.
The reflationary impulse witnessed since the beginning of 2016 has presented a macro puzzle that has been difficult to solve: its origins were initially unclear; its implications priced into a re-rating of stocks long before companies themselves began to report improvements; and more recently the quantum of cyclical earnings beats have been inversely correlated to stock price action. It would now seem clearer that the origins of reflation lay with a Chinese initiated global inventory restock which is likely to prove temporary: this rationalises the lack of synchronisation between earnings surprise and stock market performance which would be more commonly found in a more typical economic cycle which endures for longer than one year.
In the absence of Chinese stimulus, reflationary trades will likely continue to unwind with the sequencing witnessed in 2016: commodities return to a bear market; this feeds through to a deceleration in associated industrial production; and we see a continued flattening of yield curves on declining inflationary pressures which depresses heightened expectations around a recovery in bank revenues derived from lending. However, we do not necessarily believe that a resumption of a deflationary impulse, which removes the necessity for central banks to withdraw monetary stimulus, will derail real economic expansion or cause a significant fall in general asset prices. It is perfectly possible that the current period of economic expansion without inflationary pressures continues to resemble that seen at the end of the nineteenth century, perhaps punctuated by the odd year of reflationary impulse, with companies at the centre of innovation able to grow revenues, irrespective of inflation, handsomely rewarded.
Barry Norris
Argonaut Capital
June 2017
