Real estate is not the mother of cyclical stocks

Key Points:

1. Industrial enterprise revenue growth, but profit margins decline. The inequality "resource consumption > GDP growth > enterprise profit growth" continues to hold true.

In January-February 2024, industrial enterprise revenue increased by 0.73% year-on-year, showing an improvement from the -3.94% year-on-year growth rate in December 2023. In contrast, the year-on-year growth rate of total industrial enterprise profits decreased by 6.6 percentage points from 16.8% in December 2023 to 10.2% in January-February 2024. The logic of "increment without profit" continues to play out, with the operating income profit margin of industrial enterprises continuing to decline, reaching the lowest level during the period of 2010-2019. However, when looking at a broader perspective, the current profit margin level still differs significantly from the low levels of 2001-2007. This is because the driving force of the economy has shifted from the debt-driven real estate sector from 2010-2019 to a manufacturing-driven sector similar to that of 2001-2007. This shift has led Chinese enterprises to enter a more competitive environment with downward pressure on prices, thereby suppressing profit margins.

1. The reality of the domestic and international economies is stronger than expected, with demand showing signs of recovery.

In March 2024, both the manufacturing and non-manufacturing sectors have significantly recovered and are in the expansion zone. Looking at the PMI sub-indices, new orders, production, inventories, and employment all made positive contributions, with new orders making a significant contribution. The output gap has returned to positive territory for the first time since 2023. In the non-manufacturing sector, the construction industry (53.6% to 56.2%) and the service industry (51.0% to 52.4%) continue to expand above the boom-bust line. However, from a pricing perspective, the main raw material purchase prices in manufacturing have started to recover, while factory prices continue to shrink, narrowing profit margins further, indirectly confirming the earlier mentioned inequality is difficult to reverse in the short term. Globally, restocking cycles and investment cycles are beginning to resonate. In China, both the mining and manufacturing sectors have been actively restocking since the beginning of 2024, with revenue growth picking up and inventory rising marginally year-on-year. Developed economies, led by the United States, and emerging economies, led by India, have mostly seen their manufacturing PMIs return to above the boom-bust line in 2024. After entering 2024, China's export quantity index shows that capital goods have begun to grow positively, indicating that the recovery in production is also promoting the restart of the global investment cycle. However, attention should also be paid to the continued downward pressure on price indices. "Increasing quantity while decreasing price" may be a long-term scenario faced with the increasing number of overseas competitors.

1. Strong US dollar and strong commodities: The instability of the credit currency system.

Before the highly anticipated PCE data was released by the United States on March 29, COMEX gold preemptively rose to a historical high of $2256.9 per ounce. Gold is naturally a currency, and the fact that central banks around the world are buying gold in large quantities and increasing the ratio of gold reserves to foreign exchange reserves may reflect not a "price comparison" between the US dollar and gold, but a competition between credit currency and physical assets, with the latter gaining more and more advantage When the pricing system gradually shifts from credit currency to the "anchor" of physical assets such as gold, the price center of copper, aluminum, and oil is reshaped. Whether the return process is hindered or not will be verified by two signals in the future: one is whether the Fed's rate cut in June 2024 can be implemented, and the other is whether the rise in commodity prices will lead to demand destruction and delay in rate cuts downstream. Looking at the next quarter, the probability of a tailwind for physical asset prices is likely to be maintained.

Regarding stock investments, real estate is not the "mother" of "commodities"

Between 2010 and 2020, real estate was the fastest-growing industry in China, but the best investment targets emerged from consumption and manufacturing industries. In comparison, the returns of real estate stocks themselves and financial stocks are relatively lower. Currently, manufacturing has become the most important part of China's economic development, and the key investment targets may shift towards commodities. Under this logic, absolute returns depend on the validation of rate cuts and demand destruction mentioned above; from a relative return perspective, it depends on whether the market believes that debt-driven sectors represented by real estate will once again become the main driver of the economy. Currently, we are at a point where the credit currency system is loosening + global manufacturing demand is recovering in resonance, and commodities are in the most favorable position: copper, oil, resource transportation (oil shipping, dry bulk, etc.), coal, precious metals, and aluminum. Additionally, traditional manufacturing leaders in the CSI 300 (heavy trucks, papermaking, engineering machinery, steel) are also benefiting from the recovery of global manufacturing; at the same time, we remain optimistic about the Keqiang Index and dividend assets (including hydropower, gas, railways, highways, and banks) linked to physical workloads.

Main Content:

1. Foundation of Industry-Driven

1.1 Industrial enterprise profit margin decline, revenue growth > profit growth

In January-February 2024, the economic efficiency indicators of industrial enterprises continued to show the inequality "resource consumption > GDP growth > enterprise profit growth". In January-February 2024, the year-on-year growth rate of industrial enterprise revenue compared to the same period last year was 0.73%, an improvement from the year-on-year growth rate of -3.94% in December 2023; the value-added of industrial enterprises above a designated size in January-February increased by 7% year-on-year, up 0.2 percentage points from the previous period; in contrast, the year-on-year growth rate of total profits of industrial enterprises decreased by 6.6 percentage points from 16.8% in December 2023 to 10.2% in January-February 2024.

Behind the inequality: the continued deduction of the "increment not profit" logic, the profit margin of industrial enterprise revenue continues to decline, reaching the lowest value during the period of 2010-2019. We have described the current and future periods in the annual strategy "Noah's Ark" and the special report "The Road to Nirvana: Dreaming Back to 2002" A scenario of profit growth for Chinese enterprises: while the economic flow (macro total output or enterprise revenue) stabilizes or even rebounds, the profit of enterprises is difficult to rebound significantly. The reason is that the driving force of the economy has shifted from debt-driven by real estate from 2010 to 2019 to manufacturing-driven similar to the period from 2001 to 2007 when exports were the main driver. This has led to Chinese enterprises entering an environment of intensified competition, with continuous downward pressure on prices, thereby suppressing profit margins. Therefore, although we have become accustomed to the "temperature" of the economy from 2010 to 2019, it seems that we are now entering a period of adapting to a "new body sensation". Even though the profit margin of enterprises has declined to a low level of the past decade, this is not a reason for a "rebound". If we extend our perspective, we will find that the current profit margin level still has a significant difference compared to the low level of 2001-2007.

1.2 The reality of the domestic economy is stronger than expected

In March 2024, both manufacturing and non-manufacturing sectors saw significant recovery and were in the expansion zone. In March 2024, the manufacturing PMI rose sharply from 49.1% in February to 50.8%, with all sub-indices surpassing the previous month's readings and seasonal averages. From the perspective of PMI sub-indices, new orders, production, inventory, and employment all made positive contributions, with new orders making a significant contribution. The output gap turned positive for the first time since 2023, with new export order readings higher than import sub-index readings, indicating a high export sentiment. In the non-manufacturing sector, both the construction industry (53.6% → 56.2%) and the service industry (51.0% → 52.4%) continued to expand above the boom-bust line. However, from a price perspective, the main raw material purchase prices in the manufacturing sector began to recover, while factory prices continued to shrink, narrowing profit margins further, indirectly confirming the difficulty of reversing the inequality mentioned earlier. 1.3 Global Perspective on Manufacturing Industry Recovery: Inventory Replenishment and Investment Resonance

In our spring strategy "Jiangchuan Fire Alone" click here for more details, we made two observations on the demand side for 2024: on one hand, there is a global trend of inventory replenishment, and on the other hand, there is investment behavior driven by the "de-globalization" bringing new production capacity in emerging economies and the "reshoring" of manufacturing in some mature countries. Currently, there are signs of resonance between the two: looking at China's inventory cycle, both the mining and manufacturing industries have been actively replenishing since the beginning of 2024, with revenue growth picking up and inventory rising marginally year-on-year. By industry, downstream consumer goods and upstream materials and resources are actively replenishing, while utilities and some equipment manufacturing and pharmaceuticals are still passively replenishing or reducing inventory (revenue growth marginally deteriorating).

From a global perspective, after the second half of 2023, there are signs of recovery in the manufacturing industry, which becomes more evident in 2024. From the perspective of PMI measurement, developed economies are led by the United States, while emerging economies are led by India. After entering 2024, the PMI of most major manufacturing countries has mostly recovered above the boom-bust line Overseas manufacturing PMI recovery, especially the acceleration of production in emerging economies, has direct implications for the domestic market in terms of boosting exports of intermediate goods and some consumer goods. We can also observe this transmission logic from the freight rates and export quantity indices: as mentioned in the report "The Rise of the 'Outward Spiral' and the Rise of Physical Goods," when emerging economies accelerate production, they need to import intermediate goods from China, especially chemical products and textile raw materials. This relationship is also confirmed by the export quantity indices by industry, with significant positive growth in the export quantities of upstream raw materials such as chemical raw materials, pharmaceutical manufacturing, chemical fibers, metals, and non-metallic products since August 2023. Since the beginning of 2024, China's export container freight index has increased significantly, with noticeable rebounds in the US East Coast, US West Coast, and European routes that cater to consumer demand, apart from the Mediterranean and Baltic routes affected by geopolitical conflicts.

From the quantity index perspective, another noteworthy feature is that capital goods have entered a positive growth zone since 2024, and unspecified consumer goods continue to grow rapidly. This indicates that the recovery in production is also promoting the restart of the global investment cycle. China, as one of the main exporters of capital goods and the largest exporter of consumer goods, is benefiting from the global investment and restocking cycles. However, attention should also be paid to the pressure of continuous decline in price indices, as "quantity increase and price decrease" may be a long-term scenario in the face of increasing overseas competitors.

2. The Strength of the US Dollar and Commodities: The Shake-up of the Credit Currency System

The COMEX gold futures price rose to a historical high of $2256.9 per ounce on March 29th before the highly anticipated release of the PCE data in the United States. In addition to the shining gold, recent commodity prices including oil, copper, and aluminum have all risen, while the US dollar index has shown relative strength. How to understand the "financial attributes" of these commodities no longer seems to be effective? In addition to the recovery in global demand driving the demand for commodities, we believe that this may also reflect the shake-up of the credit currency system, as the rebalancing between global financial assets and physical assets has begun The system of gold pricing versus the system of US dollar pricing may explain this conjecture: In the first 20 years of the 21st century, the prices of typical bulk commodities such as copper, aluminum, and oil were inversely correlated with the US dollar index. However, this relationship gradually weakened after 2020. This "weakening" is manifested by the fact that while the US dollar index remained at historical highs for 20 years, the prices of copper, aluminum, and oil did not fall to the lows of the past 20 years, but instead remained at the upper-middle level of the 20-year range. Gold is naturally a currency. The fact that central banks of various countries have significantly increased their gold reserves and the ratio of gold reserves to foreign exchange reserves may reflect that this is not a "comparison" between the US dollar and gold, but a competition between fiat currency and physical assets, with the latter beginning to gain the upper hand.

As the pricing system gradually shifts from fiat currency to gold as the "anchor" in physical assets, the price centers of copper, aluminum, and oil have been reshaped. When we look at the ratios of the three to gold, the prices of the three are no longer at "historical upper-middle levels" but are in historically low ranges. Based on this foundation, in the future, as global manufacturing demand recovers, commodity prices should have the impetus to return to the center based on gold pricing. 2) Whether the return process is hindered will be verified in the future through two signals: on one hand, whether the Fed's rate cut in June 2024 can be implemented, and on the other hand, whether the rise in commodity prices will lead to demand destruction downstream and delay the rate cut. Currently, there is not enough information to definitively answer these two questions negatively: On March 29, 2024, the US PCE year-on-year continued to decline, in line with market expectations. To balance this "good" data, Fed Chairman Powell made a speech leaning towards the "hawkish" side, indicating that "until officials are confident that inflation is moving towards their 2% target, The statement "cutting interest rates is not appropriate" has become a "standard configuration" of the Federal Reserve, which will cause asset price fluctuations with each data release. However, the decisive factor for the trend still lies in the implementation of interest rate cuts.

The recent rebound in commodities is not enough to cause "demand destruction" and delay interest rate cuts. Evidence includes: First, from the perspective of inflation rebound, in China, although purchase prices have started to rebound, factory gate and export prices are still decreasing, and the rise in commodity prices has not yet been reflected in end product prices; Second, from the perspective of producers, in China, there is still room for downward pressure on corporate profits, which has not reached historical extremes. This means that the production process will continue for a long time in a state of "increasing quantity without increasing price". Especially in certain advantageous industries (such as automobiles), when competing globally, market share may be the primary objective function for companies in the short term, rather than profit margins. Examples like Xiaomi's cars and BYD are good evidence. Looking ahead to the next quarter, the probability of a tailwind in physical asset prices is likely to be maintained.

3. Barometer: Who is the mother of the cycle?

The reason why real estate is called the "mother of the cycle" is not because "if real estate is strong, then cyclical industries are strong". From 2010 to 2020, the growth rate of real estate investment constituted the operating income of the manufacturing industry, real estate sales constituted the credit expansion of local governments, and the rise in real estate prices brought asset inflation to residents, leading to consumption "upgrading". Therefore, when real estate is strong, it actually means that manufacturing and consumption are strong. It is precisely because this cycle was broken after 2021, with industrial drive replacing debt drive, that we entered an era where resources are king.

Between 2010 and 2020, real estate was the fastest-growing industry in China, but real estate stocks were not very good investment targets. Instead, many "bull stocks" emerged in consumption and manufacturing industries. Currently, manufacturing is the most important part of China's economic development, and the focus of investment targets may accordingly shift towards resources Under this logic, absolute returns depend on the interest rate cuts verification and demand disruption mentioned above; while from a relative return perspective, it depends on whether the market believes that debt-driven by real estate will once again become the main driver of the economy.

Investors have become accustomed to the high-profit growth brought by the debt expansion model in the past, but they have overlooked the resilience of physical consumption beyond corporate profit growth. Currently, we are at a point where loose credit monetary system and global manufacturing demand recovery are resonating, with commodity resources in the most favorable position: copper, coal, oil, resource transportation (oil shipping, dry bulk, etc.), precious metals, and aluminum. Secondly, around the Shanghai and Shenzhen 300 Index, with the improvement in both domestic and foreign demand expectations, some traditional leading companies in manufacturing sectors are starting to present opportunities (shipbuilding, steel, home appliances, papermaking, heavy trucks, etc.); at the same time, we continue to have a long-term positive outlook on the Wandeke Index-related + undervalued state-owned enterprises (banks, hydropower, highways, railways, gas, etc.).

Author: Mou Yiling, Source: Yiling Strategy Research, Original Title: "Real Estate is not the Mother of Cyclical Stocks"

Mou Yiling: S0100521120002