Asian Banks-China Banks &PPI:Timing is everything

The China banks reflation trade: Is it sustainable?

    China inflation has picked up over the past year with January PPI surprising onthe upside at +6.9% yoy. "Reflation" is often quoted as a reason for investorswanting to buy China banks. We would agree that higher nominal GDP growth& steadily rising asset prices (supporting collateral values) are general good forbank share prices. In this report we look at the linkages between the Chinabanks & PPI which is highly correlated with accelerating/decelerating creditcreation. With the banks trading a 5 year low implied CoE we see a risk thateither rates rise to fight broadening inflation or that PPI rolls over deflating theattractiveness of the China banks "reflation trade".

    Why is PPI rising and how are the banks contributing to inflation in China?

    Despite considerable commentary about “deleveraging” China has in realitycontinued to leverage up apace. At the end of January its “credit impulse” satclose to a post GFC high (a primary role of the banks is to ensure a steady flowof credit to meet the China’s stated GDP growth targets). Given we estimate inrecent years China has been creating c40-50% of the worlds net new moneysupply it is no surprise that if it accelerates investment it can have a profoundimpact on world commodity prices. It is commodity price inflation that hasdriven up PPI to date and we find a rise in PPI typically lags acceleratingChinese credit growth by 3-6 months.

    Are we close to a peak in PPI and the China bank “reflation trade” deflating?

    Commodity prices in general bottomed towards the end of Q1 2016. As such ifChina does tighten the availability of credit and/or commodity prices remainflat from here we may be just a couple of months away from a peak in PPI. IfPPI starts to roll over the “reflation” trade argument for investing in Chinabanks could start to deflate weighing on valuation multiples.

    If inflation broadens out can China afford a spike in interest rates?

    A second scenario is that inflation broadens out in coming months pushing upChinese interest rates. Given the credit driven nature of China’s growth modeland the rapid rise in outstanding debt of recent years we think the ability ofChina’s financial system to absorb a meaningful rise in debt servicing costsmay be limited. If Chinese rates have to rise faster than expected this may wellmark a turning point in terms of the sustainability of its credit driven GDPgrowth model. Neither of these two scenarios we see as supportive to Chinesebank share prices at current levels.

    Risk reward profile now looks poor for China.

    The MSCI China banks index is now trading 1 standard deviation above its 5years average 1 year forward P/E multiple and at a 5 year low implied cost ofequity (i.e. expensive vs where it has traded for the past 5 years). We think therisk reward profile now looks poor given the rising risks to what we believehave been the core drivers of the re-rating (i.e. the China reflation trade). In aregional context our preferred names to a rising US rate environment remainDBS in Singapore, KB Financial in Korea and MUFG in Japan.