China Is Not Done Slowing Down

05/09/2011 11:17 am EST


Prieur du Plessis

Author, Investment Postcards from Cape Town

The latest manufacturing survey hints at more hiccups for commodities as well as Shanghai stocks, writes Prieur du Plessis of Investment Postcards from Cape Town.

China’s manufacturing Purchasing Managers’ Index for April came in at 52.9, down from 53.4 in March.

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While the figure still indicates further expansion in the Chinese manufacturing sector, it surprised on the downside, as it was significantly lower compared to the apparent historical seasonal patterns—April is normally a bumper month:

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Although most commentators ascribe the lower-than-expected PMI to the action taken by the Chinese authorities to tighten credit conditions and rein in the property sector, my analysis indicates that the external sector—and especially, the fallout from Japan’s twin disasters—played a major role in the weak PMI number.

The new export orders sub-index of the PMI registered a paltry 51.3, whereas in normal circumstances it would have been in excess of 54, given the historical seasonal pattern.

The same is evident in the imports sub-index, which came in at a barely growing 50.6, whereas in normal circumstances it would have been in excess of 53, given the historical seasonal pattern.

In contrast, the stocks of the major-inputs category followed the historical seasonal pattern, and the 52.0 was in fact somewhat stronger than what would otherwise have been expected.

But where does that leave China’s manufacturing industry, you may ask? In short: “Overstocked!”

The ratio between the stocks of major inputs PMI and the new orders PMI is approaching a high level, similar to that of mid-2008 during the commodity frenzy that lasted until July of that year. We all know what happened afterwards!

A relatively high stocks-to-orders ratio is followed by a weaker manufacturing PMI a month later, and vice versa. The stocks-to-orders ratio therefore leads the PMI by one month.

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It seems to me that Chinese manufacturers are much more inventory-conscious than in the past, because their monthly responses to the PMI questions are highly influenced by the ratio of stocks to new orders of the previous month.

The pattern that has emerged is not limited to stocks of major inputs, though. A similar pattern is evident in the ratio of stocks of finished goods to new orders.

My conclusion is that Chinese manufacturers are currently overstocked, given April’s PMI for new orders. The PMI ratio for stocks of major inputs to new orders indicates that the manufacturing PMI in May could fall below 51, while the PMI ratio for stocks of finished goods to new orders indicates a drop below 52. That corresponds to the seasonal lull that starts to set in from May to July.

It certainly does not bode well for shipping rates in the coming months.

With the Chinese as the driving force behind commodity prices, the high stocks-to-orders ratio raises questions about the sustainability of high commodity prices in coming months.

The significant gap that has opened between China’s new export-orders PMI and metal prices specifically is most worrying.

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Although China’s Shanghai Composite Index pulled back to be more or less in line with the PMI, I think that there is still downside ahead, and will bide my time before venturing back into that market.

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