#1 Investment Weekly – Stocks waiting for capex and stocks

There is a basic formula for determining the profits generated by an economy. It states that profits are equal to: consumption (less wages), capital expenditure, inventories, government spending (less taxes) and exports (less imports). As we head into the half-term earnings reporting season, investors have a good handle on C, GS and trade, but, as usual, have little information about capex and inventories. These should be the key factors that managers should be addressing. Unfortunately, analysts’ questions hardly ever concentrate on these areas – so we may never know the full profit picture. Here are my guesses about what company managers are likely to say about the various components of their profits.

Discretionary consumption has been weak everywhere (except China) and should remain so as long as workers fear for their jobs. However, for the vast majority who are working, wages have been flat or even rising slightly. This means that bank savings are rising or debt levels are falling. In both cases, this allows banks to lend to their retail and corporate customers. This leads to the capex expectations. As global banks have been hording capital, the surge in lending by China’s banks is likely to stand out like a sore thumb. Capex on the mainland is unlikely to have been impeded by bank balance sheet restraints. Only the trade sector would have seen expansion plans put on hold, while using free cashflows to upgrade or replace equipment. The same freedom or tactics would have been applied to inventories, with basic material users stock piling while end-users have made inventory management a top priority in recent months. Overall, the picture on capex and inventories in China would have been better than many had expected, and I suspect this may have been behind recent upgrades in economic growth forecasts for China in recent weeks. Government spending has been well telegraphed during the current downturn, and forecasts are pretty transparent, while trade deficits have been improving (adding to GDP) as discretionary imports have fallen in line with demand. The weak US$ has, at the same time, boosted US and China’s export price competitiveness.

How does all of this translate into next quarter earnings prospects? Banks are always the main beneficiaries of a steady or rising economy as they are likely to record fewer losses (rather than more profits).. They will continue to lead the Hong Kong market higher. Basic material profits will be under pressure because of their inventory build up, while users will be benefitting from more efficient inventory management. Capex intensive industries will be benefitting from available credit and stimulus packages. Retailers will still be producing good profits in China (but not elsewhere) while utilities will be flat and defensive (as usual). Overall, Chinese profitability should be sound, with spectacular pockets of growth. Hong Kong profits should be showing signs of improvement, with asset prices (across the board) rising through the first six months of the year.

With this outlook in mind, one would expect investors to be slightly cheered by upcoming announcements. This doesn’t seem to tally with recent performance of the HS Index. The reasoning for the recent pull back from the high of 19,000 can be traced to two key factors: 1) new supply of stock and 2) seasonal apathy. The new supply will run its course as investor apathy eventually consumes investment banker enthusiasm. Although the latter will continue to serve the growing need for capital in China, the initial quenching of pent up demand for China IPO stories is wearing out. This should redirect some demand back into small cap names, but the main indices will continue to be dragged by investor indifference ahead of confirmation of results. Clarity on capex and inventories should allow justification of at least current index levels.