Since the start of the year, the top seven performing sectors have been petroleum and petrochemicals, non-ferrous metals, coal, building materials, steel, chemicals, and machinery—all exhibiting a clear cyclical style. Many investors are concerned about whether the opportunities in these sectors can persist. Here, I would like to share my views on cyclical industries.
We often tend to estimate the supply-demand dynamics for each industry at different stages. However, such estimations can be highly inaccurate in practice. A more practical approach is to observe inventory and price indicators. For instance, when demand suddenly improves at a certain stage (or supply falls short), we first observe passive destocking of end products alongside a simultaneous rebound in prices. If this trend continues, it generally signals the beginning of an upward cycle in corporate earnings. Therefore, I have always regarded the Producer Price Index (PPI) as a crucial indicator in investment, as it reflects the outcome of changes in supply and demand within the macroeconomy.
After more than three years of year-on-year declines in PPI since October 2022, there are now signs of a turnaround this year. A closer analysis of the data reveals that PPI has shown five consecutive months of month-on-month growth since last October, with an increasing number of sectors experiencing price increases, including non-ferrous metals, chemicals, and machinery equipment. As price declines narrow across most industries, the month-on-month growth in PPI has been expanding in recent months. Alongside this price recovery, industrial enterprise profits are also undergoing a bottoming-out reversal.
Over the past three decades, the longest period of PPI deflation occurred during the overcapacity phase from 2012 to 2016, following the 2008 four-trillion-yuan stimulus. During that cycle, year-on-year declines in PPI persisted for 54 months. The current cycle, which began in October 2022, has lasted 42 months so far, making it the second-longest deflationary period. The end of the previous deflationary cycle was driven partly by policy-led capacity reduction and partly by measures related to real estate inventory reduction. The current bottoming-out of PPI is attributed, in our view, to increased demand for related metals, materials, and equipment driven by investments in AI infrastructure (such as industrial goods like metals, optical fiber cables, fiberglass, and memory chips, as well as equipment like gas turbines, energy storage systems, and construction machinery). Additionally, prolonged weakness in corporate profits has forced the淘汰 of outdated capacity while limiting investments in new capacity (particularly in sub-sectors of chemicals and building materials). Furthermore, the real estate cycle nearing its bottom, coupled with rising investment demand in areas like power grids and shipbuilding, has contributed to the recovery of many other manufacturing sectors.
At present, the underlying logic driving these trends remains unchanged. Under continued constraints such as the dual-carbon goals, high-energy-consumption industries like building materials and steel may experience periodic supply shortages. The mild improvement in PPI during this cycle is likely not over, and cyclical stocks are expected to maintain their outperformance, with potential for the rally to spread from specific points to broader sectors.
Reflecting on the relationship between the stock market and PPI over the past 20 years, I have summarized several patterns for reference: 1) A bottoming-out in month-on-month PPI indicates reduced risks of economic slowdown, with risk-free interest rates at a cyclical low. During this phase, technology and growth stocks tend to outperform, depending on whether there is a major breakthrough in tech industries. The broader market is likely to experience volatility. 2) A turn to positive month-on-month PPI growth signals a bottoming-out in the economy and corporate profits, often heralding a bull market. Cyclical and manufacturing sectors typically deliver significant alpha, with the rally spreading more broadly. In contrast, financial and high-dividend sectors may underperform. 3) As month-on-month PPI peaks and year-on-year growth follows, consumer sectors may present relative opportunities, while cyclical sectors might be more suitable for a gradual exit strategy.
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