【Update】The “pseudo-recovery” in the chemical industry drives volatile market trends

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This article is reprinted from Global Chemical Port, sourced from **Chemical Petroleum Network. The Basic Chemicals (CITIC) Index has risen by 7.3% since the beginning of 2012, delivering a return of 3% above the benchmark; the largest increase during this period was 25%, while the highest relative return was 12%. It experienced a distinct \"rollercoaster\" trend, with the upward phase occurring mainly after the Spring Festival and the downward phase taking place after **. In the medium term, the chemical industry related to real estate should still be avoided; even though the first quarter of 2012 might represent the worst period in terms of performance, a trend-oriented recovery is still a long way off, and greater demand-related risks have not yet materialized. 　　Two factors driving the rebound We believe that there are mainly two factors behind the rebound in the chemical sector and the A-share market after the holiday. On the one hand, there is an optimistic outlook on the lower bound of the economic downturn; in particular, the sharp decline in the fourth quarter of 2011 mitigated most of the risks associated with an economic slowdown, providing investors with a safety net at that lower level. Based on the annual strategies of most securities firms for 2012, it is expected that the economy will reach its bottom between Q1 and Q2 of 2012. In terms of the performance of listed companies, the worst results – especially for those in cyclical industries – will be seen in the first-quarter reports. Meanwhile, the preliminary reports for the first quarter, which are released along with the annual reports from February to April, will help to mitigate much of the downward risk. Based on historical experience, when the real economy is at its worst, an expected improvement in recovery tends to represent the best time to invest in cyclical stocks. The first quarter seems to be such a \"good opportunity,\" and some cyclical stocks are indeed the main drivers of this rebound. 　　On the other hand, optimistic expectations of policy easing provide market upside potential for a rebound. The so-called policy expectations represent a weighted combination of certain verifiable phenomena and certain unfalsifiable conclusions. The market draws parallels with past economic downturns in 08/09 and 2010, and applies the pattern of **continuously implementing loose policies to stimulate economic recovery, with the stock market experiencing a sharp rebound first; thus, any change in credit data, interest rates, or a statement made by officials can serve as a signal of a shift or intensification in policy. This kind of predictive assumption has emerged in almost every rebound, large or small, since the third quarter of 2011; although the policy trend has been toward relaxation, the actual intensity has consistently been lower than market expectations. 　　PMI and rising prices: reinforcing the \"pseudo-recovery\" in the chemicals sector. Based on past experience, policy easing – whether through credit or increased investment – leads to a significant improvement in liquidity. Industries sensitive to liquidity, such as those in coal and non-ferrous metals, see their market performance improve first; the chemicals sector has somewhat less resilience, but companies with strong ties to the coal and non-ferrous metals industries follow a similar pattern. As the real economy slows down, industrial product production is significantly reduced, and the entire supply chain continues to work on reducing its inventory levels. Once liquidity and demand prospects improve, the inventory levels in the upstream raw material industries drop quickly, but they are also replenished at a rapid pace. 　　Against this backdrop, several specific short-term data points and trends in the chemical industry will reinforce the view that a bottom has been reached and recovery is underway. Looking at the period of recovery, it seems the conclusion is correct; but in retrospect, we prefer to define it as a \"pseudo-recovery\". 　　Firstly, following the Spring Festival, and with large-scale operations not yet underway at the downstream end of the supply chain, the chemical industry initiated a significant round of inventory building. In particular, the industry PMI figures for January indicate a sharp increase in activities related to \"stock reduction + production recovery + replenishment of raw materials\", suggesting a demand from the supply chain to rebuild its inventory after the holiday period. Meanwhile, the capacity constraints and production halts associated with the Spring Festival in January indeed caused production levels in the industry to drop to their lowest levels. 　　Secondly, with the resumption of operations after the holiday, prices of some chemical products have risen sharply. Representative products among these include butadiene, adipic acid, and BDO, with weekly price increases of over 10 percent, which seems to indicate a situation of supply falling short of demand due to reduced supply. 　　In reality, inventory rebuilding in the chemical industry remains confined to the middle segment of the industrial chain; it is the result of a rebound following supply constraints in specific sub-sectors as well as higher costs, while inventory rebuilding in the downstream sector has not yet begun on a large scale. So starting in March, both production and prices were once again suppressed by demand. Furthermore, the performance forecasts for the first quarter released by most companies were **below market expectations. With reduced supply and significant pressure, there were no signs of a bottom forming in terms of prices and profits, which led to a market dominated by pessimistic outlooks. Coupled with continued policy measures to regulate the real estate sector, this resulted in volatile market conditions. 　　Annual Strategy Verification: Assessing Valuation Revisions and Underestimated Performance Declines. In our annual strategy for the chemicals industry, titled “Pessimism Is Already Reflected in Valuations; Opportunities May Lie at the Bottom,” we put forward two points: First, the valuations of the chemicals sector at that time implied a negative performance growth of 30%–50% in the first and second quarters of 2012. Such pessimistic performance forecasts corresponded to an extremely unfavorable macroeconomic environment; this situation might reach the lower limit tolerable by policymakers, prompting policy adjustments soon after, which could create opportunities for valuation revisions ； Second, the decline in gross profit will continue until the end of Q1 2012; however, due to the high absolute prices of commodity costs and an absolute excess in production capacity, a rapid improvement in this situation is not expected. 　　Regarding the first point, the market trend is generally in line with our predictions: there was a significant rebound in the market before earnings reached their bottom (mainly due to valuation corrections, as the market believed that the economy wasn’t that bad or that a new recovery cycle would soon begin). However, the decline in the earnings of listed companies was **greater than what we had expected. From January to February, the industrial added value of the chemical raw materials sector increased by 13% on a year-on-year basis; however, the profit growth rate for this sector is expected to be around -50%. Based on the quarterly performance forecasts released by listed chemical companies, performance in traditional chemical industries has declined significantly. Sub-sectors such as chlor-alkali and chemical fibers are set to continue the trend seen in the fourth quarter of 2011, characterized by minimal profits or even losses. And various signs indicate that the current year-on-year figures are not at their worst. 　　Regarding the second viewpoint, it remains to be tested in terms of timing, but the probability of making a mistake is high. Apart from the apparent recovery in gross margins observed during the short 2-3 weeks after the holiday, driven by inventory replenishment within the industry chain, the chemical industry remains in a state of shrinking gross margins, with high-cost production capacities exiting the market or oligarchs colluding to limit production levels. These conditions have been confirmed by developments in various sub-sectors such as joint production restrictions in the soda ash industry, reduced operations by chlor-alkali manufacturers in the southwest, significant delays in the commissioning of new PTA capacity, and periodic maintenance activities at petrochemical plants. However, contrary to previous assessments, under conditions of supply contraction, the ongoing deterioration in demand has had a greater impact on the chemical industry than expected, and there is a possibility of further deterioration. 　　Real estate demand is the biggest variable in the medium term. As a typical midstream industry, its performance is determined by both upstream and downstream factors; however, there are significant differences among various sub-sectors, each serving different end-users. Therefore, before analyzing the impact of demand changes, we reviewed the market value structure of the chemicals sector once again. Based on the correlation among different sub-sectors, within the basic chemicals sector of the A-share market, agricultural chemicals have the largest market value weight (26%), with companies in this area mainly producing fertilizers and pesticides; followed by plastics and alkalis (22%), with companies involved in the production of alkalis, plastic raw materials, and related products ； In terms of downstream sectors, real estate, the automotive industry, and agriculture are the largest, accounting for 29%, 27%, and 27% of the total market value of these sectors respectively. 　　The overall research in the chemical industry will focus on the upstream sector, where crude oil and chemical raw materials (such as coal used for chemical production, electricity, and natural gas) are resources whose prices change infrequently in China. Among the downstream demands, the real estate sector represents the biggest source of uncertainty in the medium term; it was also one of the main reasons why we misjudged the timing of a recovery. 　　Chemicals in the real estate sector: Demand risks have not yet been fully resolved. Recently, the recovery in real estate transaction figures has once again become a focus for the market. Some developers have increased their efforts to compensate for lower prices by offering more properties at faster speeds, and the relaxation of interest rates on first-time home purchases in certain cities has also helped to stimulate demand among those with genuine purchasing needs. The improvement in real estate transactions has sparked renewed interest in related sectors within the market. However, if we look more forwardly at property sales, medium-term real estate investment, and the impact on related industries, this is not yet the period of lowest demand. 　　As the sale of commercial housing relies increasingly on bank financing (personal mortgages), we use the volume of new personal housing consumption loans as a constraint on real estate sales. Historically, the amount of new loans for consumer housing purposes has accounted for 10%-19% of the total new loans issued throughout the year (with 4.4% in 2008 representing an extreme case). Assuming a relatively neutral proportion of 12%-14%, 8 trillion in new loans issued over the year would correspond to 0.96–1.12 trillion in new loans for residential housing. The leverage ratio for residential sales (new personal housing loans/sales volume) remains around 15%-30%. In 2012, housing lending conditions were more relaxed compared to 2011, so a level of 20%-25% is more likely; the estimated range for residential sales growth in 2012 is -21.0%-15.2%. Sales from January to February showed a cumulative year-on-year decline of 20.9%, entering a poor range. Considering a year-on-year decline of around 10% in the average price, there is still a 10% decline in the actual sales area. However, due to the low sales volume in January and February, and under the constraints imposed by the overall annual sales figure, it is expected that the monthly cumulative sales of residential properties in 2012 will remain at low levels compared to the previous year. Since residential properties account for over 80% of total real estate sales, it is unlikely that overall real estate sales for the year will exceed expectations significantly. 　　Historically, sales have led new starts by about 6 months, with new starts in turn leading construction. At present, the growth rate of new start areas has begun to decline sharply, and it is unlikely that there will be a significant recovery in new starts at least until the third quarter. More importantly, the seemingly strong sales figures recently are largely due to property developers compensating for lower prices by increasing volumes. Unlike in the past when both volume and prices rose, thereby boosting further real estate investment, we believe that sales may gradually recover this time around. However, the effect of price cuts has significantly altered developers’ expected returns on real estate investments, reducing their enthusiasm to reinvest funds after they are recovered. Structural credit controls further limit developers’ ability to reinvest, which may result in a recovery in new starts occurring later than expected. 　　Due to the large-scale start of construction of affordable housing in 2011, while sales and new starts declined significantly, the growth rate of construction area remained relatively high. Most demand for chemical products is more closely related to the growth rate of construction area, and it is expected that construction activities will decline significantly in Q3–Q4 2012. That will likely be the time when demand in the real estate-related chemical sub-sector is at its lowest. 　　Overall, given the significant impact of the real estate sector on the chemical industry, along with the high elasticity of chemical products themselves, there are some short-term opportunities for counterbalancing price movements that cannot be refuted. However, in the medium term, it is still advisable to avoid industries in the chemical sector that are related to real estate. Even though Q1 2012 was likely the worst period in terms of performance, with high-cost companies suffering heavy losses and low-cost companies achieving only modest profits or even losses, a trend toward recovery is still a long way off, and greater demand-related risks have not yet materialized