China’s PPI has been rising rapidly in recent months, while the difference between PPI and CPI has soared from –7.5 ppt in December 2015 to +4.4 ppt in January 2017. Some investors worry that rising PPI and a widening PPI-CPI gap indicate margin squeeze for industrial enterprise, and declining profit/GDP growth shortly after. In this note, we analyze the empirical evidence between the PPI-CPI gap and industrial profitability. We conclude that both PPI and the PPI-CPI gap show a strong positive correlation with industrial profit growth and margin.

Contrary to popular beliefs, the PPI-CPI gap exhibits a strong positive correlation with the production growth and industrial profitability.

On the margin, China’s economic cycle has been driven by investment and exports. Higher PPI usually signifies stronger investment and export demand, rather than just the increase of input costs. In fact, around two-thirds of the overall PPI weight is contributed to tracking the prices of downstream manufactured products. Historically, PPI has exhibited a strong positive correlation with the investment growth and industrial production cycle in volume terms, as stronger demand growth enhances the pricing power of industrial enterprises.

Not surprisingly, profitability of the upstream and midstream industries is usually more sensitive during a cyclical upturn. However, downstream industrial profits also tend to grow faster in years of strong PPI inflation, reflecting underlying robust investment and export demand.  Revenue growth and profit margin usually move in tandem in China, since higher output volume pushes up the operating leverage of industrial enterprise; meanwhile, robust demand growth allows higher input cost to be passed on to downstream producers and end consumers.

While PPI provides a good indicator of price pressures in the tradable sector, China’s CPI are driven more by the dynamics in the non-tradable sector and changes in domestic food prices. In addition, questions are often raised about whether the official CPI has adequately captured the underlying consumer price inflation, particularly for components such as rent. We share some of the concerns on how CPI is compiled in China. Nevertheless, before any of the statistical survey methods are changed, the reported PPI-CPI gap tends to widen during a cyclical upstream.

We expect PPI inflation and industrial profit growth to remain robust this year, likely next year as well. Our high frequency “pulse check” indicates that economic activities picked up stronger and earlier this year after Chinese New Year compared with the past 5 years. We expect sizable upside to 1Q activity and corporate profit growth given a low base and solid sequential momentum post CNY.  More importantly, the reflation and industrial profit cycle will likely be more sustainable then the market expects. We foresee double digit nominal GDP growth for both 2017 and 2018.