Monday, June 4, 2012

A Hard Landing For China?

Probably the two most worrying macro events of 2012 will be, if and when, China and Spain come out of their respective property slumps.

Before focusing on China, a few words on Spain. Its problems are quite deeply embedded with its economy. Following an extended property boom, Spain’s GDP growth and its public finances, became reliant upon the housing market. Indeed, prior to the recession, Spain’s public debt situation was looked on favorably. Not anymore!

Spanish banks hold a lot of distressed properties on their books, and their bank's bad debt ratios (unlike the US banks) are getting worse with the ongoing decline in house prices. Equally worrying, Spanish banks hold significant amounts of Portuguese Government debt. So, we have a scenario of declining underlying asset prices, leading to declining capital/asset ratios, leading to the necessity for increased bank funding. Ultimately, this calls for Government aid which leads to an even bigger stress on public finances. And so it goes on. Does it sound familiar?

Well if it does, then why aren’t similar questions being asked of China?

China’s Growth is Slowing

Frankly, I don’t think there is any doubt that China’s growth is slowing and, I would be wary of chasing the commodity story higher. The world and his wife, knows that the increase in marginal demand for hard commodities has being driven by China. Indeed, the major commodity metals stocks such as Southern Copper Company $SCCO Vale $VALE and Rio Tinto $RIO have all been used as proxies for growth in China’s fixed asset investment.

Raw materials like copper are widely used in the construction industry and the price of the metal is intrinsically linked with fixed asset investment. Similarly, the main demand for iron ore comes from the steel industry and, China is the swing player in steel consumption. Indeed, the negotiation of iron ore contracts with China is a key event in Rio and Vale's revenue outlook.

If China's fixed asset investment is set to slow, then hard commodities only have one way to go. Moreover, the companies that service such growth such as Joy Global $JOY or Caterpillar $CAT could also suffer disproportionately. Joy Global's mining equipment is extensively used in China and Caterpillar is a name synonymous with construction. Both are aggressive players in China.

Before being too quick to conclude a slump, let’s look at some of the data. For example, let's consult a few charts from the official China National Bureau of Statistics.

Firstly, fixed asset investment growth is slowing.

This isn't a surprise because China's commercial floor space sales growth is now negative.

The China optimists argument is that the Government has successfully engineered a slowdown in the housing market so we should now see demand catch up with supply. The bulls point out that the slowing of real estate land purchased will ultimately result in a deficit of supply.


However, I should note that housing starts in the US started declining as long ago as 2006!  Restructuring from a housing slowdown takes time. I see no reason why China will be any different.

The Great PMI Debate

Recently, the official Chinese Purchasing Managers Index (PMI) for March hit its best level for a year whilst, the HSBC/Markit PMI number came in below 50. Moreover, the latter data represents the fifth monthly decline. Which number is more accurate?

Frankly, I find the official number puzzling because it does not tally with the direction of other official data. Nor does it correlate with the other sources of China data. For example, I’ve tabulated 3 month average automobile sales from the China Association of Automobile Manufacturers. Here are the year-on-year growth rates for recent months.
It’s hard not to conclude that China’s growth is not slowing. Indeed, BHP Billiton recently stated that Chinese iron ore demand is ‘flattening’.

Can China Grow out of a Slowdown?

Despite the gloom, there is cause for optimism. China has huge gold and foreign currency reserves in relation to its GDP. Naturally, this is a consequence of years of surpluses that have been the pride of China’s economy. No doubt this will be used to counter the effects of a slowdown. Therefore, I think that even the Chinabulls would argue that we are likely to see a change in the composition of growth.
Of course, China remains a Communist country and, is a nation that requires concerted attention to preserve social cohesion. This costs money. Consequently, I would expect a shift in emphasis towards domestic consumption and also, increased investment in social infrastructure such as hospitals. Much of which will require hard commodities, so the position is not entirely negative for commodities.

In conclusion, the composition of growth in China is going to change and, accepting this viewpoint will require a shift in thinking on which stocks will be the ways to play China. That is a subject for future debate, but for now ,I would be careful with hard commodities.