What we learnt in China

In managing our clients’ NZ and Australian investments it is critical to have a clear view on what is happening in China. China is not only the worlds’ second largest economy, Australia’s largest and NZ’s second largest trading partner, its economic performance is also very important to investor sentiment around the NZ and Australian share markets. We send a member of our investment team to China annually, as there is no substitute for being on the ground to gain a detailed understanding of what is actually happening.

While our stock picking is very much based on “bottom up” analysis, the China visit allows us to learn more, first hand, about trends, risks and opportunities in this economy. After a period of resurgent growth in China and volatile but generally rising commodity prices, Portfolio Manager Tama Willis  recently spent a week in Beijing, Shanghai and Taiyuan attending presentations, talking to companies and commodity experts and meeting with other investors from the US, Hong Kong, the UK and Australia. In contrast to the current market backdrop, our last visit to China in January 2016 came at a time of significant weakness in the Chinese equity market, concerns around capital outflows, and fears of rising risks to the financial system as a result of bad debts in over-indebted corporates (principally in property, steel, coal and infrastructure construction). The conclusion at that time was that the government had control of the capital account and that a “hard landing” would be avoided. This turned out to be accurate as the government and economy confounded the (vocal) pessimists through stimulating growth, stringent capital controls limiting outflows and some progress being made on the restructuring of inefficient and polluting industries.

Macro-related meetings during our recent visit generally confirmed that growth is likely to be supported over the balance of 2017 through infrastructure spending, prior to a political reshuffle in October. Industrial production rose 6.4% year-on-year in  February, credit growth remained supportive (+13%), property sales rose 25% and fixed investment lifted by 8.9%. Chinese corporates are benefiting from a range of influences including higher nominal GDP growth, the restructuring of industries with excess capacity like steel, coal and aluminium, and policy support to clear excessive property inventory in Tier 3 and 4 cities. However, this growth is expected to peak in the first half of the year. Looking forward to 2018 our view is that urbanisation can only support stable (rather than growing) property development and with unfavourable demographics (aging population) the momentum will wane resulting in a decline in fixed asset investment growth and slowing growth momentum overall. Time will tell whether this view is correct.

While capital investment across the economy should slow, the consumer is in good shape barring a sustained property downturn. We met the China Association of Automobile Manufacturers which expects auto sales to rise by 5% this year to 29.5 million units (+13% in 2016). The China Household Electrical Appliance Association also anticipates replacement demand for major white goods to rise 72.5% over the next five years versus the prior period. Activity in the services sector is also tracking well. Air passenger trips increased 17.6% in January on the previous year to 43.9 million trips. After a stable year in 2016 and following 40% per annum growth between 2012-2015, China’s movie box office got off to a strong start in 2017 with box office sales up 10% to a record high during the Chinese New Year holidays.

The Chinese equity market has responded positively to the recovery in growth and signs that some domestic restructuring is taking place. Domestic equities are up around 30% from the 2016 low with Chinese banks and commodity related sectors the strongest performers.

The key risk for the economy remains the rapid build-up in debt. Total non-financial sector debt stood at 277% of GDP at the end of 2016, up from 254% at the end of 2015 and up 130% since the GFC. Of this, corporate debt represents 164% of GDP, government debt 68% of GDP and households at 45%. Both government and household debt is moderate by global standards while corporate debt ranks amongst the highest in the world.

The government’s response to this alarming increase in debt has been two pronged. Firstly, it has cut excess capacity in the steel and coal industries resulting in a significant improvement in profitability. Secondly, it has boosted property demand to clear oversupply in regional markets with consumers now taking on more debt (loan to value ratios have risen to around 50%) resulting in a debt transfer from property developers to the consumer. The next major challenges for the leadership will be to manage the eventual slowdown in the property cycle (when a 100 square metre apartment 20-minutes out of Shanghai costs US$2m and when Sydney appears relatively cheap it seems inevitable), wean the economy off 10%-plus credit growth and accept a lower growth environment driven predominantly by services and consumption. With an aging population the need to generate growth above 6% will recede meaning the quality of growth will become more important. If the government can make a success of this complex transition over the next five years China can continue to confound the sceptics.

Key commodity related takeaways from the visit included:

  1. Steel capacity closures – there was a consistent view that the Chinese government’s decision to close 150Mt or 15% of domestic steel making capacity will be successful and this is expected to result in improved steel industry profitability over the cycle;
  2. Steel  demand - forecasts were in a narrow -1 to +2% range for 2017 with lower exports also expected. For this year the risk is to the upside with strong property starts flowing through to steel demand. All commentators believe Chinese steel demand will fall from current levels over the medium term;
  3. Iron ore – the market entered a “perfect storm” in 2016 with prices rising to over US$80 per tonne due to weak domestic Chinese iron ore production, iron ore restocking by traders and steel producers, and the closure of induction furnaces in China. Meetings on iron ore increased our confidence the price will fall during the second half of 2017 due to rising domestic output and increased supply from BHP Billiton, Rio Tinto, Fortescue and Vale. For this reason we remain slightly underweight the mining sector despite high free-cash flow yields;
  4. Aluminium – 40% of China’s aluminium industry is losing money at present and discussions centred on government mandated capacity closures next winter. This development presents a supportive environment for pricing. In New Zealand this is positive for the electricity sector where around 15% of electricity supply goes to the Tiwai aluminium smelter;
  5. Coal – the final day of our trip was spent on coal meetings in Shanxi, a province representing 30% of China’s 3 billion tonne total coal market. Near term domestic prices are expected to fall following the reversal of domestic production cuts across the industry but the government has effectively set a price floor at lower levels that will help support global prices.

In summary, near-term commodity demand has surprised to the upside. However, from 2018 the eventual decline in fixed asset investment growth rates is expected to see demand for some commodities like steel and iron ore flatten or even reverse which will be negative for certain parts of the commodity complex. In our view this will be the time to be more underweight in the sector.