Tuesday 16 August 2016 by Craig Swanger Opinion

China’s investment cycle collapse provides strong signal to switch resource investment from stocks to bonds – Part 2 of 4

The latest data from China shows its investment cycle has collapsed. Return on equity has declined to under 6%, debt has risen rapidly as has non bank shadow lending. Resource companies will find it increasingly difficult to generate satisfactory returns and now is a good time to sell out of the equities and buy the bonds

Quarry machinery digging hole

China’s investment in its urban centres, infrastructure, residential, office and industrial assets has been significant on a global scale, and China’s way of delivering quantitative easing, boosting its economy and growth rates.  However the end of “cheap China” was inevitable, meaning that the urbanisation investment boom had to come to an end.  The July data confirms this.    

China’s urbanisation – a driver of the Australian mining investment boom

Urbanisation is the transformation of an economy that typically occurs when of the growth of industrial jobs in cities encourages rural families to leave the country and move to the city.  Europe experienced this in the 1850s, the US in the late 1800s/early 1900s, Japan from 1960 to 1980 and then China from the mid 1990s. 

In each case, the urban population goes from around 30% of the total population to around 60%, and typically in about 20 to 40 years.  In the case of Europe, the US and Japan, the growth of urban centres was phenomenal. For example, New York grew from 2.5 million to 6.2 million people in 20 years from 1890 to 1910, and had reached 10 million by 1930.

China’s urbanisation followed very similar patterns, except this time 30% of the population involved a massive 360 million people moving to its cities since 1985, or 12 million people per year. 

The construction project that has resulted defies belief for those of us outside the country.  It is the equivalent of building the entire city of Adelaide every month for 30 years: every road, school, hospital, house, power station, airport, office building, water, electricity, and so on.  Sure the quality might not be up to Adelaide’s standard of living, but even at half the standard, the scale of this investment is colossal and the demand for our iron ore phenomenal. 

China’s investment phase has passed its use by date

Investing is about the future, and that building boom is, sadly for Australia, largely in the past.  There are two realities that investors in commodity producers need to understand:

  1. Any extension of the China investment boom is only likely if artificially stimulated by the Chinese government, and therefore of questionable sustainability
  2. Every new dollar invested is now of increasing risk of fuelling excess capacity, and therefore creating asset market bubbles in China

Economists call it “fixed asset investment”, which is the investment of capital in hard assets1 such as infrastructure, housing, buildings, and equipment.  Fixed asset investment is important for any economy, as it is only these fixed assets that increase the capacity for growth; more roads to move workers from more houses, to more factories to produce more goods. 

In a mature economy such as the US or Australia, fixed asset investments represent around 25% of GDP growth, but for emerging economies in their investment phase, this figure can be much higher.  At its peak in 2012, fixed asset investment represented 40% of China’s GDP growth. 

But China was nearing the optimal level of fixed asset investment around 2006 to 2008.  The GFC, in some perverse way, actually supported fixed asset investment as the Chinese government responded swiftly and committed US$600 billion to stimulate the economy, through investment in infrastructure and other hard assets.  This package also supported the back end of Australia’s mining investment boom.  

Since then, China’s fixed asset investment has been increasingly fuelled by debt.  Specifically, it has been the state owned enterprises that have borrowed to invest in steel, coal, infrastructure and housing projects, in order to meet Beijing’s growth demands.  The result has been healthy in many cases, promoting consumer investment in housing and new manufacturing capabilities such as high value technology that are transforming the Chinese economy. 

However, a lot of this investment was only contributing to a global glut of manufacturing capability.  This has since resulted in the longest period of global price declines in manufacturing exports, and largely contributed to the global deflationary period of the past seven years. 

The implications of excess capacity in China’s manufacturing, property and infrastructure sectors are particularly worrying for Australia’s mining sector.  Prices will be under downward pressure until supply is reduced, meaning that only low cost mining operators can be sure to survive the inevitable slowdown in Chinese imports in the decade to come.

Latest data supports this view

  1. Fixed asset investment from the private sector grew at just 2.8% in the first half of 2016, compared to 10.1% in 2015 
  2. State Owned Enterprises (SOE) have picked up the slack on investment, but funded this through borrowing:
    1. Fixed asset investment from SOEs is 23% up on last year
    2. This is largely funded by debt, with local government funding vehicles seeing a 224% increase since 2009
  3. Return on equity from SOEs is just 5.9%, compared to 17.7% for private companies (and 13% for ASX200 companies)
  4. Corporate leverage in China is up 52% since 2009
  5. Non bank (shadow) lending has jumped from 30% of GDP to 55% in the same time

For Australia, the end of the investment cycle was inevitable and should have been anticipated.  Whether it was or not is now a moot point and history will judge the governments of the day in due course.  For investors, the future is all that matters – and the future in the case of Australia’s mining companies will be owned by larger operators that are able to manage their costs and balance sheets, and continue to earn free cashflow despite a long period of low commodity prices.

For investors, the maturing and even decline of the fixed asset investment cycle means waiting for a jump in earnings from resource companies is likely to be an exercise in disappointment; it’s all about cost and balance sheet management for these companies now. 

It’s a good time to switch resource stocks that you might hold into corporate bonds in the same names, for much improved certainty of income and return:

Iron Ore and other bulk commodities:

BHP

Bond Coupon Yield to maturity
2020 USD 6.25% 3.52%
2025 USD 6.75% 4.67%
2022 GBP 6.50% 3.85%

Fortescue Metals Group

Bond Coupon Yield to maturity
2022 USD 6.875% 6.34%
2022 USD 9.75% 6.58%

Oil and energy:

Bond Coupon Yield to maturity
Santos 2017 EUR 8.25% 4.96%
Origin 2018 EUR 7.785% 6.24%
TransAlta 2022 USD  4.50% 4.50% 
TransAlta 2040 USD  6.50% 7.33%

Mining services:

Bond Coupon Yield to maturity
Ausdrill 2019 USD 6.875% 7.40%

Gold:

Bond Coupon Yield to maturity
Newcrest 2022 USD 4.20% 3.26%
Newcrest 2041 USD 5.75% 5.40%


All bonds listed are available to wholesale investors only
Note: Pricing accurate as of 16 August 2016 and is indicative only. For more information please contact your local dealer or FIIG at 1800 010 181.



Fixed Asset Investments not always “hard assets”; they also include IP and goodwill


Bond Coupon Yield to maturity
Ausdrill 2019 USD 6.875% 7.40%


Gold:

Earn over
6% pa* with Corporate Bonds

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