Australian investors need to understand the Chinese economy. The probability of a hard landing is rising and a double whammy of lower commodity prices and an exodus of Chinese capital could hit your investment portfolio
The year ahead will be make or break for China. Over the past two years we have stated that our base case for China was that it would successfully transition its economy from its addiction to investment capital, to a mature consumer lead economy – without a hard landing. We have gradually increased our probability of a hard landing from 25% to 30%, and up to 35% during 2016 as the Chinese government failed to slow down credit growth. We still think they will avoid a hard landing, but the probability of a hard landing is growing.
To recap, there is no silver lining for Australia from a hard landing in China. Commodity prices and volumes would fall steeply, both in terms of bulky minerals like iron ore and for agricultural commodities. What’s worse, an exodus of Chinese capital – currently representing $1 in every $7 in terms of transactions – would result in a severe downturn.
This double whammy to the Australian economy would likely tip us into a recession for the first time in 25 years. Contributing forces would include:
- the current weakness in domestic labor markets
- ·very low wage growth suggesting little employment growth in the near future
- low inflation and an already slowing construction sector
So, it is critical for every investor heavily exposed to the Australian economy to maintain watch over the Chinese economy. While there have been extraordinary gains made off the back of the Chinese economy’s ascendency, much of these gains can be wiped out quickly in a sharemarket downturn as we’ve seen so often. The trade off between missing out on that last 5% to 10% gain and protecting the wealth you have already accumulated is probably one of the most important investment decisions, and the toughest to make.
We can’t make it for you, but we can at least pay due respect to China and provide you with some insights into what 2017 might hold in store for us.
The current state of China’s economy
Over the past 20 years, China’s economy has depended heavily on investment into fixed assets such as roads, railways and apartment complexes. But over the past decade, as cheap exports’ share of the economy has fallen sharply and household consumption has been replaced by more and more saving, fixed asset investment has become one of the primary drivers of economic growth and employment in China. I Worryingly, it is now the cornerstone of China’s stability and not just the growth engine.
As much of China’s fixed asset investment comes from the country’s biggest state owned banks – including the “big four,” which answer directly to Beijing – its importance as a policy tool explains why Beijing has allowed credit growth to balloon to almost 250% of China’s gross domestic product (GDP).
Corporate debt, by far the largest share of China’s total debt, has likewise surged by more than 60% to top 165% of GDP. Now, a nationwide debt crisis looms amid business defaults and bankruptcies, low industrial profits, plummeting returns on investment and the prospect of another slowdown in the real estate sector.
How well Beijing manages these problems in the months ahead will, to a great extent, will determine China’s economic, social and political stability for years to come.
So far, so good.
During December we will look to China’s outlook for 2017. Before that, it is worth looking at the current state of the economy to see what momentum they carry through to next year.
- Manufacturing activity is holding steady
The China satellite manufacturing index (from San Francisco’s SpaceKnow Inc) uses satellite imagery to monitor factory activity levels, rather than rely upon oft questioned official figures. This index reached its highest level since mid 2011 in October 2016. The official Caixin purchasing manager’s index (PMI) figures, which are far less volatile than the satellite index, also rose in October to their highest level since 2014.
- Steel sector confidence jumps
The S&P Global Platts China Steel Sentiment Index, a survey of around 90 Chinese steel traders and mills, jumped strongly in October.
- Large business confidence
Listed company confidence, as measured by the Market News International China Business Sentiment Indicator, rose slightly in November but still remains well below its average.
- Small business confidence
Standard Chartered’s Small and Medium Sized Enterprises (SME) Confidence Index fell to 55 from 56.1, as government targeted capacity reductions in steel and property sectors dampened confidence.
- Retail spending
Retail spending was up 10.0% to the end of October, but down from 10.7% in September and 11.0% for the same period last year, according to the National Bureau of Statistics. Retail spending needs to hold up for China to maintain its momentum. Recent months have shown a gradual decline, however you should note that 10% growth in China’s retail spending is equivalent to around 5.5%pa growth in US retail spending, which if it occurred would boost the global economy dramatically. So 10% is a good number; we just need it to hold up.
- Private sector investment
Private sector investment growth, as opposed to investment by government controlled entities, is very low compared to 2015. It grew 18.4% in 2014, 10.1% in 2015, and just 2.1% so far in 2016.
This is an alarming vote of no confidence from the profit driven private sector, and hurts the credibility of the state owned enterprises that keep borrowing to invest in projects they claim to be attractive.
- Corporate debt and the property sector
Global concerns are rising and even China’s billionaire property developers are calling time on the boom. Wang Jianlin, the richest man in China and a property developer himself, has called the Chinese property market “the biggest bubble in history.
Summary
We saw 2016 begin with financial markets very concerned about China. The ASX fell 10.1% in three months, with big miners like BHP Billiton particularly hard hit – but that seems a distant memory now thanks to stronger economic data out of China from March. But it would be prudent to consider the sustainability of China’s apparent resurgence and consider what would happen to your portfolio in the event of fresh economic concerns about China.
Whether the concerns for China arise from a property sector slump, credit defaults or slower retail sales, a change in sentiment will hurt both the ASX and Wall Street – as they are both currently pricing in an optimistic “business as usual” scenario for China in 2017.