Tuesday 29 August 2017 by Craig Swanger Opinion

Top four winners and losers in a China hard landing

Last week, we discussed the growing probability of a China hard landing. This prompted some clients to ask what specifically would happen with different sectors they are invested in. This week, we follow up with a list of four winners and losers

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For all the talk about the possibility of a hard landing in China, there is little talk of exactly how that would flow into the Australian economy.  There is little disagreement about the macro view that a recession would certainly be likely, that the dollar, property and the stockmarket would suffer.  But for investors managing their own portfolios, it is then important to understand which sectors would be most impacted.  This list isn’t comprehensive, rather it is intended to show some of the unexpected and some of the obvious impacts from such an event.

Winner #1: Exporters

For companies with the bulk of their earnings from overseas buyers, such as education, tourism, technology, investment banking and some property sectors, a Chinese hard landing and the consequent fall in the AUD would be a welcome event.  These are the minority of Australian companies, particularly when you take into account the likely decline in exports to China, but they still exist.  Macquarie Bank is one such example with more than 55% of its revenue from offshore and little from China.  Similarly, insurers, whose income in Australia would be relatively unaffected by a slowdown here, and have earnings growth from Europe and North America. 

Winner #2: US economy

This is more of a Steven Bradbury win, but the US economy and therefore the USD, would likely be the main beneficiary of a Chinese hard landing.  The ability of China to erode the US’s global economic and military power would be reduced for years under a hard landing scenario during which Beijing would need to turn inwards to shore up social stability and engineer a recovery.  Europe’s recovery has been largely driven by export growth, much of which has been to China in the form of heavy engineering and technology.  As this recovery is weak, a downturn in China in 2017 or 2018 would send Europe back to stagnation.  Japan and ASEAN would clearly suffer too.  This leaves the US, driven by its consumer’s confidence, spending, relatively low debt and the lack of dependence upon exports, attracting more investment dollars for the years that follow.

Winner #3: Australian infrastructure

Infrastructure assets tend to be recession resistant.  Demand for their output, such as electricity, traffic volumes and airport passenger numbers, declined by only 1 to 8% during the worst recession in the US since the Great Depression.  That means infrastructure assets are considered “safe harbour” investments and will generally benefit from market nervousness.  Infrastructure development will also likely benefit as the Australian Government would (hopefully) accelerate development projects in response to the downturn.  This latter point isn’t a given as it requires politics and economic rationality to align, but it is quite likely that development project suppliers such as engineering and major construction firms would benefit, partially offsetting a decline in construction.  

Winner #4: Low risk assets

Assets that are either low risk in that they don’t tend to fall much in value or income in a recession (property with long term leases, bonds, insurance sector, grocery sector, high quality RMBS) will come under heavy demand when investors seek to reposition themselves.  Unless this time is different, this tends to happen after the event, putting these asset prices under significant upward pressure.  This is obviously the flipside with the exodus of capital from equity and other high risk asset classes in this scenario.  Even within equities, the winners tend to be higher dividend companies with relatively low payout ratios, while the losers are those companies relying on debt to maintain dividends like some of the listed property trusts in 2008 or Telstra this year. 

Loser #1: Global economy

Rest assured Australia, we will not be alone.  The global economy needs China to manage a soft landing.  This economic recovery has been the worst in history, meaning that while it is a recovery, it is a very weak one.  With each painful step in the easing of QE measures and raising of US interest rates, markets and the economy has taken one step backwards before moving forward again. 

Growth is very fragile.  Inflation is weak and in most countries, wage growth is still very weak too.  The US’s economic recovery has been the strongest and longest lasting so far, but its 2%pa GDP growth is hardly exciting by its own historic standards. 

A hard landing in China, particularly one created by a sudden end to its property construction cycle, will likely bring the European and Japanese recoveries to an end.  The US economy is more capable of surviving external shocks, assuming that there is no permanent damage caused by the Trump era.

Loser #2: Commodities

Copper and iron ore in particular, will suffer.  Copper is highly correlated to the Chinese housing market, with Asia consuming 62% of copper demand.  Approximately 75% of global demand for copper is for electric wiring, so housing and infrastructure projects are a major driver of demand.  Trump’s infrastructure program could have replaced the inevitable fall in China’s housing market, but that program is now looking much less likely.  Copper is highly sensitive to supply and demand due to the long mine development cycle.  A slowdown in Chinese housing development would likely see the price fall from its current US$3.08/pound to between $1.50 and $2.00/pound.

Iron ore has shorter mine development cycles, but it is also much more sensitive to transport costs.  This means that a fall in Chinese demand for iron ore will particularly hurt Indonesia and Australia.  Unlike copper, iron ore is also subject to inefficient production in China, so there will be a supply side reduction that will temper the impact of the global price, but a fall back to US$40-50 a tonne is likely, with downside risk if there is not supply side reform too.

Loser #3: Construction

Chinese investors aren’t buying up large tracts of Australian soil.  However, they are buying a very large percentage of new apartments and by entering the suburban housing markets in Sydney and Melbourne, they have created a wealth effect that means Australians feel they can afford to buy more expensive property and increase property investment themselves.  Official data on individual purchases of properties is not available or simply not collected yet.  But one study by the IMF estimated that there is currently A$32 billion in settlements by Chinese buyers of yet-to-be-completed apartments in Australia.  A small fraction of that supply coming back on to the market due to failure to settle will severely depress inner city prices in Sydney, Melbourne and Brisbane, with the latter two already facing oversupply pressures. 

The construction sector has driven the jobs recovery since the end of the mining investment boom.  Despite a record value under construction, wage growth is still at record lows.  Were there to be a sharp decline in conditions as we saw in 1992 and in 2004, the impact on the construction sector and on the Australian economy as a whole would be severe.  

Loser #4: Retail

The retail sector is already famously under threat.  Amazon is coming and while overdone in the current bout of hysteria in the media, the US experience is that traditional retailers have seen falling margins at best, with many going into bankruptcy.  Australia hasn’t seen the full force of Amazon or Alibaba yet, but it is obviously coming very soon.  If consumer spending were to fall, which is inevitable in a China hard landing scenario where jobs will be lost, this could be the final straw for our retail sector.  That includes, for completeness, the retailers themselves as well as retail property and property trusts.  

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