China’s real GDP growth in the 3rd Quarter of 2015 was 6.9% (annualised) according to official figures released on Monday. The official target for 2015 is 7.0% p.a. growth, and so far in 2015, the results released show China is on track. But is it really?
That’s the official stance. There are very few investors or economists that believe the official stance however. There are two schools of thought:
- Some believe that China’s data is a complete fabrication.
- Others believe they are managed but a version of the truth.
The majority of the evidence leans toward the latter, as do we.
That leaves us trying to second guess what the real story is. The starting point is to be clear about what we need to focus on. GDP growth is not what we invest in, it is merely a measure of whether there has been or likely to be a rise or fall in the demand for the goods and services produced by the companies that we actually invest in.
For the rest of the global economy, what is important is that China’s demand for trade, that is goods or services bought from the rest of the world, remains high. One more reliable source of data is China’s “nominal” (including inflation) GDP growth. Most economists agree that it is through the inflation adjustment that the official figures are managed, as the nominal GDP growth is far more volatile, like most other countries’ GDP data tends to be quarter to quarter. Nominal GDP grew at 6.2% year-on-year in the third quarter of 2015. (Note the issue with the official “real” data – Real GDP growth was published at 6.9%pa, implying that inflation was -0.7%, despite the official CPI figures being more like 1.4%pa).
In Australia’s case, we need China to remain healthy as we are reliant on exports to China for around 6% of our GDP. Tourism, education, and increasingly the property sector rely upon the wealth effect of China’s growth, and of course the mining sector is reliant upon China for iron ore and other commodity trade. So it is worth looking underneath the economy-wide GDP figures for what is going on sector by sector.
Australian sector outlook
Services
The service oriented sectors of the Australian economy that relies upon China’s demand for Australian services driven by household wealth in China, the strongest indicators of the economic trends in China is their own services sectors. There are two stories to tell:
1. Growth in China’s services sector is very strong, at 8.4%pa growth, and has been for four years. This is good news as it means that China’s economy is transitioning from an investment (infrastructure and property) lead economy to a domestic consumption lead economy.
2. Financial sector growth comprises the vast majority of the services sector growth. That is less encouraging as it could imply a leverage or stockmarket bubble is forming, but we really can’t tell whether that is the case any better than we could with western economies leading up to 2008. Nominal growth in the financial sector is growing by 27%pa up from its average since 2011 of 15%pa, while construction has fallen from an average of 11%pa to just 4%pa.
Industrial
The industrial sector is the driver of our commodity exports, the reality is that there has been very little growth in years. Steel production, for example, has risen by 5.4%pa since 2012, but nil growth since this time last year, falling slightly since its peak in March 2015. Other indicators of industrial output look much the same:
- Electricity Output: Up 0.1% year on year (yoy)
- Seaport cargo volumes: Up 1.4% yoy
- Domestic cargo volumes: Up 5.8% yoy
- Cement production volumes: Down 2.9% yoy
For Australian investors the bottom line is that China’s economy appears to be slowing at a moderate pace, which is the best we can hope for. Industrial production is not growing at the pace it was, and it is unlikely to return to those levels, so the days of the China driven commodity boom are over. But demand for our commodities will likely remain consistent, which means resource company earnings should be well supported in the longer term. For the rest of the economy, the key is the financial services sector in China, specifically “Is there a bubble forming that could burst and cause a hard landing for the consumer driven economy in China?” This would flow on to the Australian economy, hurting tourism, education and property in particular.
Our preferred strategy for hedging against ‘a harder than expected’ slowdown in China is summarised in the article, ‘Short China’ defensive portfolio. The portfolio includes: non-AUD denominated corporate bonds (particularly USD and GBP) and infrastructure bonds due to their reliability of revenue throughout the economic downturn that would be caused by a China slowdown. Avoid high PE resource stocks and those reliant upon high dividend yields to justify their share prices, favouring investment grade rated corporate bonds or the equities of the major resource companies with the ability to reduce costs.