Title: CHINA SNEEZES, AUSTRALIA CATCHES COLD Date Posted: 01/05/12
Comment: China’s economy is slowing down. GDP in the March 2012 quarter grew at only 8.1%, its lowest rate since the GFC-affected figures of March 2009. Part of the slowdown is deliberately induced. The Chinese government has imposed controls on real estate in order to get residential prices down, and it has succeeded: housing starts, sales and prices starts have been falling in recent months.
Part of the slowdown is not deliberately induced. For example, export growth dropped from 20.3% per year in calendar 2011 to an annualized rate of only 7.6% p.a. in the March 2012 quarter. Here the main cause of the 2012 slowdown is the European recession, but the trend has been going steadily downward since the GFC. Exports are still growing faster than imports, but the gap is narrowing. The March 2012 quarter trade surplus was less than half of the December 2011 quarter trade surplus – from USD 60 billion to USD 25 billion – so the calendar 2012 trade surplus is going to be a long way below the calendar 2011 figure of USD 201 billion.
Looking more closely at the March quarter GDP data, we can see that the problems are not just in property and exports. The manufacturing, agriculture and services sectors all recorded slower growth. Retail sales were flat year-on-year. Electricity output – a time series which is less subject to the vagaries of collecting statistics – has been declining since early 2011. Ominously, however, the weaker economy is not weakening the labour market, where the ratio of jobs to jobseekers hit a record high.
This litany of adverse economic indicators doesn’t mean that China is heading for some sort of crash. China does not have the pre-conditions for the sort of property collapse which the US has suffered. For example, the boom in Chinese property prices was always limited to a few hot spots like Beijing and Shanghai, Chinese banks never had residential loan exposures as big or as bad as the US banks, and Chinese households are still savers rather than borrowers. But the China bears had a win in 2011, and they’ll have a couple more in the next few years, because the Chinese economy is changing.
To put these changes in context, let’s look at how the GFC distorted China’s economy. In the three years 2006, 2007 and 2008, new bank loans were fairly stable in the range 3.0 to 3.6 trillion RMB (renminbi) each year, even though GDP growth was running at 10% or better. There was clearly no problem in funding high growth. Then in late 2008 the GFC caused exports to plummet, therefore unemployment rocketed, so a panicked government unleashed a mega-stimulus package equivalent to 14% of the then GDP. Most of the stimulus took the form of increased bank lending rather than fiscal spending, because the government has a very firm grip on China’s four biggest banks (who account for around half the loan market).
The result was that in 2009 new loans trebled to 10.3 trillion RMB, then declined to 7.9 trillion RMB in 2010 and 7.5 trillion RMB in 2011. New loans in 2012 are forecast to be below 7.0 trillion RMB. It is one of the universal truths of the banking industry that, if a bank suddenly makes a lot more loans, many of these loans will be bad – that is, the ratio of bad loans to total loans will rise. So it was with China. The banks were under instructions to lend to employment-creating projects, so many loans went to the pet projects of provincial and local governments. By end-2010, loans to local government projects totalled 10.7 trillion RMB – equivalent to 27% of China’s then GDP – according to China’s National Audit Office.
The capacity of these projects to repay was assessed optimistically, to say the least. But it was not until the projects were completed that the size of the disaster became obvious. The banks then discovered that they had lent money on buildings with no tenants, highways that collapsed, airports that no one used, and very fast trains that crashed. Between 2 and 3 trillion RMB of the loans are expected to be bad. Fortunately the banks’ write-offs will be much less because they will be bailed out by the Chinese government.
For the Chinese economy, however, there are two big consequences of the lending splurge. First, for the last three years China’s investment in fixed assets has been unsustainably high, and has therefore created artificially high demand for inputs such as metals, iron ore and coal. In the next few years growth rates in fixed asset investment will slow, which means that the commodities boom will end. Second, a significant percentage of recent fixed asset investment will never generate a commercial return. As a result China’s productivity will decrease for a few years. Both consequences of the lending splurge will lead to slower growth rather than any sort of bust.
For Australia, the slowdown in China is mostly negative, but not as bad as you might think. The two-speed Australian economy will merge back to one speed, but the disadvantages of a lower growth rate will be offset by the advantages of a lower AUD and lower interest rates. Commodity prices and mining investment will fall but export volumes will not. In 2013 and 2014 the US and European economies will be recovering, lifting export demand from these sources. A recession is likely to begin in 2013 – this will be an investment opportunity for those who can remember the last one, and an educational opportunity for those who can’t.
We do not expect the Dividend Income portfolio to be materially affected by the negative factors in this scenario. The portfolio has minimal exposure to the resources and cyclical sectors which will be hardest hit. Regulated sectors will be largely unaffected. The recession will create new problem loans for the banks, for example, but the quality of bank loan portfolios has been dramatically improved by the GFC-induced cleanup. Consumer staples may even benefit – observing smartphone usage and the growth of data downloads, we’d re-categorise Telstra as a consumer staple. The biggest beneficiaries are likely to be stocks with large overseas exposures, but we remain highly selective about these sorts of companies because they all carry high levels of industry specific and company specific risk.
Disclaimer: This report is general advice only and is issued by Millinium Capital Managers Limited, ABN 32 111 283 357, AFSL No. 284336 (“Millinium”). Investors should always consider obtaining professional advice that suits their objectives, financial situation or needs. This report may be amended, withdrawn or replaced without notice. To the extent of the law, Millinium, its officers, personnel and agents do not accept any responsibility for any loss or damage arising from reliance on this report.
................................................................ |
Title: An off-Broadway tryout for financial reform in China Date Posted: 03/04/12
Comment: When Broadway producers are preparing to put on a big new musical, they often try it out in a small theatre outside New York City. This is a risk minimisation strategy: an off-Broadway tryout lets the producers find and eliminate the bugs in a new show before they have to commit to the big costs of a Broadway opening. The logic of this strategy is the same as beta testing, where software companies trial the not-quite-final version of a new product on selected users before they finalise it for full public release.
For the last three decades the Chinese government has adopted much the same approach with reforms. A risky change to the system usually isn’t introduced with a big bang, instead it’s started unobtrusively as a small program limited to a few small geographic areas. If it goes well, it’s extended to other areas, like the concept of Special Economic Zones. If not, it’s quietly forgotten. The late paramount leader Deng Xiaoping described the virtues of this cautious approach in terms of a traditional Chinese proverb – “to cross a river by feeling for the stones.”
The Chinese government has just announced another example of this approach. It plans to create a financial-reform “pilot zone” in the city of Wenzhou, where private lenders will be allowed to operate loan companies lending to small and medium enterprises (“SMEs”). This reform is potentially important because it represents a big step beyond the current regulatory system which controls bank lending very tightly. In effect, the government is legalising the “kerb market” or shadow banking sector of unregulated financial intermediaries, a grey area where companies take deposits from rich individuals and lend to SMEs with the legal protections which are standard in Western countries.
Why is this important for China? Because if it’s successful it will lead to further deregulation of China’s financial markets – comparable to Australian deregulation in the 1980s – which will unlock the funding needed for continued Chinese GDP growth in the long term. The present system of highly regulated banks is heavily biased in favour of loans to government projects and big companies, making it very hard for SMEs to get bank loans. The city of Wenzhou was chosen as the beta test site not only because it has a big shadow banking sector, but also because it is famous for its successful entrepreneurs.
Why is this important for Australian investors? Because financial liberalization will provide a much bigger source of the funding needed to finance Chinese economic growth, removing many of the defects and bottlenecks of the present system. This is the same sort of change – only much bigger – as the Hawke-Keating reforms of the 1980s which made possible the record Australian growth rates of the last two decades.
There won’t be any effect on the Chinese economy for the next two years at least, and of course the experiment may go horribly wrong. But if the experiment works and the “pilot zone” deregulation is extended in 2013 or 2014, this would be a huge long term buy signal for China plays.
Disclaimer: This report is general advice only and is issued by Millinium Capital Managers Limited, ABN 32 111 283 357, AFSL No. 284336 (“Millinium”). Investors should always consider obtaining professional advice that suits their objectives, financial situation or needs. This report may be amended, withdrawn or replaced without notice. To the extent of the law, Millinium, its officers, personnel and agents do not accept any responsibility for any loss or damage arising from reliance on this report.
................................................................ |
Title: THE RETAILERS ARE HOPING FOR A MAGIC BULLET Date Posted: 27/03/12
Comment: Yet another month without a rate cut! The Reserve Bank obviously doesn’t agree with the retailers who are hoping that lower interest rates will stimulate demand in their sagging sectors. As the composition of the Dividend Income portfolio shows, we’re with the RBA on this – we don’t own any retailers because we don’t think the sector would revive even if Australia followed the US and Europe and cut interest rates to zero.
The retailers are in this mess because they got lazy during the pre-GFC boom. Even though the online threat was clearly visible, most Australian retailers didn’t bother to develop an online offer because the traditional business model was doing so well: money rolled in the door from credit-fuelled consumer spending. This sort of mistake is of course well known to investors – during bull markets, we are all prone to attributing our portfolio gains to our own genius.
For many retailers this sort of mistake is proving fatal. Online competitors (e.g. Amazon, Appliances Online) and new business models (e.g. Zara, Topshop) are gaining market share at the expense of long established names. Those retailers who are arguing for GST to be levied on online imports – for a “level playing field” – don’t understand their markets: the competitors start out so much cheaper that adding GST and freight still leaves them cheaper. Not to mention the better product range and the quality and efficiency of the overseas websites: it’s hard to leave Amazon without buying something.
US retailers have been much quicker to respond to the online challenge. Most of the majors offer free shipping within the US (subject to conditions), and a few – e.g. Abercrombie & Fitch, Nordstrom – offer international shipping.
There are still some exceptional Australian retailers, such as Oroton and Super Retail. But in general we don’t expect to be buying retailers until (a) the shakeout is a lot further along, and (b) the ordinary consumer is more willing to spend. When is this likely to happen?
A useful approach is to look at the long term growth path of the Australian economy, because any economy’s growth is dictated by its available resources, such as skilled labour, technology and capital. Over the last four decades (since the first oil crisis) the Australian economy has averaged GDP growth of 2.4% per year.
Between 2001 and 2007 the economy grew faster than this trend, partly because the current commodity super-cycle was getting under way, but mostly because Australian households and companies were borrowing more. After the GFC brought disaster for many over-leveraged borrowers, the mindset changed abruptly: companies raised equity in order to decrease their debt, while consumers cut back their spending and began to reduce their credit card balances and mortgage borrowings.
Companies are now where they want to be, but for consumers this process of de-leveraging will have to continue for a few more years because house prices are weakening, job prospects are uncertain, and the baby boom generation needs to rebuild its superannuation balances. We don’t expect the de-leveraging to be over before 2014, so we won’t be looking at the retail sector in the near future.
Disclaimer: This report is general advice only and is issued by Millinium Capital Managers Limited, ABN 32 111 283 357, AFSL No. 284336 (“Millinium”). Investors should always consider obtaining professional advice that suits their objectives, financial situation or needs. This report may be amended, withdrawn or replaced without notice. To the extent of the law, Millinium, its officers, personnel and agents do not accept any responsibility for any loss or damage arising from reliance on this report.
................................................................ |
