28/09/2011 - 11:20

China may escape without a hard landing

28/09/2011 - 11:20

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The economic situation in China is more an engineered cyclical slowdown than reason to hit the panic button.

I ARRIVED for a recent visit to China with a cautious attitude, but was pleased to leave with a renewed sense of comfort in the country’s long-term growth story. 

From a macro perspective, there is no doubt that monetary tightening, higher commodity prices and electricity shortages are slowing China’s GDP growth. Credit tightening is having a serious impact on small and medium-sized companies, which will inevitably lead to more non-performing loans in the banking sector.

Automobile sales are weak due to government measures, housing sales are dropping, and a weak domestic stock market points towards tightening liquidity. There is no question that China’s stimulus programs of 2009-10 led to some significant misallocation of capital and probably brought forward some commodity demand.

However, to my mind, all this suggests an engineered cyclical slowdown in the pace of growth, designed to control inflationary pressures, rather than signposts on a path to structural decline as some of the China bears would have you believe.

First, a few words on growth. HSBC recently published an interesting timeline that puts the development of various emerging markets into historical context by placing them on a timeline of US economic development. On this basis, China stands about where the US was in 1941. (Die-hard commodity bulls will notice that India is where the US was in 1882.)

However, what is even more interesting is that China is achieving in a decade what it took the US 50 years to achieve.

This rapid pace of innovation and productivity growth was apparent during my trip. For example, the Chinese have worked hard to increase the domestic supply of some resources and to bring down costs. In commodities such as aluminium, bauxite, nickel and stainless steel, Chinese companies are innovating and are, in some cases, more competitive than Western companies. In manufacturing, the significant size of the domestic market again gives Chinese companies a significant scale advantage, allowing them to invest more in R&D.

Property 

Much has been written about the supposed property bubble in China. My view is slightly more nuanced than some of the recent commentary. It is true that property prices are towards the top end of their rising trend in real terms, and the house-price-to-income ratio is high. The amount of floor space under construction has soared in the past decade and it is argued that prices need to drop to clear supply.

However, the strong counter-argument is that the total housing stock in China is still short of demand (according to some estimates, by almost 80 million units). Most of the supply has been at the top end and has been absorbed by investors paying cash (given a lack of other domestic investment alternatives in an era of negative real interest rates), leaving a real shortage in the middle and at the bottom end of the market.

The government is trying to set this imbalance right through its social housing initiative, and, over time, this will support commodity demand.

Domestic consumption is also expected to rise significantly, and should therefore remain a positive driver of demand for some commodities. The Chinese government has made it clear in its latest five-year plan that it wants to boost domestic consumption and increase levels of social harmony via growth in wages and improvements to the social welfare system.  

We should see wage increases across China from the industrialised coastal areas to the rural areas. Notably, the salary increase in rural areas and second-tier or third-tier cities will be proportionately higher as these are growing from a lower base.    

My preference overall hence remains to be invested in commodities that benefit from consumption over capex spending. Copper, energy, potash fit this bill, while I find aluminium, steel and iron ore less interesting. It is also worth noting that, unlike 2008, there is limited inventory in the system. Historically China has behaved counter-cyclically to the West and if you see a slowdown in Western world commodity demand, as commodity prices come off, you could see a re-stocking in China.  

Copper looks to be a beneficiary longer term, thanks to its importance in, for example, air-conditioning and car manufacturing. China remains committed to innovation and renewable technologies. New electric cars, for example, use up to three times as much copper as traditional ones. Cars are largely bought for cash in China and, with fewer than 60 cars per 1,000 people (compared with 750 in the US and an average of 150 in the world), the growth road stretches a long way into the future.  

At the same time copper mine supply remains constrained with high decline rates and significant increases in the cost of mining/production along with environmental/‘not in my backyard’ concerns delaying new supply.    

So the main insights from my recent trip were firstly that China remains on a structural growth path, even as it tries to navigate a near-term engineered cyclical slow-down to combat inflation. 

The second was that innovation and productivity remain strong and, while rising labour inflation is a worry, increased GDP per capita will drive the economy more towards consumption-driven growth.

Thirdly, as China moves towards becoming a consumption-driven economy (as opposed to the investment-driven growth that it has experienced over the past 10 years), the outlook for consumption commodities (energy, platinum, potash, oil) will be superior to those driven primarily by investment spending (steel, aluminium, iron ore, etc).

For investors, there will be great investment opportunities. Clearly some of the winners of rising domestic consumption will be local companies whose strong understanding of the local market and the distinctive needs of Chinese consumers will provide them with a competitive advantage.  However, I also expect some foreign businesses to gain from this. 

For instance, commodity producers that mine the raw materials needed to make the goods the Chinese consumers are after (particularly if these materials are in short supply), stand to benefit. 

Global consumer names with recognised brands are likely to continue to see significant revenue growth from this part of the world, as emerging middle classes aspire to new lifestyles. 

This is why I think taking a global approach to investing makes a lot of sense nowadays. It ensures that one can capitalise on the investment opportunities presented by, for instance, the emergence of new economic superpowers such as China but not just through local/regional stocks, where corporate governance may sometimes be an issue or whose shares may be relatively expensive.

• Amit Lodha is portfolio manager of the Fidelity Global Equities Fund. Fidelity Worldwide Investment provides investment products and services to individuals and institutions.

 

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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