Category: 2016

CHINA

• China’s GDP growth met its CY15 target, but it keeps on slowing down. It would be a lot lower if the authorities weren’t pumping up the money supply, applying fiscal stimulus to key sectors, and fudging some of the statistics.

• China’s wealthiest citizens are continuing to ship their money off to safer jurisdictions. This is one of the main reasons why the China’s currency is weak even though its trade surplus and its incoming direct investment are both rising.

• We don’t see any likelihood of a hard landing in China this year, but the downward drift of the Chinese economy is negative for resources exporters in general and for Australian resource stocks in particular.

One of the constant themes in our commentary on China since 2011 is that Chinese economic growth is slowing down. Global share markets had an attack of nervous tremors in early January before the 2015 Chinese GDP data came out, but their fears seem to have subsided again. We take this opportunity to review the Chinese economy, summarize the near term outlook, and assess the implications for Australian investors.

In 2015 Chinese GDP grew by 6.9% in real terms, i.e. after adjusting for inflation during the year. This was not only below the 2014 figure of 7.3%, it was also China’s slowest growth rate since 1990. It was, however, in line with consensus forecasts and the government’s official target. A negative indicator was that growth appeared to be decelerating over the year, because growth in the December quarter was only 6.8%, but this figure is acceptable because the government’s official target for CY16 is only 6.5%. So we can conclude that the Chinese economy is slowing as expected.

The composition of the 2015 national accounts suggests that the economy is responding to the government’s efforts to re-balance it away from investment-led growth and towards consumption-led growth. The main cause of the slowdown was secondary industry, which grew at 6.1% real during 2015, whereas the services (tertiary) sector grew at 8.2% real. This trend is consistent with a slowing in the growth rate of fixed asset investment (FAI) to 10.0% year on year, its slowest rate since 2000. The rise of the services sector is evident in the fact that, for the first time ever, it made up more than half of GDP – 50.5% compared to 48.1% in 2014.

The high growth rate of the services sector is in part a consequence of government policy, but also due to the fact that the services sector does not rely on external inputs as much as secondary industry. In particular, the small businesses which are common in the services sector have very modest capital needs, so they are not dependent on credit growth. The services sector also uses less energy and less materials, so that its growth is better aligned with the government’s policies to reduce environmental pollution, given the rising public concern over many obvious examples of pollution of food, water, soil, and urban air. As the services sector is labour intensive, its rapid growth will help absorb the labour made redundant by factory closures in secondary industry.

Most importantly, the average citizen is enjoying a higher income: average income per capita rose by 7.4% year on year, faster than GDP. Consumption accounted for 66.4% of GDP growth in 2015, up from 51% in 2014. China’s household consumption spending, however, was only 38% of GDP in 2015, compared to the typical level of about 65% in developed countries.

The slowdown in secondary industry has been a major factor in the collapse in global commodity prices. Steel output fell 2.3% and electricity generation fell 0.2%, so it is hardly surprising that China’s imports of industrial commodities also fell, e.g. coal imports were down 30%. This is the explanation for the slide in coal prices which has been killing Australian miners.

Falling prices are a key feature of the Chinese economy. China’s nominal GDP grew by only 6.4% in 2015, which was less than its real GDP growth rate of 6.9% because of the effect of deflation. Lower commodity prices are the main reason why China’s Producer Price Index (PPI) has been falling for the last four years, although the Consumer Price Index remains positive. Another deflationary factor is the over-capacity which has built up in many sectors, such as steel production, mining, and oil refining.

Although deflation is not intrinsically bad, it does have the unpleasant effect of increasing the real value of any nominal debts. As China’s debt to GDP is one of the highest in the world at 209%, continuing deflation will represent a problem for Chinese companies unless they have the active support of a local, provincial or national government. The four-year decline in the PPI has pushed corporate revenues down, making it harder for companies to service their interest and principal obligations unless they have some form of state support, e.g. subsidies or government contracts. This is one of the main reasons why the central government continues to provide fiscal stimulus, such as building more infrastructure, and monetary stimulus, such as interest rate cuts and reserve ratio cuts. A recent change to tax levels on new cars sparked an 18% increase in car sales in December alone.

The most urgent policy problem facing the Chinese government is capital flight. In the decade from 2003 to 2013, the Chinese yuan rose steadily against most major currencies, so investors and speculators got used to treating the yuan as a one-way bet. China steadily built up its foreign exchange reserves, reaching a peak of USD 3.99 trillion in June 2014. The gentle decline which began in 2014 accelerated in the second half of 2015, reducing the foreign exchange reserve level to USD 3.33 trillion at December 2015. The problem is not one of declining investment, as foreign direct investment (FDI) reached a record USD 124 billion in 2015. The 2015 capital outflow of USD 676 billion represents the decision of portfolio investors, currency speculators and Chinese residents to reduce their exposure to China.

Considering the whole picture of China’s national accounts, it is clear that growth is continuing at rates which the rest of the world would envy. There are a number of problem areas – such as the rapid rate of credit growth – but it is unlikely that China faces a hard landing in the near future. In the wake of the CY2015 figures, the consensus forecast for GDP growth is 6.5% in CY2016 and 6.0% in CY2017. It is, however, far from assured that China’s growth rate will reach the average of 6.5% which is forecast for the period of the Thirteenth Five Year Plan, from 2016 to 2020. Nor is it likely that the Chinese yuan will remain as stable as it has been under the last two decades of tightly managed exchange rates.

The implications for Australian investors are clear. Exports to China represent 5.1% of Australia’s GDP, which is by far the highest exposure among developed economies. The continuing slowdown in China is a negative for Australian resources companies, and – apart from tourism and education – the Australian services sector has been slow to engage with the growing Chinese services sector. Accordingly, we remain cautious on the prospects for Australian economic growth and the Australian dollar. Although the Australian resources sector will bounce from time to time in sync with commodity prices, we regard it a long term value trap.

Last month we addressed investor concerns about slowing growth in China. This month we look at how trends in other emerging markets might affect Australian investors.

The core of the problem is that growth in emerging markets, which has been strong for a decade, is now slowing down, mostly because of the way that the China slowdown and falling commodity prices depress the value of commodity exports from low income countries. Although GDP growth in the developed economies remains stable (albeit uninspiring) at 1.6% pa in aggregate, growth in emerging markets has been falling steadily for the last three years. The absolute level at present is still 4.1% pa, but the downtrend is clear.

Should we fear a re-run of the 1997 Asian crisis? No, because the Asian economies involved have made sure that they don’t have the same risk exposures this time around. The 1997 Asian crisis was triggered by high levels of USD borrowing by companies in Thailand, Malaysia and other east Asian countries. When local borrowers had difficulty repaying their USD debt, their local currencies fell against the USD, making the problem even worse. This time around, thanks to better regulatory oversight, foreign currency borrowing is much lower, and most of the countries involved have built up significant foreign exchange reserves as a precautionary measure.

Should we fear a re-run of the 1998 Russian crisis, which ruined Long Term Credit Management and led the US Federal Reserve to intervene to prop up the US financial system? Russia now is a lot smaller and less important than it was then. We tend to think of Russia as globally important because of its past role as a nuclear superpower. In 2014 Russia’s GDP was only USD 1.86 trillion, ranking it at number ten in the global league tables, after India and before Canada according to the World Bank, and equivalent to only 2.4% of world GDP of USD 77.87 trillion. The state of California, by comparison, is much more important: its 2014 GDP was USD 2.31 trillion. The current recession in Russia is unpleasant for Russians, but of no importance for the rest of the world because Russia’s exports are mostly oil and other commodities. (In the GDP league tables Australia comes in at number twelve with GDP of USD 1.45 trillion.)

But there are many other low-income and middle-income countries whose economies have been buffeted by the collapse in commodity prices. In its October 2015 Global Financial Stability Report, the IMF warned that emerging markets should prepare for an increase in corporate failures. In the last year, the resources giants Glencore and Petrobras have seen their share prices fall 60%-plus, and there are plenty of similar examples among Australian resource companies. Brazil and Russia are already in recession, and last year’s oil price slide has driven the oil producer Saudi Arabia to repatriate more than USD 50 billion from its overseas investment portfolio.

It is clear that investors are taking emerging market risks seriously. Capital flows to emerging markets turned negative in late 2014 for both bonds and equities, and current trends suggest that 2015 may be the first year of net capital outflows since the 1980s.

For Australian investors who have no exposure to emerging markets, all this turmoil might seem irrelevant. But the global economy and global financial markets are very much interconnected, so recessions in emerging markets do have an adverse impact on the economies of the developed world. First, they  reduce demand for the exports of the developed world, which tend to be goods and services with high value added, such as expensive cars, airplanes, information technology, pharmaceuticals, medical instruments, telecommunications equipment, sophisticated machinery, and complex services such as insurance. In short, if a low-income economy is suffering falling exports or a falling currency, it cannot afford to buy as much from rich countries.

A second effect works by making the exports of low-income countries cheaper as their currencies fall. Cheaper exports tend to displace competing goods made in rich countries, whether in their home markets or in export markets. Neither of these effects has much impact on the US economy, because the US is much less dependent on trade than most other developed economies. In 2014 US exports accounted for only 14% of GDP and imports only 17%, well below the levels typical of developed countries.

The fact that many of the largest listed US companies are transnational companies suggests that problems in emerging markets should have a negative impact on the US share market, but data deficiencies make it difficult to estimate how serious this impact might be. It is true that global sales accounted for 47.8% of total sales of S&P500 companies in 2014, according to S&P Research in July 2015. But this figure conceals wide variations: 186 of the 500 companies had zero foreign sales, 46 had 0% to 15%, and 22 had more than 85%. The limitations of the reported data meant that 22.2% of total sales were simply ascribed to “foreign countries” without any regional detail – that is, we don’t know which countries nearly half the sales went to. Nor do the statistics capture change of domicile by companies.

In addition, the term “global sales” does not distinguish between exports from the US, local sales by a subsidiary operating in a country, and intracompany “sales” between, say, Australia and a nearby jurisdiction which just happens to have low tax rates. These three forms of “global sales” have very different implications in the real world. Export sales may rise or fall depending on exchange rates; sales by in-country operations are a matter of foreign currency translation; and the level and location of intracompany sales are decided at the discretion of management. As a consequence of these holes in the data, the aggregate effect on the S&P500 is impossible to calculate – the best we can do is identify the individual companies which are most or least affected. For example, the US equipment maker Caterpillar generates 60% of pretax profit outside the US: its sales have been falling since 2012, and it has closed 20 plants outside the US.

For financial markets, the most important consequence of recessions and falling currencies in poor countries is that the companies in these countries find it harder to pay the interest and principal on their debts. This effect becomes much more severe if the debts are denominated in foreign currencies rather than local currencies. Nonetheless, any large default causes problems locally and globally. The local consequences are obvious – job losses, flow-on insolvencies, and GDP losses which are not easily recovered. The consequences for financial markets follow from investors’ losses of principal or interest, which motivate investors to re-appraise and re-price the risk in corporate bonds. Credit spreads will widen, making debt more expensive for risky companies at the same time as it becomes cheaper for “safe havens” such as US government debt and top-rated companies’ bonds. The re-appraisal of corporate debt risk will eventually flow through to equity investors’ perceptions of these companies.

The implications for Australian investors are straightforward. We continue to favour the US and Europe, and to avoid all Asian markets. We expect that the resources sector will continue to underperform, and all companies with global operations should be assessed on a case-by-case basis for their exposure to emerging markets. As we noted last month, the short term outlook for China is not as bad as global investors seem to think it is, and this view has positive implications for the Australian share market. Investors who are not risk averse could look at opportunities in Australia outside the banking and resource sectors.

Neill Colledge

November 2015

Most Australian investors have watched the recent gyrations in US and European bond markets with a feeling of relief that all this excitement doesn’t affect them, because they don’t own any US or European bonds. They have been watching the Grexit turmoil with similar emotions, because they don’t own any Greek bonds or shares. It is true that the immediate effects on Australian investors are modest, but we believe that these types of wild market moves are symptomatic of major underlying problems which will lead to further trouble in future.

US Treasuries and German government bonds are among the world’s safest assets. We can say this with confidence because their credit default swaps (which offer insurance against default) have long been priced more cheaply than almost all other forms of debt, even during the GFC. The safety of US government debt is what motivated finance theory’s concept of the “risk free rate” – i.e. the asset where you are sure what your return will be. When bonds like these suffer falls of up to 20% in their market value as a result of their yields rising 90 basis points, it signals that market perceptions of risk are changing for the worse.

What does the turmoil in global bond markets mean for Australian equities? The upcoming problems are the result of the ultra-low interest rates available to borrowers since the GFC. Companies and countries have been able to expand their borrowings because debt servicing costs are so low. At the same time, investors’ “reach for yield” has allowed many low-quality borrowers to access debt markets, because they are offering relatively high interest rates. The net effect is that there are a lot of bonds out there which should never have been issued, because the issuers are likely to default when global interest rates rise or if their own cash flows deteriorate.

The problem areas are not the “investment grade” bonds, where default rates are typically very low. Since 1920, according to Moody’s, the default rate on investment grade bonds has averaged only 2%. Speculative grade (“junk”) bonds are much riskier: their default rate often passes 10% in a recession, and it touched 14% in the GFC.

Greek sovereign debt has been in unofficial default since 2010, in the sense that that was when the supranational bodies the European Commission, the European Central Bank and the IMF started to lend Greece money to pay out its urgent private creditors so that it could reform its finances. Greece’s official default will be painful for the few banks which are directly affected, but it has long been anticipated by the bond markets, along with other basket cases like Ukraine and Venezuela.

The pain for investors in sovereign debt will come from unexpected defaults – that is, where a country’s finances have deteriorated so quickly that bond markets have not fully priced in the likelihood of default. Most of the problem areas here will be in emerging markets, where events such as domestic recessions or the Chinese economic slowdown have reduced a country’s ability to service its debt which is denominated in a foreign currency (usually USD). Another negative influence will be the eventual rise in US interest rates, which will not only raise loan servicing costs directly but will also support the ongoing rise in the US dollar against most currencies. Countries considered to be highest risk include Brazil, Colombia, Indonesia, Peru, Turkey and South Africa.

For corporate junk bonds, 2015 has already seen an upturn in defaults in some important sectors. The collapse of the oil price last year has put pressure on high cost producers worldwide, especially  the US shale oil sector which relied heavily on debt financing. In China, the slowdown in GDP growth and the fall in house prices has triggered defaults from some property companies. We expect that corporate defaults will accelerate, for much the same reason as sovereign defaults – the negative effects of rising interest rates, falling Chinese demand and domestic recessions on foreign currency borrowings. As a general rule, corporate bond defaults tend to track sovereign bond defaults, because they spring from the same underlying economic causes.

Bond defaults, whether sovereign or corporate, impact investors’ risk tolerance very quickly. A single default causes bond portfolio managers to analyze their portfolios for any similar exposures, and the equity portfolio managers at the next desk will start checking their portfolios to see if they have any exposures like this. The impact is twofold: the re-assessment of risk means not only that previously ignored risks take centre stage, but also that all risks are re-priced upward.

In these circumstances, equity investors become more cautious too. They want to sell out of some holdings where they used to think that the risks were acceptable, and they want to be compensated for taking on new risks, i.e. they want lower prices.

The past history of the “reach for yield” in Australia means that, in the next downturn, many high-yield stocks will be vulnerable rather than defensive. The coming rise in US interest rates, coupled with the re-assessment of risk, will force investors to focus on the downside risks of stocks which have above-average yields but poor growth prospects. The sector most at risk in Australia is the banks, where organic growth has been hard to find outside residential loans and where further capital raisings are a certainty. Next come the utilities and infrastructure sector: in the periods between the standard five-yearly regulatory re-sets, the utilities stocks are very bond-like. The property trusts will also be negatively affected, but the impact will also depend on the growth prospects of their underlying markets. The sector as a whole is over-priced relative to book values, but there are big differentials in future growth rates between subsectors, as well as wide variations in trust gearing and the quality of their asset portfolios.

Neill Colledge

July 2015