China conundrum helping shares stay in the doldrums

Australian investors looking for a reason why the Australian sharemarket has underperformed its global peers since April last year, the answer is China.

Australian investors looking for a reason why the Australian sharemarket has underperformed its global peers since April last year, the answer is China.

While the world has been glued to events, or lack thereof, in Europe the controlled slowdown in the Chinese economy has cut the legs from under the sharemarket. This would seem remarkable given China is still growing at a rapid clip of about 8 per cent. The figures though do not lie.

The Shanghai A Share Index has fallen about 35 per cent since April last year. Over this period, the All Materials index (mining index) on the ASX, has been slavishly correlated, slumping 38 per cent. The overall Australian market has fallen just 19 per cent during this time, of which the Materials index has contributed two-thirds of the fall despite only being a third of the overall market.

The bear market in mining stocks has resulted in BHP Billiton and Rio Tinto trading 25 per cent below analyst valuations.

The correlation of China and mining companies is not hard to explain. China is the biggest consumer of minerals in the world. It accounts for about 63 per cent of global demand for seaborne iron ore and 55 per cent of metallurgical coal. A spike in inflation and a property boom from 2009 to 2011 saw the Chinese government restrict lending to cool economic growth. It seems to be working with stockpiles of coal bulging and energy consumption slumping to about 5 per cent.

Concurrently, mining companies around the globe are in the process of expanding production to meet demand into the future. Uncertainty about the supply and demand relationship has induced the nasty bear market in mining companies. In the next six months, this will be partially rectified by a blast of liquidity around the globe as Europe's illness infects economic growth.

So much for the history. What does China hold for us in 2013 and beyond and what does it mean for our unloved mining companies?

Andrew Forrest took a deep breath and ponied up over $100 million buying Fortescue Metals shares last week, in a sign he is confident the future looks rosy. Forrest has more at risk than virtually anyone else in the listed market when it comes to China's future.

Fortescue is spending about $US10 billion tripling its iron ore production over the next few years, funding this through debt and cash flow. A 30 per cent fall in the iron ore price over the next 18 months would crucify the company.

The Chinese are trying to rebalance their economy to increase domestic consumption, taking the burden off fixed-asset investment, though this will take many years. In the meantime, the industrialisation of the world's most populous country requires high levels of steel given the lack of arable land and the desire to build up rather than out. All this must be music to Forrest's ears, but offsetting this is a dramatic rise in the quantity of iron ore that will come on to the market as supply expands over the next four years.

Some analysts predict supply of seaborne iron ore and metallurgical coal could comfortably outstrip demand by 2014. This would suit only the lowest-cost producers such as BHP and Rio Tinto.

The Chinese economic miracle has been such an outrageous success that many countries, including Australia, may well consider following the model of centralised decision making and orderly changes of government. This is highly unlikely and symbolises the vast gulf between the West and China.

The reality is no one fully understands how China operates and thinks, including the mining companies. When China appeared on the world stage early last decade not one company was ahead of the curve in preparation. Again in 2008, Australian mining companies were sidestepped by China's decision to run down inventories, forcing mine closures and capital expenditure deferrals in Australia.

Australian miners are effectively dealing with one customer when it comes to China - Beijing. Decisions from Beijing on a daily basis ruminate through the industry. Most companies that only have one major customer are marked down because of the associated risk.

The Chinese approach to business is, in many respects, polar to Western thinking. Profit margins and returns on capital are regularly ignored to achieve an outcome that suits societal harmony and change.

A stark example of this is the steel industry, which commonly runs at a collective. Strangely, the authorities seem content to pay record prices for steel inputs of iron ore and coal. This has ballooned the profits of foreign companies like BHP at the expense of Chinese steel producers.

Another confusing point for Western observers is economic data in China. For an enormous country, the macro-economic data is produced in such short time-frames many find it difficult to believe, given the country is running to strict five-year growth plans. Beijing is aware that a major drop in economic growth to about 5 per cent could ignite its greatest fear - widespread civil unrest.

The New York Times recently reported that government officials in regional centres have overstated economic output, corporate revenues and tax receipts in a bid to achieve stretched economic goals. This would not instill confidence into an already skittish global investor.

China is unlikely to grow as quickly this decade as the past one, as a demographic tailwind turns into a stiff headwind. This will dovetail with the rise of the consumer and the relative gentle decline of the fixed-asset investment boom. Only the most efficient miners will survive as supply ramps up to feed the best.

I am a believer in the Chinese economic miracle and its longevity. The re-emergence of the middle kingdom and its 1.3 billion people on the world stage has changed global economics and politics forever. Effectively, the decline in Europe will be superseded by the rise of Asia, led by the Chinese.

For investors though, especially in the mining industry, this helicopter view is not enough to ensure rising share prices into the future.

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