China slowdown holds the key in an uncertain future

AUSTRALIAN investors looking for a reason why the Australian sharemarket has underperformed its global peers since April 2011, the answer is China.

AUSTRALIAN investors looking for a reason why the Australian sharemarket has underperformed its global peers since April 2011, 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 our local stock market.

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 2011. 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 declined just 19 per cent during this time of which the Materials index has contributed two thirds of the fall despite only being one third of the overall market. The bear market in mining stocks has resulted in companies, such as BHP and Rio Tinto, trading at 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 short term (next six months), this will be partly 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 'Twiggy" 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 a combination of 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. This, though, 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 onto 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 decades, not one company was ahead of the curve in preparation. Australian mining companies are effectively dealing with one customer when it comes to China Beijing. Decisions from Beijing on a daily basis ruminate through the resources industry. Most companies that have only 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 such as 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 years growth plans.

Beijing is acutely 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. China is unlikely to grow as quickly this decade as the last 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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