Summary: Chinese data has been disappointing recently, but the major miners have been holding up reasonably well. Analysts are split on the outlook for iron ore, while our big miners are the lowest cost producers and volumes are surging. Meanwhile, the Chinese government accounts are pristine, meaning it could enact monetary easing and fiscal stimulus if it wanted.
Key take-out: In the unlikely event of a sustained decline in Chinese growth, resource stocks would be hit more forcefully than they have been to date.
Key beneficiaries: General investors. Category: Economics and investment strategy.
Recent Chinese data has largely disappointed on the downside. Industrial production for instance slowed to an annual growth rate of 6.9% in August from 8.8% previously - which is the weakest rate of growth since the GFC. Similarly retail sales are down, fixed investment has slowed, money supply growth is down and imports actually fell in August. Following on from that, a number of investment banks no longer think the Chinese government’s growth target of 7.5% will be met.
Now, we’ve already seen the result of some of that slowing. Iron ore prices are down about 35% or so this year - at $US84 at the time of writing. Indeed it was only in April that iron ore was trading at around $117!
Chart 1: Iron ore prices plummeting
What’s interesting is that despite this price slump, our big miners have been holding up reasonably well. There are a handful of reasons for this resilience:
- The big miners are the lowest cost producers of iron ore. If the price slump induces some higher cost producers - especially in China - to exit the market, then that’s a medium-term positive.
- Analysts are split on the cause of the price fall and the outlook for iron ore. Some suggest that the slump is an inevitable consequence of China’s slowing growth, steel production etc, exacerbated by a burst property bubble and a lift in environmental protection measures. Others suggest that prices will bounce and the recent fall has only been cyclical - just part of the usual price volatility since benchmarking was scrapped in 2010. In effect that means the price decline could be driven by the usual stocking and destocking swings of steel producers - and a temporary credit crackdown by the government (in order to avoid a debt bubble). Another suggestion has been that the large mining players themselves are driving prices lower - deliberately in order to squeeze out higher cost producers out.
- Prices for iron ore are down, but volumes are surging.
- It’s not clear how much of a deceleration is underway anyway - or how long it will last.
The last two points are perhaps the most important and many are rightly sceptical about what a Chinese slowdown would even mean.
Chart 2: Iron ore exports to China still surging
As chart 2 shows, iron ore exports to China are still growing at a very rapid rate - up 16% over the last year, despite China’s slowdown. For all practical purposes, the deceleration means little.
Moreover, even if there is a deceleration underway, the Chinese government may decide to loosen policy somewhat. Compared to the US, UK, Europe and Japan - Chinese economic policy is extremely restrictive and has been for many years. One year lending rates are at 6%, which may only just be above average, but it compares to rates well below 1% in Europe, Japan and America. On a comparative basis, monetary policy is very restrictive in China.
On the fiscal side, the Chinese government accounts are pristine. The budget deficit is only 2% of GDP and public debt is only about 50% of GDP including all levels of government - it’s even lower (effectively zero) when you consider the $4 trillion in FX reserves that the government has accrued. What this means is that the government could enact targeted monetary easing, so as not to inflame credit growth to property investment, as well as large scale targeted fiscal stimulus - if it wanted.
Whether they will use those measures or not is another question - a very important one. Don’t forget that authorities are trying to slow credit growth and are very happy with lower economic growth more generally. It’s more manageable. More specifically, they want to redirect credit from property or areas where they believe there is excess. That doesn’t mean they want to halt the process of urbanisation or development. That hasn’t changed. Similarly, the government is trying to implement an environmental clean-up program. That doesn’t mean, as many analysts have incorrectly concluded, that a property or credit bubble has burst, or that there is some unrestrained or unwanted slowdown in place. The Chinese government is still well and truly in control of the process.
With that in mind, the inflation figures are very important. Inflation is currently low and stable at around 2%. That’s a fairly benign rate and one that would allow the government to conduct a stimulus program if it saw the need.
Now while that debate plays out, I don’t think there is going to be much action for the big miners - they’ll probably continue to range trade and at the moment they’re at the mid-point. It will simply be a case of watching the data.
In the unlikely event that we do see an unplanned, sustained and material decline in Chinese growth that isn’t met with increased stimulus measures from the authorities, then the impact on our market may not be uniform. Resource stocks would clearly be hit more forcefully than they have been to date - BHP, Rio Tinto and other iron ore miners (see Winning Rio). Yet less exposed would be energy stocks, given the bulk of our energy is for South Korean and Japanese markets anyway, and the exceptionally favourable environment for energy exploration - especially gas.