PORTFOLIO POINT: Buying mining stocks will gain indirect exposure to China, but the direct investment path – although risky – will potentially get quicker results.
Recent Chinese data seems to suggest the economy is starting to experience an upswing. Certainly that is now the consensus following industrial production and retail sale figures.
Now for me, these latest figures weren’t a major rebound or anything. Take a look at charts 1 and 2. They both show production and sales well down from their peaks. Not that it should matter, mind you, whether growth is 10 or 20%. It’s still rising rapidly. I guess people are probably excited because it’s now clear we’re not talking about a hard landing anymore.
Anyway, taking a ‘rebound’ as done, two questions come to mind: will it fizzle, and if it doesn’t what’s the best way for investors to play it?
Taking them in order, I think the chances of the upswing fizzling are remote. Think of how or why the slowdown occurred in the first place. It wasn’t because of the European crisis or even a dip (a modest dip I might add) in global growth. Sure, Europe is China’s main trading partner and people who are spooked by that would probably refer to statistics showing exports contribute something like 60%, sometimes even 80% of Chinese economic growth.
This is misleading though. The fact is, China re-exports a lot of goods. That is, it imports them, assembles them and then exports the finished product. Realistically, it’s only the value add that should be counted when you’re trying to determine the importance exports make to the Chinese economy. Doing this, you get estimates of between 10% and 20%. That is, if growth is 10% per annum, then 1%-2% of that is due to exports. That’s why you saw Chinese GDP averaging 8% growth (just below) during the GFC despite exports dropping sharply.
In any event, 80% of China’s exports go elsewhere anyway – to either the US or Asia. As I have highlighted before, intraregional trade is as important as Europe or the US. And the US isn’t doing badly, nor the Asian region more generally.
The other thing that we need to consider is that the Chinese slowing started around the middle of 2010 and through 2011. At that time European GDP growth was actually quite robust – annual growth of 2% or more, which for them is good.
We can’t look to slowing exports to Europe as the casual factor then, although they would have certainly weighed somewhat and export growth has been slow.
China’s slowdown was in fact a deliberate policy choice – it was engineered, which I don’t think is something many people appreciate. Why so? Well there were two reasons.
- To deal with rising inflation.
- To curtail the property boom.
Recall that inflation was the key concern of China’s central bank during the 2010-11 period. We saw consumer prices spike from negative annual rates recorded during the Global Financial Crisis (see chart 3 above) to a peak of 6.4% in mid-2011. This was approaching the pre-GFC peak of just over 8%, and something had to be done. Inflation is a much more insidious threat to emerging economies than it is in advanced ones because most of it is driven by food. Food, of course, comprises a much higher proportion of household expenditure than is the case in Western countries. So when inflation rises sharply, political or social instability can be the result.
I‘d even go so far as to say that this was a much more important factor driving the policy response than the property boom. People in the West are too caught up in this given the experience of the US, Spain, Ireland etc. But for the Chinese government, the property boom was confined to a small proportion of property speculators who had the wealth to take hits from a volatile market. It was less of a threat. Moreover, the government is the monopoly provider of land, so if things get out of hand it can adjust the supply accordingly. It’s not so much of a problem as generalised inflation, as it’s much easier to control.
Now the policy response you can see in Charts 4 and 5. You can see that the reserve ratio (% of loans banks must hold on deposit at the central bank), shot up to over 20% from 15% in 2008.
Similarly, the base lending rate (chart 5) went up to 6.5%. This doesn’t even capture the more direct methods used by the government to slow down credit and economic growth. It simply directs banks to lend less, and even set industry quotas. But the charts do give an indication of a government keen to rein in excess ‘something’ and, in China, that something is usually inflation.
Now this brings me to my initial point, which was whether the rebound would fizzle or not. Have another look at chart 3. CPI has come down sharply and in the latest reading was at 1.9%, well down from the peak and about where it averaged through 2005-06.
This is critical. Inflation was the cause of the slowdown – inflation is now low – and this frees up the People’s Bank of China to ease up on some of the restraints it had put in place to bring inflation down (if it needs to).
Moreover, don’t forget that China’s leadership transition would also have slowed things down. Big decisions tend to get put on hold as attention becomes diverted, and this is a government that is in a position to make big decisions if it so chooses with a deficit of 1% of GDP and foreign exchange reserves totalling over US$3 trillion, or 45% of GDP. Having said that I don’t think we’ll see a return of growth rates to around the 12% mark that we saw pre-GFC. Inflation is low now, but the Chinese are very conscious of the huge inflation risk that QE in the US, Japan and Europe presents. The central bank warned about this again just over the weekend and nominated inflation as China’s key economic concern.
So the second issue is how to play it. Buy miners right? Well, yes, but I made that point in July. I’ve got nothing new to add to that – if you bought then you’re doing ok and outperforming the market on those assets with gains of between 5%-10%. I still think they are a great medium-term buy, and if you missed that I’d certainly buy on any dip into the fiscal cliff.
Having said that, I actually think there is a better way to play the China story at the moment. It’s riskier, granted, but with risk comes reward and on a risk-adjusted basis it’s still very attractive. And that is a pure play on Chinese stocks.
The Chinese equity market has been one of the worst performers this year, down about 8% compared to the All Ords, which is up 5.6%, and the S&P500, which is just over 7% higher. Since a post-GFC peak in mid-2009, the index is down about 40%. The Shanghai exchange suggests you’re looking at an average P/E of around 10, which again is cheap compared to Australia at 14, and the US (S&P500 at 15.9). Fair to say that Chinese stocks were one of the biggest pre-GFC booms – up 600% or more, but then GDP was 150% higher as well. In any event, all of those gains were given back in the ensuing crisis.
So then, seen from 2005, Chinese stocks may still look expensive being up 100%, which compares to the US market gain of 12% and the All Ords of almost nothing. But then again, the Chinese economy is 300% larger since then, while Australia’s economy is about 50% bigger. Looked at this way, the Chinese stock market offers exceptional value.
Indeed Warren buffet was/is apparently a fan of valuing relative richness/cheapness via this metric. The idea is that a market is cheap when market cap/GDP (I think he preferred GNP, but they are very similar) is 70-80%, and rich when it’s over 115%.
Using this to value, China’s stocks you get a reading of 30%, maybe 45% if you throw in stocks that trade in Shenzhen. Either way, this is extraordinarily cheap and compares well to the US reading of about 100% and Australia’s of 85% (although here again Australia’s market seems cheapish on the Buff-o-metre).
To buy China there are several options open to investors. The easiest and cheapest is probably to buy a straight ETF or an ETF with a heavy weighting on China such as ishares FTSE China 25 Index Fund (ASX code IZZ).
Alternatively, if you prefer, you can buy shares direct through a broker – it’s more expensive though. Note that many Chinese companies increasingly dual list in Hong Kong, or even in the US (such as CNOOC, Petro China, Bank of China, China Telecom) so buying through one of these exchanges is best if you’re going down that route.