Looking beyond China

If Chinese commodity demand really is unravelling, it's time to take stock of where the next opportunities lie.

By Michael Feller · 12 Mar 2012

By Michael Feller ·
12 Mar 2012

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PORTFOLIO POINT: It's difficult to assess whether Chinese commodity demand is collapsing, but the signs aren’t good. Luckily, there are other offshore opportunities for Australian investors.

Only a few days after keeping interest rates on hold, the Reserve Bank really got egg on its face. Not only had quarterly GDP numbers disappointed and unemployment edged back up, but the Australian Bureau of Statistics recorded a shock trade deficit of -$673 million for January, down from a $1.998 billion surplus for December 2011.

Sharply lower iron ore (-$1.227 billion) and coal (-$268 million) exports were the main contributors to the fall, bringing total exports down 8% to $25.372 billion. This was largely on the back of lower demand from China, (down $2.135 billion from a peak of $7.298 billion in October), which is itself suffering a terms of trade deficit: the largest in a decade.

As regular readers would know, I’ve been bearish – possibly too bearish for those with a shorter-term horizon – on the sustainability of Australia’s trade relationship with China, which is built, as I see it, on the back of a fixed capital investment bubble, most graphically illustrated by empty freeways to nowhere, enormous ghost cities in inland provinces and massive public transport projects that may never prove to be economic (see Shock and ore). Yet I nevertheless concede that despite these latest figures, it may still be too early to tell if this really is a sign of a collapse in Chinese commodity demand, given the inevitable seasonal effects of the Chinese New Year and adjustments to new sources of supply coming on stream, as well as ore brought in from Brazil in a new fleet of 'Valemax’ bulk carriers.

Still, worries over China’s resource demand do not come down to a single data point and it’s not as if Brazil has been immune from a sharp slowdown in growth either. Already, the World Bank has expressed its misgivings over the long-term sustainability of Chinese growth without a larger consumer sector. And the institution’s sister organisation, the International Monetary Fund, earlier raised its own concerns as well on the sustainability of China’s banking system, much of it directed by government edict to extend lending on uncommercial terms to politically-favoured projects.

And now, coming soon after the lowering of China's official growth target to 7.5% – a figure that doesn't leave much space for the kinds of construction activities that demand Australian exports if targets for an increase in consumption as a share of GDP are to be achieved – Credit Suisse has called the peak of the cycle: "As the economy shifts its growth engines away from infrastructure, construction and exports toward consumption, especially service consumption, the propensity of demand for commodities is bound to decline," the investment bank wrote. "Getting a massage simply does not use as much steel as building an airport."

Credit Suisse: "we think China’s supercycle for commodities is behind us"
Source: Credit Suisse, CEIC, World Steel, Brook Hunt

To put this into perspective, credit ratings agency Standard & Poor's last week predicted a recession for Australia if China's economy slowed to 5%. A decline to 8% growth, which S&P euphemistically calls a "soft landing", may have already been responsible for the recent drop in property prices. As for other forecasts, meanwhile, Beijing-based economist Michael Pettis, a finance professor at Peking University’s Guanghua School of Management, projects an average of 3% growth in China over the coming decade, though a fall to this level may take another two to three years to play out.

This is a view in line with that of UBS’s London-based economist Paul Donovan (whom I spoke to last week), who sees China’s political change this year as almost guaranteeing enormous efforts to keep the economy afloat and unrest at a minimum. Then again, all I can think of are previous attempts by the Soviet Union in the late 1980s to stave off their unsustainable top-down economic model.

And for those who put their faith in the predictive abilities of the government bond market, the yield curve of Chinese government bonds has inverted in much the same way that the US Treasury bond yield curve inverted before the global financial crisis.

Source: Pragmatic Capitalism, Bloomberg

China's problems, as I see them, come down to this: growth has come as a government reaction to political unrest – whether perceived or real – not as a product of natural demand or development. And this growth, via low-margin exports and building surplus infrastructure that manufactures the appearance of GDP growth, has otherwise generated insufficient cash flow to trickle down and create a sustainable consumer sector. Moreover, this growth has eaten into China’s ecological, social and political balance sheet at a time when the country’s population is already approaching the peak in its dependence ratio.

And while one of the chief by-products of this model – America's pre-2007 debt levels that were the result of Chinese investment in Treasury bonds driving US cash rates to bubble-friendly levels – has already come asunder, China's internal imbalances, being the other side of the bilateral coin, are all the more worrying considering its additional vulnerabilities as a relatively poorer country – one that has built itself as a low-value outsourcing destination, currently without the safety-valves of pluralistic democracy.

When the day of reckoning thus eventually arrives for China – and there are limits to China's supposed ability to forestall this through ample policy tools like additional cheap money supply and local government bailouts – Australian investors who truly believed we were witnessing a permanent, historical change in global power could be hung out to dry.

Thus, I am disturbed not just by the above, but by more coal-face indicators such as plummeting construction equipment sales, and falling forex reserves considering that front-ended and debt-financed fixed-asset investment still accounts for the lion's share of China's GDP.

And with Chinese officials sending mixed messages too on the apparent “need” for house prices to drop 30%, or on how to control shadow banking, I am also doubtful of the government's purportedly infallible ability to deal with any serious economic crisis, let alone a potential social crisis borne of environmental, labour, or civil grievance.

As I'm only too aware from the past year, predicting the point of any economic reckoning is a mug's game, yet despite the valiant efforts thus far of China's government to keep the party going – whether in the form of the central bank's Chinese New Year credit intervention, or in the form of new consumption stimulus proposals – eventually the mao-tai punch bowl will empty without more sustainable drivers such as demographic growth (the repeal of the one child policy is a start), better innovation policies or a more consumer-oriented economy.

Yet how can China grow out of its present debt-fuelled model when that growth is driven by the very same model it's supposed to grow out of?

Like building a pyramid on the beach, when sand is heaped on more sand eventually the critical angle of repose is breached and the whole thing comes tumbling down. Eventually the options for the country's current economic model will run out and the sand pile – imported as it is from Australia – will need to be replaced with something a little more concrete, like internal demand built on a mix of domestic industries and the structure of a modern welfare democracy.

With this view for commodities such as iron ore, coking coal and copper – which I covered last week (see Copper cauldrons and paper houses) – where then is an Australian investor supposed to invest? As I’ve been saying for several months now, the answer is offshore – particularly the United States, considering the Australian dollar’s correlation with both the terms of trade (natural) and overseas enthusiasm for the commodities story (somewhat artificial, but understandable considering our still-high cash rate). In Australian dollar terms, US equities are still quite inexpensive on a price to earnings basis, though there are emerging concerns that profit margins for US firms may be unsustainable all the same.

The other place to invest, taking advantage of a relatively strong currency and relatively high interest rates (though the former has admittedly fallen now to around $US1.05 and there are calls for the latter to fall by at least 25 basis points or even 50bps next month), is in hedged funds and fixed-income products. Doug Turek wrote an important piece last month (Hedging's little extra) on how even gold can produce a yield when Australian investors enter it via a hedged ETF and now is still a good time to lock-in a favourable term deposit rate as banks feel the squeeze between a skittish overseas funding market and a lacklustre domestic mortgage market (see The Ten Commandments of Income Investing).

But more than these, Australian investors can still very much invest in commodities and expect to do well in the coming years, but just not all commodities. I’ve written about soft commodities and energy before (see An emerging opportunity and Fuel for thought), being particularly bullish on Australian agricultural stocks and oil prices despite the respective impact of a strong Australian dollar and the substitution of shale oil (though shale, with a far lower profit margin and energy returned on energy invested measure is likely to remain a marginal source of supply – and very risky investment proposition – for a very long time). In fact, Tim Treadgold wades into the soft commodity space – specifically phosphate – today, with a look at what's happening around UCL Resources and Minemakers (for a backgrounder on phosphate, see my article Phosphate's Promise). I’ve also written about green energy and water as being investment angles to take, though with definite technology and platform risks to carefully consider as both these themes are only just emerging as investable asset classes (see The East is green and The world's real liquidity crisis).

But in Friday’s Under the Radar column, I will be writing about something else: mining companies that have nothing to do with China’s fixed asset bubble.