Materially worse

PORTFOLIO POINT: With the materials sector making up a large part of the Australian market, a slowdown in China has major negative consequences.

Two weeks ago the Australian materials sector emitted a rather foul odour and was kicked outside in the cold.

My repeated conviction of a weak materials sector was reinforced, and readers will know this does not auger well for the Australian sharemarket in the foreseeable future. From both a market weighting and economic-driver perspective, the influence on our market is negative.

The combined materials and energy sectors account for 29% of the Australian market, so they have a large influence over its direction because marginal buyers and sellers – foreign institutions – will come and go depending on their sentiment towards global growth prospects.

Australia’s mining sector also accounts for 7% of GDP and contributes 50% to the value of exports. Most commentators claim the mining sector single handedly saved Australia from the recent recessions experienced by most of our western peers. But we are now seeing signs of maturing of Australia’s remarkable run.

A few weeks ago I reported China’s biggest maker of construction machines, the Sany Group, announced a cut to its 60,000 workforce, on the back of falling demand. Sany produces concrete machinery, excavators, cranes, pile drivers and road machinery. Its annual revenue exceeds RMB80 billion, or US$12.5 billion. Sany has been selling machines on generous credit terms and in 2011 its net receivables doubled.

While the macro picture is uncertain at best for China, when you look at the balance sheets of individual companies you find that the picture is even worse.

Recently, China also announced its inflation for June of 2.2% year-on-year. While I accept lower food prices played a role in the deceleration in the rate of inflation from over 7% a year earlier, the falls have been broad based. This news will be welcomed by the Chinese consumer, who will benefit from more stable prices. The bad news is that this is signalling industrial weakness evident in the Producer Price Index (PPI), where slowing demand is showing no end in sight.

Members of our team have travelled to China a number of times in the past two years and concluded the number of white elephant apartment blocks and shopping malls would eventually cause some pain on various local government instrumentalities and selected property developers. This will flow to steel makers, iron ore suppliers (a subject I have written to you about now for almost a year), cement suppliers and the banks that have been lending them all their money.

And this weakness is not confined to China. Japan, their most important trading partner, just saw machine orders fall by 14.8% year-on-year, versus expectations of a 2.6% fall.

The reason for my continued focus is Australia’s growing reliance on China as a trading partner. Over the past 20 years Australia’s merchandise exports to China has grown from 6% to 38%. Over the same period, Australia’s merchandise exports to Japan have declined from 45% to 26%. By destination, China and Japan collectively account for 64% of our exports, compared with 50% 20 years ago.

China’s June quarter 2012 GDP growth decelerates

Until recently China would release its GDP data for a particular quarter on the third day of the subsequent quarter. Given the complications within the world’s most populous country, their mainframes must have been working over time. Nowadays the release takes a little longer and on Friday,13th July, China announced its real GDP growth rate for the June 2012 quarter had decelerated to 7.6% year-on-year growth, the slowest pace in three years and well below the 10% average of the past 30 years.

With the country transitioning from fixed investment assets (much more than 45% of GDP) to consumption (35% of GDP), we expect the dynamic growth of the last 20 years to be a little more muted. It is interesting to note that for the world, investment as a share of GDP is 20%, while consumption as a share of GDP is 60%. In the case of the US, these figures are 15% and 70%, respectively. Maybe the US is transitioning in the opposite direction to China, with more investment and less consumption.

One of the biggest issues for China is that 22% of its exports go to Europe. The fragile European economy and stubbornly slow recovery in the US is placing pressure on China’s exports. In turn, this is starting to place pressure on Australia’s exports to China and the Australian economy generally.

There’s a very good reason Jim Chanos has been short Australian iron ore producers. While it may appear that stocks like BHP are good value, be very careful they aren’t a value trap! They’ve already caught a few fundies (who bought and advocated BHP) off guard.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.