The China crisis is here: What now?—Pt1

For years, China was flavour of the month. So popular were its attractions that the Rudd government had enough time to stitch together a new mining tax and Gillard unstitch it. Yes, it’s been that long.

When faced with economic difficulties, the United States could first rely on Alan Greenspan to make money cheaper and then on Ben Bernanke to make it free. Australia had its very own ‘put’ based on China. No matter what went wrong in Gondwanaland, the industrialisation of the world’s most populous nation would dig us out of a hole by paying us to dig more and bigger holes on its behalf.

All we had to worry about was a soaring currency that allowed us all to take cheap overseas holidays. When you’re living it up in Barcelona, really, where’s the problem?

The excitement this induced in the west quickly outpaced reality. In almost all industrialisations, property rights and an independent legal system are central to the development process. Not in China—its path to prosperity remains a vast and intriguing experiment.

The fall in the price of iron ore—down more than 50% in the past year—has been the point about which the China Put turns, an excuse for all those long-standing concerns about Chinese growth to gain some air.

Media tone change

The change in tone of media coverage has been quite something. The China bears have always been there but when iron ore was changing hands at $180 a tonne, no one wanted to listen. Now iron ore is less than $90 a tonne you can’t hear anyone else.

Take Société Générale’s Albert Edwards, a well-known China bear. He has, reassuringly, called Australia, leveraged to China and with a banking system heavily dependent on external investment, a ‘CDO squared’. Collateralised debt obligations (CDOs), you may remember, were those nasty little things that blew up the global banking system.

In a blog post titled The macroeconomics of Chinese kleptocracy, John Hempton of Bronte Capital described China’s political system with brutal frankness. The ‘K’ word was never really in doubt but it’s a measure of how much has changed that it’s got so much attention.

More worrying are the comments and stats emerging from within China. According to a report in the Financial Times (see Bears at the heart of the dragon), some of the biggest China bears are Chinese economists, who have nothing to gain from talking things down.

An unnamed but ‘well respected’ local economist said at a conference in Tianjin, ‘I believe China is going to experience a very serious economic downturn and I think it has already started. The government is trying now to stabilise the economy but the instruments they have are very limited. If it can’t turn things around then I expect huge and widespread social unrest.’

Saigon calling

The FT went on to quote, again anonymously, a western fund manager: ‘After what I’ve heard I’m really worried now about being the dumb foreigner sitting across the negotiating table from the locals who are packed and ready to run to the airport.’ Who would have thought 18 months ago that China would sound like Saigon circa 1975?

Members shouldn’t be too surprised by this. In November last year we published a boldly titled special report, The Coming China Crash. It made the argument that Chinese growth was being driven by investment rather than consumption and that the situation bore a striking resemblance to that of Japan in the late 1980s. And we all know how that ended.

Thus far, it appears the China crisis is running to script. Call us prescient, and lucky.

The report then examined the top 20 stocks for their exposure to a Chinese crash and went one step further, pitching a basket of companies that might offer some protection against a Chinese slowdown.

With the media replete with ‘China is crashing’ stories, it seems like a good time to revisit the stocks in this special report, starting with the top 20. Table 1 lists these stocks along with the total returns (share price and dividends) since the report’s publication and current recommendation.

Let’s start with the big four banks—Commonwealth, Westpac, ANZ Bank and NAB—all of which are indirectly exposed to a China slowdown.

As SocGen’s Edward’s noted, the need to source funds from the wholesale money market is the bank’s Achilles heal. If funds dried up as they did in 2008, especially at a time when unemployment and mortgage stress was increasing, property values could fall quickly. That may quickly see a sharp increase in bad loans and pressure on capital adequacy ratios, which is where a banking crisis tends to start.

Banks are very well aware of this, which explains why there’s been a flood of recent hybrid security offers—it shores up their funding by shifting risk to investors. Nevertheless, the banks have been a big beneficiary of the flight to safety with share prices and dividends increasing.

Members should closely adhere to our 10% portfolio limit on the banks and don’t double up on the risk. If you do own any of the hybrids, include them in your portfolio calculations. If there is a bank crisis, they’ll convert to equity anyway so there’s no reason for them not to be included in your portfolio limit.

As for insurers QBE Insurance, AMP and Suncorp, the same rules apply. Keep your portfolio allocation to the sector to 10%, and restrict your allocation to the financial sector, which includes banks, insurers and fund managers, to no more than 25% in total.

Prices increasing

While many of the stocks on the list haven't graced our Buy list, many of the stocks in the top 20 have performed exceptionally well. The growing appetite for high yield stocks and the rush to safety has seen a number of them rise substantially.

Westfield Group, for example, has achieved total returns of 36.3%, a combination of the appetite for yield and the attraction of its overseas earnings. Although it’s still exposed to the second round effects of a Chinese slowdown, which haven't really started to reach Australia yet, it’s currently a HOLD. Westfield Retail Trust is far more exposed to these second order issues and explains why we now have a preference for Westfield Group.

CSL has been another great performer, delivering total returns of 40.2% since the report and up 35.0% since our original recommendation on 20 Jan 10 (Long Term Buy – $31.30). The price rise reflects a fantastic annual result and an acknowledgement that this is a business that can grow in most economic environments.

Of course, it remains exposed to the Aussie dollar although a China crash would bring a welcome boost to earnings in local currency terms. However, on a price-to-earnings ratio of around 21, some of the currency correction is already priced in. It remains a HOLD.

Telstra, which is getting its act together (see Telstra Pt II: What’s it worth?), is another stock benefiting from the appetite for high yield stocks. Enjoying total returns of 30.4% since the publication of the report, the company’s exposure to China remains very low. Another HOLD.

The indirect exposure to China of Telstra, Westfield Group and CSL remains largely unchanged but with the price rises, all are now more 'fully valued' than they were. Each is now closer to a Sell than a Buy so please don’t rush out and load up on them.

Wesfarmers share price is up about 10% since the report due to its perceived defensive qualities and the ongoing turnaround at supermarket business Coles. There’s no change to its China exposure, although its resources business is likely to have a tough 2013 because coal prices have fallen about 20% since early July. Many of Wesfarmers’ other businesses have been profiting from the resources investment boom but this is likely to fade with the slowdown in a year or two. HOLD.

As for Woolworths, it’s share price has risen 17.3%, again because it’s a purer defensive play. A slower Australian economy would still have some effect on this businesses but it has a very low China exposure. With the outlook a little weaker than at the time of the report, we’re sticking with HOLD.

Mining stocks

The rising share prices in these large, defensive stocks seem to have come at the expense of the mining sector. Fortescue Metals has been severely affected by the plunging iron ore price, with its share price down 29.4% since the release of the report in November last year. BHP Billiton and Rio Tinto have been largely unaffected, reflecting their very diverse mining operations.

The long-held belief that the price of iron ore couldn't fall below $120 a tonne has been shattered. We made the case for falling iron prices here and highlighted why Chinese steel production would slow here. Again, choose luck over prescience.

With the iron ore price now less than $90 a tonne, just half its peak, margins are being squeezed. Rio and BHP are still making plenty of money and BHP in particular is starting to look attractive, as Gaurav Sodhi explained on 13 Sep 12 in Iron ore: Trumpets and warning bells. Both are HOLDS.

As for Fortescue, with higher costs and lots of debt, it may well continue to struggle. Although shareholders may take some comfort from the fact that the debt is so large it’s the banks’ problem rather than the company’s, there’s still time to get out. It’s unlikely the ore price would fall to $30 a tonne as it was in 2002 but it could easily fall to $80. AVOID Fortescue.

Coal & Allied is a stock we no longer have to worry about, it being fully taken over by Rio. Nevertheless, as explained in Coal: A dark future ahead on 11 Jul 12, coal prices continue to fall and it’s more likely this is a permanent rather than cyclical phenomenon.

Woodside has been a victim of it own ambitions. The Pluto project has started production but, as we declared in Woodside hits planet Pluto on 18 Aug 11 (Hold – $36.87), returns will probably be in the low single digits. Company specific factors, more than developments in China, will influence the company's performance.

As for gold, it hasn’t done much at all. Newcrest's share price fall of 15.6% is more down to company specific problems, although as Gaurav Sodi explained in his analysis of the latest result, there’s reason to HOLD.

Curious effects

The performance of Origin Energy and Santos, two long standing Long Term Buy recommendations, has been curious. Both aren't exposed to a China slowdown but the fear of one has affected risky stocks, including these two. There are company specific factors—the soaring cost of construction in Australia, for example—that have contributed to price falls but so has a lower tolerance for risk.

With the share price of Origin down 15.3% since the time of the report and Santos down 2.5%, both remain a LONG TERM BUY.

That wraps up our coverage of the top 20 stocks and their exposure to a China crash. In part II, to be published next Wednesday, we’ll examine the performance of the China crash protection portfolio and make a few adjustments to it.

If you haven’t yet prepared for a Chinese slowdown, please don’t leave it until it’s too late. Reread the report here, review your portfolio, taking note of our portfolio weightings for each stock and sector, and then adjust it accordingly. It’s possible that a huge Chinese stimulus package, as we saw in 2009, may save the day but it’s not something to rely on.

Companies deeply exposed to China, especially those that are highly leveraged like Fortescue, will struggle to get through this period in tact. There’s no need to rely on a kleptocracy to bail you out when you can do it yourself.