China is one of the biggest themes for next year, in what’s expected to be a continuation of this year’s macroeconomic problems, according to analysts at Credit Suisse. They warn of competitive threats from the country and a possible Chinese hard landing in the next two to three years.
Interestingly, they also see internet-related names as being undervalued despite their broad outperformance during 2015. They name a number of themes they see as impacting the world’s markets and even making some sectors that would usually look good at this point in the current economic cycle look less attractive.
Competition in China
Analyst Andrew Garthwaite and team released their report entitled “2016 Outlook: Themes, Sectors and Styles” last week. They named competitive threats from China as the biggest and most important theme as the country makes up one-quarter of global capital expenditures.
Because of multiple devaluations of the Chinese yuan, the nation is now reducing prices in order to export all the extra capacity it has. China’s producer price index and gross domestic product deflation are both close to record levels.
[drizzle]Further, the Credit Suisse team reports that there appear to be no efforts to shut down that excess capacity based on a lack of bond defaults or mergers resulting in capacity closures. Meanwhile the loan to deposit ratio remains low and enables NPL rollovers. They explained:
“Ultimately, China is engaged in employment rather than profit maximisation. The steel and aluminum industry provide [sic] a good example of this, where nearly all production is loss making and yet China continues to be a major exporter of both commodities.” The chart below is particularly shocking?
Caterpillar, GE among the most threatened by China
Another problem for the West is that China continues to move up the value-added curve at a faster pace than expected. Research and development costs make up 2% of the nation’s GDP, a significant increase from 0.6%. Also China sees 45% more patent applications than the U.S. does and graduates 31% of the world’s engineers.
The Credit Suisse team sees the sectors facing the biggest threat from China as being handsets; telecommunications, mining, railway, and healthcare equipment; power generation; bearings; process automation, wind and solar; bulk chemicals; sweeteners; vitamins; and autos. They said the semiconductor business is increasingly being threatened as well.
The stocks that may be the most threatened by China include Caterpillar, General Electric, BMW, Toshiba, and “all basic steel and aluminum companies.”
In the 428 page report they note:
Although the pace of consolidation in the old economy has accelerated through 2015 (from a very low base), there is not much evidence that this is improving margins (and thus diminishing the global competitive risk). Relevant to the competitive threat theme are the railway, shipping and metallurgy sectors. China’s two major bullet train makers (CSR Corp and China CNR) completed their merger in H1 this year, a decade after having been split off from the same parent. COSCO and CSCL have published a merger plan after receiving a central government directive, and China Merchants Group may merge Sinotrans and CSC. In Metallurgy, China Minmetals Corp announced on 8 December that it will merge with China Metallurgical Group – a business with a similarly diversified business structure and asset scale. In sum, we think that China, like Japan, is operating a policy of employment maximisation at the expense of profit maximisation, and therefore appears reticent to shut down excess capacity. We remember that when Japan exported its excess capacity on the wrong cost of capital, its share of US exports tripled as it moved up the value added curve.
Hard landing expected in China
So with the threat China poses and with the economic climate there, what’s an investor to do with it in 2016? Garthwaite and team suggest that investors remain underweight on most “China-related plays” because they expect a hard landing in two to three years. They’re concerned that there’s been a “triple bubble: the third biggest credit bubble; the biggest investment bubble and an abnormally large real estate bubble, aggravated by a declining workforce.” They add:
“This triple bubble only becomes problematic when there is PPI deflation, falling property prices and outflows of FX reserves. We have seen all three in 2015 (though the second, property prices, has been a little better since the summer).”
The Credit Suisse team warns especially about the Chinese real estate market, saying that if real estate prices fall by at least 15% and/ or if the loan to deposit ratio raises from 67% or 80% including the shadow banking system to 100%, then China might not be able to avert a hard landing. In the near term, however, they do see some stability in real estate prices.
Because of their concerns about China, they see potential short positions as being Burberry due to its luxury brand and Volkswagen and BMW (or German autos in particular). Other possible short plays related to China include those in industries listed above, like mining equipment and carbon steel and aluminum companies. We have embedded Credit Suisse’s full chart of exposed stocks at the end of this article.
Specifically they state:
The structural challenge remains that China is in the midst of the third biggest credit bubble (in terms of the rise in credit to GDP over a five-year period), one of the largest investment bubbles (in terms of the investment share of GDP) and a real estate bubble (on IMF data it represents 15% of GDP, with five years of overbuild in Tier 3 and 4 cities) compounded by worsening demographics, with the working age population shrinking.
Ordinarily, bubbles burst when excess investment results in falling prices, and there are now clear signs of this: in China, the GDP deflator and PPI deflation are both close to record lows. The key to us is the banking system’s loan to deposit ratio and real estate prices.
To us the key to the hard landing thesis is real estate prices (if they fall 15% or more) and the loan to deposit ratio (if it rises to 100% from 67% or 80% including the shadow banking system), then a hard landing may be unavoidable.
Real estate is key, in our view, as it represents half of household assets, c55% of banks collateral, a third of local government revenues and 15% of GDP, according to the IMF.
While LTV ratios would suggest that there is more of a cushion, especially with mortgage debt-to-GDP being just 16% compared with 100% in the US at peak, we fear that when there is such a big increase in credit growth combined with a property bubble, there might be more hidden leverage seeped into real estate, than official data suggest (for example with developers de facto funding some of the down payments).
We fear that, if real estate prices fall 15% or more, then NPLs could reach 25%, a level they have reached twice in the past 30 years, which would imply that the cost of the NPL problem