Recent economic data is piling up to make it clear that the “Old China” economy (manufacturing, metals and mining) is really slowing down, and might even begin to contract in the next couple of quarters, while the “New China” economy (tech, internet and insurance) continues to rev up.
According to two new reports from Goldman Sachs Commodities Research and Economics Research, the worm is truly turning today in China. The transition to the New China consumer economy is fully underway, and the continued slump in metals complex is yet more proof that the Chinese manufacturing giant is slowing down in middle age.
Metals complex are foreshadowing decline of the “Old China” economy
In April, Li Lu and Bruce Greenwald took part in a discussion at the 13th Annual Columbia China Business Conference. The value investor and professor discussed multiple topics, including the value investing philosophy and the qualities Li looks for when evaluating potential investments. Q3 2021 hedge fund letters, conferences and more How Value Investing Has Read More
Goldman Sachs analyst Max Layton and team argue the metals complex is acting like the “canary in the coal mine” for China’s old economy: “What has also occurred since late October has been an eye catching rise in Shanghai Futures Exchange open interest across the metals complex – for copper, it has been the largest increase in Shanghai open interest in 12 months – since the 1Q15 collapse in Chinese metals demand. In our view, this development raises a red flag regarding ongoing and near term activity in China’s ‘old economy’ and metals demand growth, as measured by our GS China Metals Consumption Index. Indeed, over the past five years, periods of rising SHFE open interest and falling metals prices have been associated with concurrent or imminent weakening in China’s commodity intensive ‘old economy’.”
Also of note, given SHFE open interest has provided a correct bear call on four out of five occasions since mid-2011, the current developments in the metals market clearly has bearish implications for China’s upcoming activity data releases.
Services sector strong in China so far in fourth quarter
According to Goldman Sachs Economics Research team Andrew Tilton and Maggie Wei, China’s third quarter real GDP growth hit 6.9% year-over-year/ 7.1% qoq annualized, just above consensus. Although initially reassuring, the new data raised questions several among analysts.
One concern mentioned is that nominal GDP growth has dropped to the lowest ever at 6.2% yoy. This means the implied GDP deflator comes to -0.6% yoy, far below +0.1% yoy in Q2, despite CPI inflation moving up a bit in Q3 from Q2. Second, the composition of real GDP growth suggests accelerating activity in “other” services and strong financial sector growth despite the stock market slump. Third, key monthly economic data from China was notably poor, with the NBS manufacturing PMI hitting a multi-year low in the third quarter (the nonmanufacturing PMI flirted with an all-time low), industrial production dropping to 4.5% qoq annualized (adjusted) and fixed asset investment sliding also decreasing.
Tilton and Wei argue that these contradictory figures reflect a “divergence in activity between different sectors of the Chinese economy.” One key takeaway is that the services sector is clearly outperforming manufacturing. Looking at the PMIs, other sector level indicators, or even company-level data, you consistently find faster growth in services. For example, the revenue growth of listed companies in “new China” sectors such as internet, life and health insurance was a solid 35% yoy as of 1H 2015, while “old China” sectors such as metals and mining actually had 0% revenue growth in the first half of the year.
Interestingly, this is a theme which John Burbank of Passport Capital has discussed in the past. According to a transcript of a May 2014 conference:
John Burbank of Passport Capital recommended buying Chinese internet companies and selling Cloud related firms. This internet spread trade serves as a hedge against his structural long SPX vs EM equity position, which he reminded, is only in the 3rd year of a typical 7yr spread cycle.
EM equities have lost their entire advantage in operating margins over DM amidst a sharp fall in net income in EM. There is a lot more to go in trend EM underperformance, he claimed, but this is now consensus, exposed to more noise, and thus has become more of a ‘longer-term trade’.
But, it’s the recent violence in equity markets that has caught his eye. Since early March, there’s been an EM rebound against DM and within DM, large caps have substantially outperformed small caps as has value over growth. This, he argued, leads to stress and can produce significant dislocations. And, it opens up the internet spread trade.
Pervasive China bearishness has produced a sizeable drop in China equities, including a very sharp drop in Chinese internet companies. John produced a screen of the cheapest and most expensive stocks in US markets using EBITDA and growth rates and found that 12 of 21 cheapest are in China; most are internet companies. These companies represent ‘new China’ as opposed to ‘stale old China’ and provide exposure to a consumer driven growth model.
Yet, they are priced exclusively by Westerners in US stock markets disregarding their hundreds of millions users amidst a highly immature consumer service and retailing system in the country. Several of these companies could become monstrous winners. Meanwhile, 7 of the 12 most expensive stocks on the screen were cloud stocks. That’s the short; the unwind in tech has a ways to go and this could weigh on China internet.