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.
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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.
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 could be c50% of GDP, given that private sector leverage is the highest it has ever been. If this were to happen, that would greatly limit the government’s fiscal flexibility. The second key variable to us is the loan-to-deposit ratio, as it reflects the ability to ‘throw good money after bad money’, i.e. the ability to refinance NPLs. On this score, China scores well, as the LDR is only 67% (though if we include shadow banking, it is closer to 80%).
We think that for as long as the loan-to-deposit ratio is below 100%, Chinese banks have the capacity to roll over NPLs. The unusual aspect of China was that the credit boom was fuelled by a deposit boom. As a result, China has significant potential to raise the LDR and thus defer the NPL problem. Recently, deposit growth has slowed, while loan growth has remained stable, which should push the LDR higher. The low LDR perhaps also explains how China can have high, single-digit wage growth when profits are flat and prices are falling by 6% y/y – we don’t think this is sustainable indefinitely but it seems to be for the time being.
Lastly, stabilising foreign exchange reserves is important in the near term. Monetary flexibility had been limited over the past quarters, as China experienced close to record FX outflows, which had a negative impact on money supply (via the selling of dollars and buying of RmB). That meant that any increase in domestic liquidity via a reduction in RRR or cutting interest rates was only working to offset/sterilise the capital outflows.
In the past few months, the Chinese authorities have attempted to limit the pace of capital flight, by limiting unofficial outflows. Gross FDI into China is $160bn (into HK and China) and China has a current account surplus of 2.1% of GDP. Thus by tightening up the capital account, for example by enforcing the policy of not allowing Chinese residents to take more than $50,000 a year out of China, China would be able to limit capital outflows and stabilise FX reserves.
Recently, FX outflows have become less extreme, and we note that FX reserves increased by $10bn in October, before falling again by $87bn in November (although by less once we adjust for currency valuation changes). Moreover, our FX strategists expect that the SDR inclusion of the Chinese Renminbi will result in $150-200bn of inflows into Chinese assets
The Chinese economy has accounted for 40% of global GDP growth over the past five years. However, the foundation of that growth was, in our view, unsustainable, with the post-2009 growth rebound ultimately generating an extreme triple-asset bubble (of real estate, private sector debt and investment). While we discuss China in more detail in the macro section, we believe that on a two-year view the risk of a hard landing remains extremely high. Moreover, the market appears to be underestimating the deflationary pressure and increased competition from Chinese corporates, with deflation falling by near record amounts on both the GDP deflator and PPI.
Internet potential still an area of opportunity for investors
Internet-related stocks – particularly FANG, or Facebook, Amazon, Netflix and Google – have had a blockbuster year, but Credit Suisse analysts see another theme here that they believe offers opportunity for investors. Despite the skyrocketing valuations in the sector, they see more room for upside, especially for Alibaba, Google parent company Alphabet, Facebook, and CheckPoint, which they believe are “cheap.”
They said smartphones and 4G mobile networks remain the main drivers of the internet opportunity as smartphones now make up 42% of the global installed base. The Credit Suisse team expects this percentage to increase to 53% over the next year or two.
Why is there still room for upside in the skyrocketing internet sector?
Among the most important drivers of the internet opportunity are advertising, education, health monitoring, e-financial services, and corporate inter-connection. They added that content, network and internet security are frequently the “critical facilitators.”
In slapping a value on the internet sector, they estimate a net present value of $1.7 trillion, assuming that 40% of ad spend goes digital, 20% of retail sales go online, and 1% of the world’s consumption is spent on other internet activities. In figuring the value, they also assume “conservative margins and discount rates.”
They see room for upside in the highly valued internet sector because the Thomson Reuters DataStream World Internet Index has a market cap of only about $1.043 trillion, excluding Amazon. They say ad revenues, retail sales and non-retail internet sales will drive upside over the next several years. Here is their full list of key internet plays.
The biggest threats to the internet-related theme include legal threats like anti-trust breaches, allegations about tax dodging, net neutrality, mobile ad blockers, competition, and the move toward video ads away from static ads, although this move does benefit Google and Facebook, among others.
Credit Suisse’s list of stocks exposed to the Chinese problem
All graphs and charts in this article are courtesy Credit Suisse.