While the S&P 500 is hitting new all-time highs, we look through the euphoria and remain focused on the global risks that continue to persist and are important for global equity investors. Readers will know only too well that we have serious concerns over the nature of China’s growth model and the resulting build-up of loans in the banking system that are deteriorating in credit quality.
We examine the most recent economic data from China and conclude that the recent optimism over China’s stronger-than-expected growth will be short-lived and is the result of renewed imbalances. The scorecard is not a healthy one. See for yourself.
Investors in Montaka will know that, at the beginning of the year, Chinese policymakers put their foot back on the growth-accelerator (perhaps to avoid a financial crisis which was a very real prospect in the first two weeks of January). This was a painful period for Montaka as many low quality businesses that we were short rallied hard.
We can see this stimulus in the numbers. New bank lending, shown below, hit a record in the month of January. This was a large-scale credit-injection designed to spark a mini-boom in the economy – and it worked. The only problem is, the boom has occurred in all the high-risk areas (infrastructure and property investment), which already have deteriorating credit characteristics.
The Chinese corporate sector can be broadly split between State Owned Enterprises (SOEs) and private companies. Not surprisingly, when the government wants to inject credit into the economy, it instructs state owned banks to lend to state owned enterprises which are instructed to invest immediately.
The chart below illustrates clearly the sharp acceleration in SOE investment in fixed-assets since the beginning of the year. Remarkably, growth in fixed asset by private companies has now dropped to zero! The importance of this chart, in our view, relates to the implications for underlying Chinese demand for fixed asset investment: it’s probably very weak. Private companies invest based on demand – and they are not investing. SOEs are not investing based on demand – they are investing because they have been instructed to by the government.
Dissecting China’s fixed asset investment growth even further results in the following observations. Mining and manufacturing investment growth have already turned negative. This is actually good news given the significant level of overcapacity that already exists in these sectors.
Infrastructure fixed asset investment, on the other hand, has reaccelerated since late last year – which makes sense given this is typically “funded” by local governments. Property investment accelerated on the January credit-injection, though has already started to fizzle out as of June.
Australian investors will be all too familiar with the recent rally in iron ore producers. This is connected with the above acceleration in Chinese fixed asset investment. Indeed, China recently clocked a monthly record for crude steel production, as shown below. We believe this reflects a “pull-forward” of demand. This has sent the iron ore price rocketing. But this will be temporary, in our view. More demand today means less demand tomorrow.
Accelerating growth in fixed asset investment is an easy way for Chinese policymakers to boost its aggregate growth rate but is not actually good for the longer-term health of the economy. Imagine I instruct you to borrow money from your bank to build a bridge to nowhere: this is great for the economy while you build your bridge (immediate employment of construction workers and consumption of commodity inputs), but longer term is a problem. If the bridge generates insufficient cash for you to service your debt, then your bank has to write down the value of your loan. This absorbs bank capital and reduces new lending. Reduced new lending constrains future economic growth which potentially impairs other loans. And so on.
Debt levels of local governments and SOEs in China are already at levels deemed by many to be unsustainable. Adding more debt to build additional (and likely unproductive) infrastructure will only create bigger problems down the road.
Professor Michael Pettis, one of the most astute China observers on the planet, had this to say about Chinese debt, recently:
- “Debt is certainly a serious problem for China, and it is almost a mathematical impossibility that GDP growth can recover from current rates (except under great strain and for a very short time). In fact it is almost a mathematical impossibility that GDP growth remain close even to current levels. It will continue to drop…”
We remain bearish on the sectors within the Chinese economy that rely on fixed asset investment growth. While we have been wrong about this during the first half of 2016, we believe we will be right over the medium and longer term.
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.