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Slower growth in China is necessary to avoid a bust--but it will reshape the investing landscape
04/19/2013 8:30 am EST
In slightly longer-term I think this slowing in China’s growth rate is good news.
You see I think it’s intentional. (Which means that a return of fears about an unintentional hard landing aren’t justified.) China’s government is trying to slow its growth rate because its afraid of setting off another bout of real estate speculation, of increasing the flow of hot money into China’s economy, and of the rising tide of borrowing and debt in China especially at the local level.
Investors around the world who had decided that they could count on China revving up its economy again to 9% or 10% growth were indeed disappointed. They’d placed their bets, especially in the commodities sector, based on those expectations. And when those expectations weren’t met they sold and sold.
But the only way China could meet those expectations would be to go back to the old days of stimulus, stimulus, stimulus based on massive spending on infrastructure and other hard assets financed by loans that stood almost no chance of being repaid.
China faces a choice—a slowdown today or a crash tomorrow. And I think that China’s new leaders have picked “slowdown.”
Now like most medicine this one isn’t the tastiest thing to swallow. It does mean global expectations will have to be reset in sectors from metals to luxury goods to fried chicken. China’s decision to go slower isn’t going to make everyone inside China happy either even if it is accompanied by a rebalancing that points more of China’s growth toward the country’s consumers. But considering the alternative—and I laid it out for you in my April 16 post on the potential for an developing economy bust fueled by cash from global central banks http://jubakpicks.com/2013/04/16/i-dont-think-monday-was-the-beginning-of-a-market-bust-but-the-conditions-for-one-are-certainly-out-there/ --I think this is a medicine that should be swallowed.
In this post I’m going to lay out quickly the case that this slowdown in China is intentional, and then suggest three ways that it changes the investing landscape.
In China it’s not just what is said, but who says it that’s important. So when earlier this week Zhang Ke warned that local government debt was out of control, it was a big deal.
First Zhang Ke isn’t some minor official in the ministry of something in Beijing. Zhang founded and heads ShineWing, China’s largest Chinese-owned accounting company. He’s been vice-chairman of the Chinese Institute of Certified Public Accountants since 2004 and in 2005 he was voted one of the country’s top 20 accountants by China’s Ministry of Finance. He’s taken ShineWing to Hong Kong, Singapore, and Australia—and, quite frankly you don’t get to be the flag bearer for China in the international markets without a nod from Beijing.
Second, Zhang’s warning comes on the heels of a downgrade of China’s credit rating from Fitch Ratings. And on April 16 Moody’s Investor’s Service cut its outlook—not its rating—from positive to stable. The Chinese government’s knee-jerk reaction to criticism like this from outside organizations is usually to circle the wagons, deny the existence of a problem, and blacken the name and motives of these critics. This time, however, Zhang piled on.
Local government debt is “out of control,” he said, according to the Financial Times. ShineWing had all but stopped signing off on bond sales by local governments. “We audited some local government bond issues and found them very dangerous,” he added. “Most don’t have strong debt-servicing abilities. Things could become very serious.” And, he said, “It is already out of control. A crisis is possible but since the debt is being rolled over and is long term, the timing of its explosion is uncertain.”
Add in recent steps by the People’s Bank and the Beijing government to reign in a new round of real estate speculation by increasing taxes on profits, and efforts by the central bank to withdraw liquidity from the economy to offset inflows of money from overseas and you’ve got a government that seems determined to live up to its rhetoric: These are the actions of a government that believes the days of double digit economic growth are over.
I’d suggest three ways an intention to live with 7% to 8% growth changes the investing landscape.
First, not everyone who has some claim to a share of the pie as it has been divided is on board. In fact, I see signs that this stance by China’s top leaders has set off a scramble among the politically connected to grab for economic advantage. If the pie is going to grow more slowly, these members of the country’s elite are going to try to get a bigger share of the pie.
This is the common thread, to my mind, that connects such seemingly random events as the attack on Apple (AAPL) orchestrated by the official China Central Television that claimed the company offered skimpier warrantees in China than elsewhere in the world and efforts by China’s big telecom operators to either slow the growth of Tencent Holdings WeChat mobile phone application or to grab a slice of the revenue by forcing Tencent Holdings to pay for the bandwidth that its 300 million subscribers use. Politically connected state enterprises, and no companies in China are more politically connected than China’s state-owned China Mobile (CHL), China Unicom (CHU), and China Telecom (CT), have a long tradition of using their connections to reorganize the economic playing field to their advantage.
The preliminary evidence points to an increase in this kind of political jockeying that will make it even harder for investors to figure out what any stock is worth in China. How in your stock analysis do you factor in the possibility that a state-owned enterprise will grab a hunk of the revenue of the business you’ve invested in?
Second, I think we can expect more of the “anti-conspicuous consumption” campaign launched last March. The effects, for example, have been to lower sales for Kweichow Moutai’s baijiu liquor, a traditional premium gift and a standard at official banquets, and Longjing tea. The campaign has extended to expensive dinners at government expense. In the first two months of 2013, sales at restaurants and catering businesses with annual revenue above 2 million yuan ($320,000) fell 3.3% from a year earlier. The frugality campaign is also being blamed for a deceleration in retail sales in January and February.
I’m not sure how long this will last or how far reaching the effects might be, but it should cause investors to rethink some of their assumptions about the Chinese luxury market. I don’t think the market will go away or even shrink very much, but I’d be on the lookout for a shift in what goods get purchased. There is already some evidence of a move away from “everybody has one” goods such as Louis Vuitton leather goods and wow-em-with-the-label scotch. In the liquor market, for example, sales of products priced at more than $160 a bottle (1,000 yuan) have seen the biggest drops because of the drive. To me this suggests looking for smaller luxury goods makers who sell products not yet owned by everyone—and that therefore don't signal conspicuous consumption—and upper middle market rather than very upper end goods.
Third, I think we’re going to see a period of adjustment while the global economy comes to terms with a Chinese growth rate of 7% to 8% rather than 9% or 10%. The toughest adjustments will come in sectors where projects have long lead times and companies are already spending on expanding production for a growth rate that is less likely to materialize. This suggests a wrenching period for commodity producers, for example, with the current cuts in capital spending just the beginning of a painful process. On the other hand, companies with shorter investment cycles and that have the flexibility to respond relatively quickly to changes in demand and in supply should find China’s 7% to 8% growth very attractive.
If I’m right about an intentional slowdown in China’s economy and the effects of that policy, you might prefer to own Yum! Brands (YUM), McDonald’s (MCD) and Café de Coral Holdings (341.HK) than Rio Tinto (RIO.) You might prefer New Zealand milk producer Fonterra (FSF.NZ) and Nestle (NSRGY) and DANONE (BN.FP in Paris or DANOY in New York) to cognac maker Pernod-Ricard (RI.FP in Paris or PDRDY in New York.)
A slower growing China isn’t, after all, a no-growth China. It will just take some getting used to.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did own positions in Café de Coral and Tencent Holdings as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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