Conclusion: A potential record power outage looks to incrementally slow growth and marginally quicken inflation in China. Even still, we welcome these developments to the extent we may eventually be able to buy one of our favorite long ideas on sale when our models signal to us that it’s once again “safe” to significantly increase our exposure to equities in the Hedgeye Asset Allocation.
In yet another manifestation of our once out-of-consensus call that Growth Slows as Inflation Accelerates, China faces a power shortage that may incrementally slow economic growth and marginally quicken inflation. Multi-year high coal prices (+36% since Jan. ’10) driven largely by a significant pullback in Australian supply (the world’s largest producer) is causing Chinese utilities to slow electricity production, in addition to causing them to demand and receive higher prices.
Furthermore, the worst drought in a half a century is threatening to exacerbate the current reductions in aggregate power generation by limiting the capacity of China’s hydropower stations – particularly the Three Gorges Dam in the Hubei province (the world’s largest). Anecdotally, silicon makers and aluminum & copper smelters in the region are slowly suspending activity due to a lack of electricity on the margin.
The decline in hydropower output (22% of total power generation) in Hunan and Hubei is placing incremental pressure under coal prices (70% of total power generation) and exacerbating the energy supply situation across the country broadly. At an 11-month low of 8.6M metric tons, coal inventories in China are around nine days’ supply vs. a normal range of two weeks. In an attempt to incentivize utilities to reaccelerate electricity production amid rising costs, China just raised electricity prices for industrial, agricultural, and commercial users in 15 provinces for the first time in over a year by +2.2%, with further increases not being specifically ruled out. This is following a +2.7% increase to power tariffs in 12 provinces on April 10. Interestingly, in a bid to limit consumer price inflation, the National Development and Reform Commission held residential rates flat.
Still, we feel the recent hike has the potential to be passed through the supply chain to Chinese consumers and could put upward incremental upward pressure on China’s CPI – a sharp fundamental reversal (recall that we had been and continue to be bearish on the slope of Chinese inflation over the intermediate-term TREND). The NDRC believes the recent increase could indirectly add +5bps to headline CPI. Obviously any further increases in producer’s energy costs will skew the surprise risk here to the upside.
All in, the combination of lower coal-fired and lower hydropower electricity output is estimated to leave China 30-40 gigawatts short of its energy supply needs this summer (down roughly 4-5% from the full-year total) according to the State Grid Corporation of China. From a glass-half-full perspective, a government-imposed energy use reduction plan implemented last summer that helped slow YoY GDP growth -230bps from 1Q10 to 3Q10 should limit any potential YoY drop-off in economic output some. That said, however, should the current blackout target be hit or breached, this summer’s electricity shortfall will surpass the previous record set back in 2004 when YoY GDP growth slowed -130bps from 1Q to 3Q as the chart below indicates. With Chinese equities demonstrably broken from a TREND perspective, the risks to growth appear to be indeed significant. On a marginally positive note, charting the Shanghai Composite’s 2004 performance vs. 2011 YTD, we don’t see much of a difference in trajectory mid-way through the year, which suggests the magnitude of the slowdown could be similar.
All told, we prefer to continue waiting and watching before re-exercising our bullish thesis on China in the Virtual Portfolio. As the data behind the research call we made continues to play out in spades (China’s May Input Prices PMI ticked down overnight to a 10-month low of 60.3 vs. a prior reading of 66.2), we maintain our conviction that China will once again present itself as one of the best markets to invest in across the globe – particularly as consensus unwinds the incredible cognitive dissonance associated with being levered-long of US equities amid 1970’s-style Jobless Stagflation.
For now we’ll continue to ride the bullish wave in the bond market over the nearer term until our models signal to us that it’s “safe” to significantly increase our exposure to equities in the Hedgeye Asset Allocation. And as consensus slowly figures out that the US has a structural growth problem, we think the multiples paid for unlevered, elevated Chinese growth rates will expand on both an absolute and relative basis going forward.