- We continue to see evidence that confirms our view that China’s credit-fueled fixed-assets investment bubble is firmly in the process of popping. Furthermore, this unwind will remain a growing headwind to Chinese GDP growth for the foreseeable future (CLICK HERE for more details).
- Such confirming evidence underpins our long-held view that China’s growth potential and its demand curve for certain resources (namely commodities) is structurally impaired – thus necessitating a commensurate shift in the way investors should seek to allocate capital to China plays.
- As such, we see value in being exposed to our LONG “New China” (i.e. growth in the consumer and services sectors + broad deregulation) vs. SHORT “Old China” (i.e. the concomitant bubbles in credit and fixed assets investment + anti-pollution regulation) theme. For equity investors, this equates to being exposed to Chinese technology and consumer staples names on the LONG side and exposed to Chinese financials and industrials names on the SHORT side. We also see value in being exposed to foreign companies with “New China” exposure on the LONG side.
- Switching gears, we continue to think Chinese economic growth will go from slowing to stabilizing to accelerating throughout 1H14; we lack conviction in our (or any) 2H14 outlook for Chinese growth amid policy uncertainty on the economic reform front (more details below).
- Make no mistake, however, if China can’t “comp” ridiculously easy growth compares with clear signs of #GrowthAccelerating in 1H14, we think Chinese real GDP growth has downside to the mid-to-low 6% range by year’s end. That would represent a material delta vs. current consensus estimates of +7.4% YoY real GDP growth in 4Q14 and would obviously have broad negative implications for a variety of asset classes (particularly emerging market assets and commodities).
Today, China released its DEC credit data. Headline total social financing figures were solid sequentially, but all was far from well underneath the hood:
- DEC Total Social Financing:flat at +1.23T CNY MoM
- New CNY Loans:+482.5 CNY MoM vs. +624.6B prior
- Ratio: 39.2% of the total in DEC vs. 50.7% in NOV; 51.4% in 2013 vs. 52% prior
- Non-Traditional Credit (TSF less CNY and FX Bank Loans, Net New Corporate Bond Issuance and New Equity Capital Raised): +553.5 CNY MoM vs. +377.9 prior
- Ratio: 45% of the total in DEC vs. 30.6% in NOV; 29.9% of the total in 2013 vs. 23% of the total in 2012
- Total Social Financing: +9.7% YoY in 2013 vs. +22.9% YoY in 2012 vs. -8.5% in 2011
- New Loans: +8.4% YoY in 2013 vs. +9.8% YoY in 2012 vs. -6% in 2011
- Non-Traditional Credit: +42.8% YoY in 2013 vs. +43.2% YoY in 2012 vs. -29.7% in 2011
- New CNY Loans:+482.5 CNY MoM vs. +624.6B prior
The demonstrable ramp in non-traditional (a.k.a. “shadow”) financing speaks volumes to our long-held view that perpetually rising NPLs have clogged traditional credit channels in China – forcing both corporations and lenders to find creative (and often convoluted) ways to maintain financial lubrication throughout the economy.
While this creativity has offset some of the downward pressure on Chinese economic growth over the past 2-3Y, it has dramatically increased system-wide financial risks and has effectively tightened monetary conditions by giving less creditworthy borrowers and institutions a seat at the table (side note: SOE and government borrowers are the only entities in China with access to cheap capital via bank loans; everyone else must scramble to find capital from whatever source at whatever cost they can find).
As a result, we’ve seen a demonstrable rip in borrowing costs all throughout the Chinese economy that has weighed on economic growth amid what we believe to be rising quantities of traditional financing that are coming due without the necessary cash flows to retire the debt – essentially financing debt rollovers at the expense of net new credit growth (see: “Key Problem Loan Areas” chart below). Consider the following data points:
- Almost 22% of the 17.89 trillion CNY ($2.96 trillion) of local government financing vehicle debt outstanding comes due in 2014. Local government debt overdue at the end of June was 1.15 trillion CNY, or 10.6% of borrowings, according to National Audit Office data… Meanwhile, the rate on AA-rated five-year notes jumped +146bps in the past year to a record 8.3%; that compares to a TTM rise of +104bps to 5.2% for Bloomberg’s EM USD Corporate Bond Index. Most local government financing vehicles are rated AA in China. (sources: China Daily, StreetAccount and Bloomberg News)
- Liabilities at non-financial companies may rise to more than 150 percent of gross domestic product in 2014, raising default risks, according to Haitong Securities Co. The ratio of 139 percent at the end of 2012 was already the highest among the world’s 10 biggest economies, according to the most recent data. That compares with 108 percent in France, 103 percent in Japan and 78 percent in the U.S., figures from the Bank for International Settlements and the World Bank show. (source: Bloomberg news)
- China Cinda Asset Management, one of the nation's four state-owned bad-loan managers, raised $2.4B in Hong Kong's biggest IPO in a year as it prepares to take on more distressed assets. The IPO will help Cinda to profit from a new round of non-performing loans following a $6.5 trillion lending spree since the end of 2008. Non-performing loans at Chinese banks increased for an eighth consecutive quarter in Q3 to 563.6B CNY ($93B), extending the longest streak in at least nine years. (source: StreetAccount)
Perhaps most importantly, it is our view that the aforementioned phenomenon will remain a structural headwind to Chinese GDP growth. The good news is that, for whatever reason – be it policy guidance or the pervasive extrapolation of recent trends – consensus is now squarely in our camp with respect to structurally depressed expectations for Chinese GDP growth.
As such, we continue to believe that investors should not be looking to passively allocate assets to China as a play on elevated rates of economic growth – especially if expectations for the second derivative of GDP are set to remain in negative territory on a structural basis. Rather, we continue to call for investors to #GetActive with their China exposure.
One of the ways we think investors should be actively managing their China exposure is by being LONG “New China” plays and SHORT “Old China” plays. For equity investors, this equates to being exposed to Chinese technology and consumer staples names on the LONG side and exposed to Chinese financials and industrials names on the SHORT side. It’s worth noting that on an equal-weighted basis this strategy is up +2,039bps since we introduced it on 12/4/14. This is obviously net of transaction costs and we are fully aware these aren’t investable indices; still, we think the takeaway is clear.
Another way investors can play our LONG “New China” vs. SHORT “Old China” theme is by being LONG foreign companies with material exposure to the growth of the Chinese consumer and service sectors. The following table is a screen of US, German, UK and Japanese equities (i.e. the four developed markets we like on the long side of equities here) above $10B in market cap that attribute > 33% of their sales to China. Obviously not all companies break out their revenues by geographic segment, but this is a good starting place for those that do. QUALCOMM Inc. looks very interesting from a valuation perspective and, to a lesser extent, so does Murata Manufacturing Co. Ltd.
Thus far, the focus of this note has been from a strategic asset allocation perspective. In adopting a more tactical purview, we continue to think Chinese economic growth is slowing and we think it is likely to continue to slow for the next 1-2M.
From there, Chinese growth should stabilize and then accelerate throughout the balance of 1H14. A favorable base effect, easing money market conditions and seasonality are all supportive of an acceleration in Chinese GDP growth in 1H14.
It’s tough to have a strong view beyond that given the continued lack of clarity on the economic reform implementation front – though the latest signs are indeed positive. Specifically, Shanghai FTZ capital account reform is likely to come as soon as 1Q14, per the latest official commentary (click HERE, HERE and HERE for detailed explanations on why that is the most important catalyst for a positive upside surprise with respect to Chinese GDP growth over the intermediate-term TREND and long-term TAIL).
Make no mistake, however, if China can’t “comp” ridiculously easy growth compares with clear signs of #GrowthAccelerating in 1H14, we think Chinese real GDP growth has downside to the mid-to-low 6% range by year’s end. That would represent a material delta vs. current consensus estimates of +7.4% YoY real GDP growth in 4Q14 and would obviously have broad negative implications for a variety of asset classes (particularly emerging market assets and commodities).
The analytical table is now set; best of luck risk managing your China exposure(s) from here. Feel free to ping us with follow up questions.
Have a great evening,
Associate: Macro Team