Turning on China’s Economy

When the going gets tough…people turn on each other. BHP Billiton has turned – very publicly – on the government. Jac Nasser, BHP’s Chairman, criticised the Fed’s industrial relations and taxation policies yesterday. He’s right to criticise, of course. This government is one of the most ham-fisted Australia has had for many a year.

But such criticism is almost useless. Politicians meddle. That’s what they do. Where we see a temporary credit driven boom pushing up commodity prices, politicians see super profits. They want to tax them. And the ‘greedy’ companies exploiting their workers (by paying them over $100k for moving dirt around) apparently need tougher industrial relations rules to keep them in line.

Before you think we’re being harsh on mining employees, you should know that we think financial sector employees are the most overpaid and under-skilled around. Perhaps 10% of people in the industry deserve what they get. The rest are on the gravy train of central bank credit that first flows through the financial system before spreading to the wider economy.

But it is what it is. Hugh Hendry put it best in his latest letter to investors.

‘Rightly or wrongly, the highest return on intellectual capital of any endeavour in the world today comes from the management of other people’s money.’

Perhaps by the time this bear market has run its course that won’t be the case. Or at least not as flagrantly so as it is today.

Getting back to BHP…and while its Chairman turned on the government yesterday investors turned on the company. As you can see in the chart below, BHP’s share price broke through the all-important $34 level yesterday. The last time it passed through this level (on the way down) was back in the turmoil of late 2008.

Does this make BHP a buy? Is it now cheap at these levels? Who knows…it’s practically impossible to value resources companies with any accuracy. BHP looks cheap. But it looked cheap over $40 too. The company, along with all other Aussie resource stocks, has benefited from China’s historic credit boom.

We’ve talked about this plenty of times before. China panicked in the 2008 downturn and ordered its banks to lend. So they lent to the big state owned enterprises (SOEs), which are run by all the crony communists, who went and built things like railways, airports and shopping centres irrespective of the actual demand for them.

All this building required raw materials. Australia supplied those raw materials in, well, spades. And while we shipped dirt to the Middle Kingdom, China’s economy sent cash our way. You can see the visual representation of the effect of China’s credit bubble in Australia’s terms of trade chart, below.

Iron ore and coal have contributed most to the increase in the terms of trade since the pullback in 2008. Not surprisingly, RIO and BHP have benefitted handsomely from this. Like all good credit bubbles, the Chinese bubble threw off all sorts of false signals. It caused companies to announce big investment plans to satiate China’s supposedly unquenchable thirst.

Not long ago, BHP told investors it planned to invest $80 billion over the next five years. Now, it says that’s not going to happen. China’s economic boom is turning into a bust. Companies are reassessing expansion plans very quickly.

Check out these statistics on the Chinese housing market, sent to us this morning by our mate, the editor of Slipstream Trader, Murray ‘the bear’ Dawes:

  • Year-on-year sales in the first quarter for all real estate DOWN 14.6%.
  • Residential property sales DOWN 17.5%
  • Total amount of floor space ‘for sale’ was up 35.5% year-on-year
  • Floor space of residential units ‘for sale’ grew 47.4%
  • Housing starts DOWN 14.4% year-on-year and 23.4% month-on-month
  • April land sale revenues DOWN 54.7% year on year.

That should be a wakeup call to anyone who thought China’s central planners could manage the downturn. They can’t. China’s real estate market is in the process of crashing. And it’s bringing China’s economy down with it.

Consider this Bloomberg report:

‘Combined net lending by Industrial & Commercial Bank of China, China Construction Bank Corp., Bank of China and Agricultural Bank of China Ltd. was almost zero in the two weeks through May 13, Shanghai Securities News reported today, citing an unidentified person familiar with the matter. China’s central bank and commercial lenders sold 60.6 billion yuan ($9.6 billion) more foreign currency than they bought in April, the first net sell-off this year, according to People’s Bank of China data. That indicated capital may have flowed out of the world’s second-biggest economy.’

Zero net lending in two weeks? Holy credit crunch, batman. That is not a good sign for a credit dependent economy. If you think lower reserve requirements (RR) will stimulate lending, think again. The last time China cut its RR was in the 2008 downturn.

Interest rate cuts won’t work either. Via negative real interest rates, it will just repress China’s savers even more. The central planners are trying to rebalance the economy by encouraging consumption. Lower interest rates will not assist in that cause.

China is in all sorts of trouble…and you’re seeing the effect of that now in the resource sector. Capital intensive sectors are always the first to feel the effects of an economic contraction. The question you should ask though, is how long China’s bust will take to impact Australia’s real economy and other areas of the stock market?

My guess is in another three months or so the evaporation of China’s credit pool will begin REALLY hurting the property market…and therefore the banks. We explained the link between China and the Aussie property market which we wrote about back in March.

In short, a slowdown in China will hurt national income and impact households’ ability to service mortgage debt. Moreover, it will impact people’s ability to PAY astronomical prices for property. The property bust has already started in Australia. But it’s set to get much worse.

But the market’s not seeing that right now. Money is moving from resources to defensive sectors…and the big banks are enjoying their defensive status. Don’t make the mistake of thinking a resilient share price means inherent strength. Soon, the market will turn on the banks too.

Perhaps it’s already started. The Commonwealth Bank (CBA) provided a trading update today. It contained nothing sinister. But there was no good news either. The share price is down 2%. Investors have turned.

And while we’re on the theme of ‘turning’ today, what about the gold price? Investors (actually, speculators) have abandoned the market. Gold is a whole other story, and one we’ll dig very deeply into tomorrow…

Until then…


Greg Canavan
for Markets and Money

From the Archives…

Is the Australian Economy… Booming…or Busting?
2012-05-11 – Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 – Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 – Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 – Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 – Dan Denning

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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Gold is at US1,574 currently. Ok it’s off it’s highs but if I had to choose between Marcus Padley’s stock picks over the past 5 years and gold, I would choose gold EVERYTIME!

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