China’s economy had me puzzled back in 2011. My understanding was that the country’s growth miracle was founded on exporting cheap goods and labour to the rest of the world. That, presumably, would make it highly dependent on global GDP growth.
Yet as the United States and Europe, combined some 50% of global GDP, were muddling their way through the worst recession since the 1930s, China was reporting economic growth of well in excess of 10% per annum. How is it possible for an export driven economy to grow at double digit rates when its main trading partners are shrinking?
As an Australian fund manager, I needed to answer that question. China’s hectic growth was driving voracious demand for Australian resources. That, in turn, was propping up our economy and sending resources stocks (we didn’t have one in the portfolio) to stratospheric heights.
My research uncovered all of the usual bull and bear arguments. The bulls argued that China’s migration of its population from unproductive rural peasants to educated city-dwellers had many decades to run, and that China’s GDP per head was still a small fraction of the US or Japan. The most common bear argument seemed to be that a communist government could never create a first-world economy.
None of this made much sense to me. If all you needed was hundreds of millions of rural workers and a large gap between your GDP and America’s, then India and Indonesia should also be growing as fast as China. And, as for the Communist Party, they made a decent fist of it over the prior 30 years. In fact, the ability to build decent roads and airports seemed something of an advantage when compared with the dysfunctional political system in the US (or Australia, for that matter).
Then I stumbled across research by Michael Pettis, a professor at Peking University in Beijing. It was one of the more important finds of my investing career.
It’s the investment, stupid
First, Pettis outlined what was happening in China’s economy. Net exports had indeed fallen, from 8% of GDP in 2008 to 4% of GDP in 2009, but even the 8% was much smaller than what I had expected for an “export-driven” economy. That went some way to explaining why the global recession wasn’t pounding China’s economy. It turns out China’s economy was (and is) an investment driven economy, with half of its GDP comprised of spending on roads, buildings, airports and the like. The fall in net exports was being more than offset by an increase in construction, fired by government stimulus and associated debt.
That gave me a much better understanding of China’s growth model. What he explained next, however, was the crucial part. Pettis explained that there was nothing unique about China’s “miracle economy”. And that every other economy that had grown in a similar fashion had eventually come unstuck:
“In all previous cases of countries following similar growth models, the dangerous combination of repressed pricing signals, distorted investment incentives, and excessive reliance on accelerating investment to generate growth has always eventually pushed growth past the point where it is sustainable, leading always to capital misallocation and waste. At this point – which China may have reached a decade ago – debt begins to rise unsustainably.
China’s problem now is that the authorities can continue to get rapid growth only at the expense of ever-riskier increases in debt. Eventually either they will choose sharply to curtail investment, or excessive debt will force them to do so. Either way we should expect many years of growth well below even the most pessimistic current forecasts. But not yet. High, investment-driven growth is likely to continue for at least another two years.”
You may have read or seen some of the exposés of China’s ghost cities, but Pettis explained in 2011 why and how the entire economy’s growth was unsustainable. I summarised my thoughts in China’s Boom: Why it Won’t Last but it Won’t End Now. Then I started preparing for the tsunami to come. We bought ASX-listed stocks with exposure to foreign currencies in our Forager Australian Shares Fund. We avoided anything with exposure to the wider mining sector. And we launched a new fund, the Forager International Shares Fund, to get even more money invested offshore.
If you are going to panic, panic early
Today China’s economic problems are on the front page of newspapers around the world. Every week we see a new factory output statistic or Purchasing Managers Index that tells us the slowdown might be more of the hard variety than the soft. That wouldn’t surprise me one iota. But today’s investors face a dilemma.
Sure, you can sell your Rio Tinto shares because the China dream is over. But you will be selling them for $49 each, not the $85 they were changing hands for in 2011. You can sell your BHP Billiton shares, but you’ll be banking less than $23 a pop instead of the $45 you could have received four years ago.
The stock market looks through the front windscreen, not the rear. Stock prices don’t wait for current data, they move as soon as expectations change about the future. Yes, China’s economy is deteriorating, but I can assure you today’s buyer of Rio Tinto is already aware of the fact.
Indeed, Forager has added the first ever mining stock to its portfolios in the past few month. BHP Billiton spinoff South 32 owns a world class collection of assets, mining alumina, manganese, coal, silver, nickel and lead.
It is among the world’s most efficient producers in each commodity class, which means that a majority of competing mines will be bleeding red ink while South 32 remains profitable. The balance sheet is robust, and the early indications are that the managers are top notch (and have been buying shares with their own money).
Today’s share price suggests the company is only worth half the replacement cost of its assets. We expect things to remain ugly for a few years yet, but I find it hard to envisage a world where these assets produce such lowly returns over the long-term.
I remain bearish on China’s prospects and the impact on the Australian economy. Domestic interest rates will fall further and could potentially get down to zero. But it’s too late to sell your mining stocks now. The time to panic was four years ago.
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