Macro Overview - September 2017

China’s "supply side" reform measures are beginning to bear fruit and have far-reaching impact, deserving the attention of global investors.

An important development that is not receiving the attention it deserves from global investors is the “supply side reform” that is under way in the Chinese economy.  These reforms are important, because:

1. They are bringing about a step change in profitability for the industries that are seeing capacity closures, not only within China, but also across the globe.

2. The improving profitability in previously over-supplied industries in China will lead to a reduction in non-performing loans^[1] in the banking system and, with it, a significant reduction in the risk of a financial crisis in China.

The supply side reforms address a key weakness in the structure of China’s economic system, namely, the coalition of local governments with local banks to develop and bankroll local state-owned enterprises (SOEs).  This pattern of local development contributed to significant over-capacity in a wide range of fast growing “commodity-like” industries (such as steel, cement, glass and chemicals) and, with it, a growing burden of non-performing loans for the banking system.  When the downturn came, the importance of employment for the sponsoring government meant a great reluctance on all three parties to close loss-making capacity.

As discussed in our Macro Overview – March 2017, supply side reforms were initially focused on the steel and coal sectors.  Redundancy funds were provided by the central government to compensate laid-off workers, easing local governments’ reluctance to follow through.  The State Council directed the closure of sub-scale plants as well as operations not adhering to environmental and safety standards.  It should be noted that these directives related to SOEs, not private enterprises.  Having said that, “unapproved” plants built by private firms, notably in the steel sector, were also targeted for closure.  It is estimated that steel capacity has shrunk by 13% and coal by 10% since the start of 2016, resulting in significant improvements in the profitability of these industries.  Prices for Australian coal exports are up nearly 100% since early 2016.

Initially, there was much scepticism when the supply side measures were announced.  Over the last 15 years Beijing had announced plans to close sub-scale and polluting plants on a number of occasions, with little effect.  Even if some capacity was closed, it would reopen within weeks or months.  Most observers therefore expected a similar outcome with this recent round of directives from the centre.  However, this occasion does appear to be different.  For plants to qualify for redundancy funds, they first had to be decommissioned.

Supply side measures have since been extended from steel and coal to other industries such as PVC and aluminium.  What is probably more significant though is that anecdotal evidence shows that environmental regulations are being policed strictly, which is resulting in capacity closures across a broad range of industries.  Another variable is that banks are simply not prepared to extend financing to industries where there is excess capacity, whether that be as a result of following central directives or for purely commercial reasons.  The upshot is that small private operators that have closed for commercial reasons and were hamstrung in restarting capacity may now be viable with higher prices.

Another observable development is the consolidation that has started to occur, with significant transactions resulting in the merger of cement groups, or the merger between the country’s largest coal producer with one of the large power generation companies.  There is also clear evidence in government statistics (for what they are worth) and company accounts that investment in oversupplied industries has collapsed.

While Beijing has been successful to date with these supply side measures, we should consider why this “central” control over a large and disparate group of enterprises should hold.  In the first place, there is an industrial logic that would be recognised by any Western businessperson.  SOEs are “owned” by the government and consolidation makes more sense than fierce competition amongst what are essentially sister companies, and better profits mean higher taxes.  In reality, the ability for Beijing to have created this outcome is most likely a resultant of the consolidation of power by China’s current leadership.  It is clear that local politicians, managers of the SOEs, government employees (particularly those with the responsibility of enforcing these reform measures) and bank executives understand that if they do not comply with Beijing’s policies, there is a real risk of loss of job and, for the more serious infringements, potentially time behind bars.

The reason that these changes deserve serious attention from global investors is that they have dealt with one of the key weaknesses in China’s economic system.  Together with the reforms in the financial system that have brought under control the rapid growth of the shadow banking sector, the supply side reform measures have substantially reduced one of the key risks for the Chinese economy and, indeed, the global economy.  It also means that resources in the economy will progressively be applied to the more dynamic private sector where opportunities abound.  The focus of investments in China today is clearly on those areas dominated by the private sector, such as electric vehicles, robotics, biotechnology, and e-commerce.  The only SOE-dominated area where we can observe significant investment is infrastructure, which is a result of the One Belt One Road initiatives and which we think will have significant benefits to the broader economy.

The main note of caution we have in regard to China is the shorter-term outlook for the next six to 12 months.  The government has once again been broadening restrictions on residential property purchase and financing in cities where demand and prices have been strong.  The result has been a slowdown in new property sales and, with that, the potential deferral of construction activity.  Residential construction is a significant contributor to economic activity.  Our view is that the Chinese residential market is fundamentally under-supplied (please refer to Kerr Neilson’s recent paper, The Rise of Asia, as well as our past quarterly reports for an outline of the key factors underlying China’s demand for urban housing), and therefore this area of activity will remain robust for some time to come.  Nevertheless, there may be some loss of momentum in economic growth in the months ahead.

Market Outlook

The world’s other major economies appear to be in good health.  European and Japanese economies are continuing on a path of steady improvement, and the US continues to grow strongly.  This co-ordinated global growth is providing a strong backdrop for global markets.  Indeed, returns for Australian investors from global shares have compounded at over 16% p.a. for the last five years.^[2]  Returns of this magnitude should lead one to be cautious about the outlook for future returns.  This view is, however, somewhat at odds with the opportunities that are presenting themselves at an individual stock level, where we continue to find companies to buy at attractive valuations.  Usually we would not associate the ready availability of interesting opportunities with markets that are at dangerous levels.

When we look around for risks in markets, our key concern is US interest rates.  This is particularly worrisome because of the extraordinary crowding by investors in bond markets around the world, making this, in our view, the mostly likely scene of any accident in financial markets.  We could see higher rates potentially disrupt the US economy and global markets in a number of ways.

The first is the traditional rate cycle of the US Federal Reserve.  History tells us that as rates are increased, eventually the US economy will respond and slow down, and before that is even readily apparent, the US stock market will start to fall, taking with it most other global equity markets.  Making assessments about the exact timing of such events is highly problematic.  Currently, rising labour costs are the key concern for inflationary pressures and further rate rises.  However, it is questionable whether companies are in a position to pass on any increased costs to consumers.  For example, Target recently raised their minimum hourly wage to US$11, with a commitment to raise it further to US$15 by the end of 2020.  But given the brutally competitive environment in retail as a result of e-commerce, price rises seem an unlikely prospect.  However, one assumes that rates will at some point rise to a level where there is economic and market impact.

The other potential issue is a blow-out of the US budget deficit as a result of President Trump’s proposed tax plans.  If the proposed tax cuts come to fruition, the financing requirement could cause significant upward pressure on US bond yields.  Given the lack of success of the Trump administration in its efforts to pass reform agenda to date, markets appear to be putting little weight on the prospects of these tax cuts being passed, at least as initially proposed.  We can add little to this debate, but tend to favour the view that Trump's tax plans will need to be significantly watered down to have any chance of success.  Clearly though, political events of the last two years suggest that one shouldn’t be complacent, particularly given investors’ current enthusiasm for debt securities of all types across most geographies.

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