How to Profit from a Changing China
By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors
“If you ask me, China’s economy hasn’t
finished impressing the world with its strength.”
Jim O’Neill
More than a decade ago, the acronym, BRIC was coined. Most investors know the countries it stands for, but few remember the name or background of the man who came up with the term.
It was back in 2001 when Jim O’Neill, formerly of Goldman Sachs, grouped Brazil, Russia, India and China to represent the economic shift away from developed countries toward emerging nations. According to a 2010 story in the Financial Times, he came up with the bold prediction that “by 2041 (later revised to 2039, then 2032) the BRICs would overtake the six largest western economies in terms of economic might.”
For China, it was an incredible call. Back in 2001, China’s share of world GDP growth was only about 11 percent. Now, it’s almost double that. As O’Neill points out, China’s economy is three times France’s and half of Brazil, Russia and India combined.
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You’d have to rewind the clock another seven years to when I first began hunting around China for companies to invest in. At that time, the Asian country made up only a fraction of global growth.
Today, while the economies of Brazil, Russia and India may be disappointing to O’Neill, he remains staunchly bullish toward China. In a recent article on Bloomberg View, he put the Asian nation into perspective for perma-bears who believe that while China averted a crisis today, the country might not succeed next year. He writes:
“It isn't clear to me why China's economy must deteriorate next year. China's slowdown to its current 7.5 percent growth rate was well signposted by a sharp slowdown in leading indicators. Those measures, including monetary growth and electricity usage, are no longer flashing red.”
Like we’ve recently published, China’s purchasing manager’s index is improving. Consumption measures such as retail sales have held up, and the current account surplus is down to about 3 percent of GDP, says O’Neill.
The three major indicators used by Chinese Premier Li Keqiang are also up. In August, on a year-over-year basis, power production increased 13.4 percent, which is the fastest rate of growth since June 2011. Rail freight volume is also up, rising 7.9 percent, the highest since September 2011. Bank loans outstanding climbed 14.1 percent. While bank loans are currently trending down, they are stabilizing.
Taking the weighted average of the year-over-year growth of 40 percent power generation, 35 percent total loans outstanding, and 25 percent rail freight volume, the “Keqiang Index” showed an increase of 12.3 percent. This is the fastest since September 2011 and solidly above the three-month average.
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To us, the index is a very telling indicator, as the premier looks at railroad activity, energy consumption and the health of the banking sector to get a gauge on Chinese growth. Basically, he’s paying attention to the biggest catalysts for creating jobs. It offers rare insights to what the premier will tolerate in terms of upper and lower limits for government policy intervention.
This past week, Portfolio Manager Michael Ding has been at the CLSA Forum in Hong Kong and had a chance to listen to China Macro Strategist Andy Rothman, who provides one of the most balanced perspectives on the country. Andy has a local perspective, collecting numerous data on China, so he’s able to separate the sensational doomsday stories from reality.
Andy says it is normal for the country to grow slower. His tone was similar to O’Neill’s, in that the slowdown does not mean a crisis. He says that even if China’s growth does slow, the absolute amount of growth is much more than in the past due to the higher base, which means investors should not be too bearish on China’s demand for many products and materials.
Keep in mind that China is in the process of rebalancing its economy, moving from a reliance on exports to greater consumption and services. That’s why the focus in November will be to reform the hukou system, which was the primary means for controlling migration throughout the country. Chinese leaders will also be looking at fiscal reforms, a modest financial sector reform, environmental protection, and the one-child policy.
This rebalancing means that the “winning investments will be quite different than before,” says O’Neill.
We believe this is positive for investors who selectively invest in Chinese stocks. As O’Neill puts it, “When a country is embarking on a significant compositional change to its economy, stock-pickers rather than index-trackers have the upper hand.”
Index Summary
- Major market indices finished mixed this week. The Dow Jones Industrial Average fell 1.25 percent. The S&P 500 Stock Index lost 1.06 percent, while the Nasdaq Composite appreciated 0.18 percent. The Russell 2000 small capitalization index rose 0.13 percent this week.
- The Hang Seng Composite fell 1.16 percent; Taiwan gained 0.26 percent while the KOSPI appreciated 0.31 percent.
- The 10-year Treasury bond yield fell 10 basis points this week to 2.63 percent.
Domestic Equity Market
After rallying for three weeks in a row, the market took a breather this week as the S&P 500 fell by more than 1 percent. Weakness was across the board with all sectors posting losses for the week. After hitting new highs mid-week last week, it felt like a normal pullback to consolidate recent gains.
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Strengths
- The consumer discretionary sector was the best performer in a down week. Nike led the way, gaining 6.16 percent on better-than-expected quarterly earnings results. Newspaper-related companies were also strong. Gannett rose 4.5 percent as its merger with Belo Corp. was approved by shareholders. The Washington Post also had a good week, rising 5.3 percent.
- The utilities sector was not far behind industrials, with interest-rate-sensitive stocks rallying as bond yields continued to move lower this week.
- Applied Materials was the best performer in the S&P 500 this week, rising 10.62 percent. The company announced a merger with Tokyo Electron, making the combined company by far the largest company in the semiconductor equipment industry.
Weaknesses
- The consumer staples sector was the worst performing group, falling by more than 2 percent. Weakness in the sector was broad-based, with food companies and tobacco stocks among the worst performers.
- Financials also lagged for the week with the large banks and brokers among the worst performers. Goldman Sachs, Citigroup, Morgan Stanley and Bank of America were the worst performers. Earnings estimates have been coming down for the large brokers as the third quarter was a particularly tough quarter for fixed income trading revenue.
- J.C. Penney was the worst performer in the S&P 500 for the week, falling 30.17 percent. The company announced it was raising equity which dilutes existing shareholders by about 30 percent. The company is attempting to execute a turnaround and required additional liquidity to ensure cash through the critical holiday selling season.
Opportunity
- The current macro environment remains positive as economic data remains robust enough to give investors confidence in an economic recovery but not too strong as to force the Federal Reserve to change course in the near term.
- Money flows are likely to find their way into domestic U.S. equities and out of bonds and emerging markets.
- The improving macro backdrop out of Europe and China could be the next catalyst for the market to move higher.
Threat
- A market consolidation could occur in the near term after such a strong year.
- Higher interest rates are a threat for the whole economy. The Fed must walk a fine line and the potential for policy error is potentially large.
- The debt-ceiling debate has captured investors’ attention this week and potential missteps in Congress could create uncertainty and offer short-term oriented investors a reason to sell.
The Economy and Bond Market
Treasury yields rallied sharply again this week after last week’s surprise announcement from the Fed that it did not begin tapering its quantitative easing (QE) program. Economic data was mixed this week, but obviously the market felt comfortable enough with the Fed’s position to rally. The 10-year Treasury has rallied about 40 basis points after peaking near 3 percent at the beginning of September.
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Strengths
- The market is gaining confidence that the Fed may not taper its QE program until a new chair is in office, which would likely be early next year.
- New home sales bounced back in August, growing 7.9 percent. The spike in mortgage rates in recent months had weighed on the market.
- Household net worth rose 1.8 percent in the second quarter, which equates to $1.341 trillion. This wealth effect has a positive influence on economic growth and spending.
Weaknesses
- Consumer confidence stagnated in September, as economic expectations moderated.
- Private foreign investors reduced the amount of treasuries owned by $1.59 trillion in the second quarter for the first time since 2009. Foreign governments and institutions also cut their exposure by more than $4 trillion.
- Uncertainty over Obamacare implementation and the looming debt-ceiling impasse is likely having an impact on business decisions.
Opportunity
- Despite recent conflicting commentary, the Fed continues to remain committed to an overall accommodative policy and is unlikely to raise interest rates in 2013 or 2014.
- Key global central bankers remain in easing mode such as the European Central Bank, Bank of England and the Bank of Japan.
- Economic data hasn’t instilled a lot of confidence lately and the bond market rally that started three weeks ago may still have some room left to run.
Threat
- Inflation in some corners of the globe is getting the attention of policymakers and may be an early indicator for the rest of the world.
- Trade and/or currency “wars” cannot be ruled out which may cause unintended consequences and volatility in the financial markets.
- The recent bond market selloff may be a “shot across the bow” as the markets reassess the changing macro dynamics.
Gold Market
For the week, spot gold closed at $1,336.65, up $10.6 per ounce, or 0.80 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, lost 2.29 percent. The U.S. Trade-Weighted Dollar Index lost 0.20 percent for the week.
Strengths
- The recently concluded Denver Gold Forum may have seen a small drop in attendance, but the number of one-on-one meetings grew sharply this year. This growth suggests numerous buyers might be on the prowl. According to Mineweb’s Lawrence Williams, the 61 percent rise in one-on-one meetings this year bodes well for a considerable increase in mergers and acquisitions activity in the sector over the next few months.
- Gold bullion recovered some of its recent loses in the latter part of the week as investors closed bearish bets amid risk of a possible U.S. government shutdown. Congress is yet to approve a new budget as lawmakers tussle over the funding of Obamacare.
- Toronto-based Barrick Gold is aiming to eliminate its regional managers in favor of a central management system as it seeks to cut overhead costs. Barrick CEO Jamie Sokalsky announced the restructuring would help bring Barrick’s four-continent operations closer to home in Toronto. The reorganization is set to cut complexity and emphasize long-term efficiency.
Weaknesses
- On Wednesday, the U.S. Commodities Futures Trading Commission (CFTC) announced it closed its five-year long investigation into manipulation of U.S. silver prices and decided not to file any charges. According to the CFTC, there is no basis to bring enforcement actions against suspected participants in the alleged silver market manipulation. The disappointment among participants in commodity markets was made evident by CFTC Commissioner Bart Chilton himself who stated there has not been a more frustrating or disappointing resolution made by the CTFC.
- Despite the optimism seen at the Denver Gold Forum this year, there is no denying the junior gold exploration cash crisis continues to mount, with no quick turnaround in sight. According to Kaiser Research, back in November 2012 the number of juniors with less than CAD$200,000 available to them was 632 out of around 1,800 public gold companies. In June this year, the number grew to 751, and more recently it grew to 816, nearly half the equities measured.
- Evy Hambro, manager of one of the world’s largest gold funds, stated he is expecting more chief executives of gold producers to exit as companies continue to book writedowns. According to Hambro, the end-of-year reporting will bring further writedowns to exploration assets and booked resources for global mining corporations, especially gold where bullion is more than 30 percent off its 2011 peak. Optimistic assumptions on gold prices used to calculate the value of assets on their books have led to major producers, from Barrick to Kinross, announcing multi-billion dollar writedowns in recent months. In Hambro’s view, the tendency is set to continue and it would be surprising if we didn’t see more changes in CEOs across the gold industry.
Opportunities
- Goldcorp’s CEO Chuck Jeannes outlined during the Denver Gold Forum that his company is not ruling out participation in new takeovers and hinted the company is not against looking at large multi-billion dollar capital-intensive gold projects that have alarmed investors in recent months. In his view, Goldcorp’s strong balance sheet is a result of outstanding capital discipline in recent times, and even though the company’s focus is on building three existing projects to boost production, the company will continue to look at new opportunities.
- Newmont Mining, the largest U.S.-based gold company is on the lookout for potential gold and copper acquisitions. Newmont’s CEO Gary Goldberg stated the company will consider assets with long mine life, which are value accretive, and operationally cost efficient. Goldberg’s comments appeared to be directed towards copper producers as he argued copper is a logical step in Newmont’s business given the disappearance of gold companies’ valuation premiums over base metal producers. NGEx Resources, a Canadian-based exploration company with assets in Argentina, Canada and Chile, could certainly be among the targets pursued by Newmont.
- The Mining Recruitment Group, a Canadian mining-executive recruitment firm, published a survey revealing mining executives continue to believe gold will be favored among great commodities over the next three-year period. The survey found that 74 percent of mining executives hold a bullish outlook on gold, compared to only 64 percent during the previous quarter. Gold claimed the first spot in executives’ three-year outlook, followed by copper and silver with 64 and 53 percent, respectively.
Threats
- The Denver Gold Forum brought a certain dose of optimism to the sector, but as Dorothy Kosich of Mineweb reports, times are changing in the gold sector and more clear, visionary leadership is needed. As chief executive ranks dwindle, it becomes evident there are few up-and-coming leaders that exhibit the creative innovation of the legendary CEOs who made everyone listen. The Denver Gold Forum left us with numerous homogeneous presentations and cookie-cutter formulas for success. But, according to Kosich, there is hope the optimism engendered by this year’s forum translates into the emergence of young, visionary, caring leaders from within the sector who can replace the status-quo rhetoric with refreshing transparency.
- Despite having sold its South African assets more than a decade ago, Anglo American had to settle a compensation claim by 23 gold miners with the lung disease silicosis. The settlement could potentially bring an industry-wide lawsuit worth hundreds of millions of dollars, according to a source close to the matter. In a recently filed lawsuit, an application for a class action lawsuit representing 17,000 former gold miners from South Africa, Botswana, and Lesotho against more than 30 gold firms could result in Africa’s largest class action lawsuit and threaten the sustainability of the mining sector in South Africa.
- Randgold’s CEO Mark Bristow, one of the most respected executives in the sector, gave a very compelling presentation during this year’s Denver Gold Forum. Bristow, who has a track record of creating shareholder value, explained the disconnect between gold prices and stock prices is a result of an over-emphasis on production growth over profitability. Bristow argues the industry’s mining and reserve grades have halved, forcing gold producers to increase their production by 50 percent to keep their production rates stable. This is an unsustainable venture, leading Bristow to conclude the gold sector must move its cut-off grades higher in order to return to profitability.
Energy and Natural Resources Market
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Strengths
- China’s thermal coal imports rose for the second consecutive month in August, with the country buying 14.14 million tons of imported steam coal, climbing 5.9 percent from July to a new seven-month high, Platts reported, citing data from China’s General Administration of Customs. The August volume was also 11 percent higher than the same month in 2012. Total thermal imports over the first eight months of the year were 99.5 million tons, up 6.7 percent from the January to August 2012 period.
- China steel output keeps rising, with daily crude steel output for the mid-10 days of September rising (+0.7 percent) to 2.14 million metric tons per day (mmtpd) versus 2.129 mmtpd in the first 10 days of September. The latest figure annualizes to 783 million ton per year versus output of 709 million tons in 2012, according to CLSA.
- After a sharp correction in the second quarter, China’s domestic coking coal prices and Australia’s prime coking coal prices have recovered since August to Rmb 1,050 per ton and $150 per ton, respectively.
Weaknesses
- Natural gas futures fell 2.7 percent this week to $3.59 per million British thermal units (mmbtu) on rising inventories and weak seasonal demand.
- West Texas crude oil futures fell $1.86 per barrel this week to finish at $102.81 as heightened political risk in the Mideast has eased recently.
- On Friday, Shanghai steel futures slid to their lowest level since July and are set to stretch losses to a sixth straight week as Chinese supply rose faster than demand. Slack steel demand and an approaching week-long holiday are curbing appetite for iron ore and limiting activity in the spot market, traders said, putting the raw material's price on course to end weaker in September after a three-month gain.
Opportunities
- Royal Dutch Shell has picked a site in Louisiana for a plant costing at least $12.5 billion that would turn natural gas into diesel, jet fuel and other liquids, the Louisiana governor’s office announced Tuesday. Shell said the project could help to harness more domestic natural gas to make transportation fuels.
- Makers of renewable fuels are set to meet with congressional negotiators today, as lawmakers try to pull together compromise legislation that would freeze the U.S. mandate for corn-based ethanol. Representative Fred Upton, chairman of the House Energy and Commerce Committee, and Representative Henry Waxman, the panel’s top Democrat, are negotiating changes to the Renewable Fuels Standard that would keep the ethanol requirement at this year’s level for the next two years and add incentives to boost low-carbon biofuels, according to people familiar with the moves who asked not to be identified discussing sensitive talks. Corn producers and ethanol makers have resisted legislative changes to the current requirements, which escalate each year through 2022. Officials from their Washington-based trade groups are set to meet with Upton’s staff member s today to discuss a possible freeze in the share of ethanol required, two of the people said.
- China National Offshore Oil Corporation (CNOOC) expects to add five liquefied natural gas receiving terminals by 2015, doubling its total capacity to 35-40 million tons per year. The expansion from four terminals, with a current receiving capacity of 18.7 million tons per year, will enable China's top offshore oil explorer to import more LNG to meet strong demand growth in the country, Reuters reported. China, the world's top energy consumer, aims to raise the share of natural gas in its energy mix to 8 percent by 2015 from 5 percent now to cut emissions from coal and lessen dependence on oil imports. CNOOC will commission a floating storage regasification unit in the city of Tianjin and a conventional terminal in Zhuhai by year-end, Reuters cited a CNOOC official as saying at an LNG industry conference.
Threats
- The large volume of U.S. liquefied natural gas exports projected to enter the market from the end of this decade could exert downward pressure on Australian LNG cargoes prices, a senior WorleyParsons executive has said. This price pressure would, however, be mitigated by the buyer nations’ interest in diversifying their supply sources, vice president of global hydrocarbons Dorel Iosif said at the CWC Asia Pacific LNG Summit in Singapore. Analysts have pointed to potentially between 45 million tons and 50 million tons of LNG exports a year from the U.S. entering the market before 2020. These could represent a diversion from as much as 20 percent of Australia’s exports to Asia annually from 2020 and beyond, if the U.S. cargoes were to be exported to the region, Iosif said, citing data from Deloitte & Touche.
- China's annual steel consumption is expected to peak at 825 million tons in 2018, Baoshan Iron and Steel said, as demand growth runs out of steam. Big iron ore suppliers have used growth in appetite from Chinese steelmakers to justify their rapid expansion plans. But representatives from the Chinese steel industry have repeatedly stressed that domestic demand is slowing and that an iron ore supply glut will drive down prices. Dai Zhihao, general manager of the company, also known as Baosteel, was speaking Wednesday at an annual industry conference in Qingdao, Shandong Province. Zhong Ziran, chief engineer with China's Ministry of Land and Resources, told a conference earlier this year that domestic steel consumption was likely to peak before 2015, with annual iron ore demand expected to stabilize at around 900 million to 1 billion tons.
Emerging Markets
Strengths
- Dedicated emerging market equity funds reported a third consecutive week of inflows, up $1.88 billion for the week ended September 25. Philippines and Indonesia were among the countries with the largest inflows relative to assets under management for the week.
- China’s September HSBC Flash PMI rose to a six-month high of 51.2, ahead of market expectations and accelerating from a 50.1 final print in August, thanks to a strong rebound in new export orders and ongoing restocking activity.
- Vietnam’s GDP accelerated to 5.54 percent year-over-year in the third quarter from 5 percent in the second quarter, as foreign investment and exports helped offset weakening domestic credit growth.
- Peru’s business confidence is on the rise according to a recent Central Bank survey. For the month of September, business confidence in the Andean nation rose to 55 percent, improving for a second month in a row. The survey highlights the percentage of companies that anticipate accelerating their investments in the following six months.
- The Czech koruna strengthened this week as the monetary policy council rejected central bank Governor Miroslav Singer’s proposal to lower rates by selling the currency into the markets. For a second meeting in a row, the monetary policy committee highlighted the recent data showing an economic recovery to keep interest rates stable.
Weaknesses
- Singapore’s industrial production growth for August came out weaker than expected at 3.5 percent year-over-year, down 1.4 percent sequentially from July, as a result of an inventory adjustment among electronics manufacturers.
- Thailand’s manufacturing production declined by a worse-than-expected 3.1 percent in August, moderating from July’s 4.9 percent drop, due to weakness in output for auto, food, and appliances.
- The Indonesian Finance Minister indicated that economic stabilization takes priority over economic growth in a government policy response to the trade balance crisis.
- Brazil’s manufacturing confidence index fell to 98 points in the month of September. The downtrend, which began in May 2013, brought Latin America’s largest economy’s manufacturing confidence index to the lowest level since July 2009.
Opportunities
- Economic confidence in the eurozone increased more than economists forecast in September, adding to signs the single-currency bloc’s recovery is gaining momentum. An index of consumer sentiment rose for a fifth month to 96.9 from a revised 95.3 in August, according to the European Commission. With euroezone economic sentiment turning up, the risk of a short-term relapse in activity is significantly lower according to Amsterdam-based ING Bank.
- The presidents of Chile, Colombia, Mexico, and Peru – member countries of the Pacific Alliance – signed a memorandum of understanding that will subscribe a formal free trade agreement by November. Following the signing of the agreement, the member countries will have a more homogeneous macroeconomic policy, thus enabling the Alliance to negotiate trade agreements as a block. The Pacific Alliance countries are recipients of 26 percent of total foreign direct inflows into Latin America.
- China’s business-to-consumer online sales are expected to grow by an annualized 34 percent over the next five years, with the non-food category expanding from 6.2 percent of total non-food retail sales in 2012 to 14.6 percent by 2017, according to CLSA Research. In addition to such enabling factors as internet and smartphone proliferation, the online payment revolution, and transportation infrastructure availability, the government plans to raise broadband penetration for mobile and fixed line from 21 percent and 31 percent, respectively, in 2012 to 85 percent and 70 percent by 2020.
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Threats
- Lingering uncertainty about the Fed chairmanship and the tapering schedule of quantitative easing in the U.S. remains a major source of concern for Southeast Asian countries with sizable current account deficits in the near term, as skepticism toward any quick fix may prevent global capital from flowing back into these markets en masse.
- The possibility that the comprehensive fiscal and energy reforms in Mexico are not approved by congress are increasing the nation’s chances to disappoint, according to S&P. The credit rating agency has warned the country that it may lower its positive outlook to stable.
- A Croatian court issued a detention order for Hungarian-based MOL Chairman Zsolt Hernadi following his declining to answer questions in an ongoing fraud investigation as Hernadi failed to appear before a committee of Croatia’s Office for Suppression of Corruption and Organized Crime. The investigation continues to tarnish the nation’s largest oil company. Croatia’s ex-Premier Ivo Sanader is serving a 10-year prison term for corruption related to a 2009 agreement that gave MOL control over INA.
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