Two years ago I wrote a bearish post on China titled “The China Syndrome: Will GDP Growth Top 5%?”. I argued a “soft landing” was unlikely because: A) It would inevitably be tough to shift from export-and-investment driven growth to consumer-led growth, particularly when B) China had to manage this feat while shouldering a huge load of debt, much of which financed uneconomic boondoggle projects concocted by corrupt local governments.
And so it has come to pass. These days no one believes China’s GDP is really growing 7%, although economists at some banks with business interests in China still pretend to believe it. Weak electricity demand, declining auto sales, and the comments of U.S. multinationals tell a far more negative story. And there are some new elements to the bear story:
- Xi Jinping’s purge of the party elite cannot help but disrupt economic activity. If you’re a top bureaucrat in Beijing, it’s hard to concentrate on managing the economy when you are plotting your escape to Vancouver or London.
- Xi’s broad-based attack on freedom, including a free Internet, will severely retard development of the service economy. It puts most Chinese knowledge workers at a competitive disadvantage.
- The stock market debacle reveals two things. China has yet to get off the debt bicycle—speculation was simply shifted from housing to stocks. And China won’t be able to “liberalize” its financial system because the government can’t stomach capital markets that go down as well as up.
Weak Chinese demand for commodities, corruption, and the strong dollar are hurting many other emerging markets, including Brazil, Russia, Venezuela, and South Africa. U.S. industrial firms are feeling the pain:
- Eaton: “on the South American vehicle market . . . we just don’t see any recovery occurring in that marketplace during this year”
- Praxair (industrial gasses are a good barometer of industrial activity): “[Global] Volumes declined 2% as new project contribution was more than offset by weaker underlying industrial activity in Brazil and China, as well as weaker energy, metals, and manufacturing end markets in the United States.
- United Technologies: “In Asia, the China market has clearly slowed. Real estate investment, new construction starts, and floor space sold are all under pressure. Otis new equipment orders in China were down 10% in the quarter, and we also saw a slowdown in the rate of backlog conversion.”
- 3M: “Organic growth was down 2% in China/Hong Kong in the second quarter. Healthcare delivered strong growth which was offset by declines in safety and graphics, electronics and energy, and consumer. We continue to see the Chinese economy adjusting to new growth levels . . . “
- Mettler-Toledo, maker of precision instruments (including the scale your butcher uses). Sales dropped 11% in China, 30% in Russia, and 27% in Brazil.
- BorgWarner, an auto parts maker, cut guidance due to “slower light vehicle production growth in China, unfavorable mix of light vehicle production in North America and weak commercial vehicle markets around the world.”
The news is not uniformly bad; Apple’s revenue in “greater China” soared 71%. Still, China’s economic and political problems are bad enough that they will be a drag on the industrial-and-commodity complex for the foreseeable future. Another risk is protracted strength in the dollar. On the plus side, Europe – a much more important market than China for most multinationals – is growing slowly; eventually European demand will benefit U.S. industrial multinationals.
What It Means for Investors
- It is dangerous to “bottom-fish” in beat-up industrial and materials equities, some of which, alas, are to be found in my portfolio.
- On the other hand, look for names that are being inaccurately tarnished as “energy plays” or “China plays” and will have better than expected earnings. Hopefully I own a couple of those as well.
- Lower for longer energy costs, plus solid employment growth in the U.S. and improvement in Europe, are positive for domestic consumer companies. But many of these stocks are expensive.
- At a more philosophical level, the problems of China and other Emerging Markets exemplify why I am no fan of direct investment in EM. Political stability, the rule of law, properly functioning capital markets (even in bear markets), and an unregulated Internet are taken for granted by U.S. investors but are pretty rare globally.
Copyright Thomas Doerflinger 2015. All Rights Reserved.