- The large GDP-credit gap in China could be a win-win; panics should be seen as an opportunity to buy on the cheap.
- Forecasts for the yuan are negative indicating further depreciation. Don’t fight the positive dollar trend for now.
- Some sectors are going to get crushed by China, thus it is a threat.
In the last two years, China has shaken the markets twice: once when the Chinese market correction began in August 2015, and when it seemed that we were in for a Chinese/global recession in January 2016.
Figure 1: S&P 500 in the last two years. Source: Yahoo Finance.
Fortunately, China didn’t slow down much and there were no indications of a new global financial crisis starting because of China. Therefore, the S&P 500 quickly recovered and soon reached new highs.
Today we’ll analyze whether China is a threat or opportunity for your portfolio, and how you should be positioned.
Situation In China
The first S&P 500 market correction in August 2015 was caused by the fact that for the first time in a few decades, Chinese growth had fallen below 7% and the market was expecting a hard landing. The funny thing is that Chinese growth has declined further since and the Chinese government forecasts growth between 6.2% and 6.7% in their five-year plan, but the markets haven’t crashed on the updates.
Figure 2: Chinese economic growth in the last two years. Source: Trading Economics.
We avoided a decline because the Chinese government increased stimulus keeping the economy up and running. However, some voices are now pointing to the Chinese debt—especially corporate debt—as a new source for, not just a hard landing, but a full-blown financial crisis. Let’s see what all the fuss is about.
Chinese debt has grown at a yearly rate of 20% in the last seven years. This boom in credit was influenced by high government lending in order to boost infrastructure spending and building that many see as overbuilding, especially in tier-two cities, similarly to what happened in Japan, Spain, and Thailand.
Figure 3: Widening Chinese credit gap in relation to GDP. Source: iMFdirect.
The above is certainly an issue, but how will it affect our portfolios?
The Chinese government will have to take some action in order to mitigate the risks. IMF’s advised actions are to stop lending to weak companies. A financing halt to unprofitable Chinese producers should boost markets globally as many Chinese high cost, non-profitable producers would be forced to close down. Think of coal, fertilizers, steel, etc.
The next step would be to recognize losses, which is something Chinese banks weren’t doing as bonds weren’t allowed to default. This would negatively influence our portfolios as huge losses would probably spillover on financial markets globally.
The IMF is positive and believes the issue can be solved if swift action is taken by increasing competition, improving the legal framework for insolvency, and by improving local government finances. This would lead to short-term pain but also toward longer-term economic gain.
In any case, we have positive scenarios for our portfolios. If China does nothing, the credit boom will expand increasing global demand. If China does something, a brighter long-term economic outlook will soften the blow.
The third option for China, and the most plausible, is that the majority of that debt is issued to state corporations. Thus, the Chinese government can, and probably will, manage the recognition of non-performing loans in order to keep it under control and continue with the status quo.
Just to be fair about the panic for Chinese debt levels, a global comparison has to be shown.
Figure 4: Global debt to GDP levels. Source: Bloomberg.
China is at the same debt level as the U.S. while Japan is far ahead. The good news for China is that almost 67% of the debt is corporate.
To conclude, if there is more panic around China that spills over to global markets, it might be a good opportunity to buy assets on the cheap as the long term outlook is positive.
The yuan has been weakening in relation to the dollar in the last two years. This is because the dollar has gotten stronger and because of the above described economic issues. However, the weaker yuan helps the Chinese export economy, but it weighs on foreign denominated Chinese corporate debt which is $1.2 trillion according to The Wall Street Journal. An example of a sector that has been hit is the Chinese airline sector which mostly borrow in dollars to buy planes.
Figure 4: Yuan versus dollar 10-year chart. Source: XE.
Forecasts are negative for the yuan, so investors in China have to account for possible future depreciation. On the other hand, a weaker yuan makes Chinese products cheaper which should help their economy and further weaken the economies with strong currencies.
We can conclude that the currency cycle continually evolves and at this point, the dollar is strengthening. It will turn around in the future but until that happens, don’t fight the trend. The trend will change when the U.S. economy is close to a recession. As this isn’t forecasted for now and higher interest rates are anticipated, it’s better to stay overweight the dollar, for now.
Car Industry Threat
Recently, in an article available here, we discussed how investors should be aware of the short term cycle in the automotive industry, but seize the long-term growth cycle. However, there is a threat to the industry coming from China.
Chinese automotive manufacturers have managed to produce cars of the same quality as global household names. This could easily lead to more competition, if not globally, then certainly in Asia which is the backbone of growth in the industry.
Figure 5: Quality automotive manufacturer ranking (lower is better). Source: J.D. Power.
If you are invested in the automotive industry, you might want to have some Chinese producers in your portfolio.
Similarly to what is going on in the automotive industry, other sectors that used to be protected by knowledge intense production requirements might be under threat.
We can’t expect Chinese growth to be linear. What we can expect is growth, and a lot of it. Market panics will come and go and we will witness even a few hard landings and recessions here and there. Therefore, China is both a threat and an opportunity for your portfolio.
The best thing to do is to be prepared. Look at what’s going on from a longer-term economic and credit cycle perspective as such insights will give you courage to act when everybody else is selling, and a cool mind to take your profits when the market is in bubble territory.
For now, China will do well, as will the U.S. in the short term. When the dollar strengthens further, start looking for hedge options around the world, especially in China.