"We trip not on mountains, We stumble on stones"- Chinese Proverb
It seems that a single day doesn't pass without some news about China's slowing economy. Yet, at the same time, plenty of people feel what is happening in China now is just a little bump in the road for a great long-term story. This group is a bizarre little bunch, because they say a lot without saying much at all. Guys like Thomas Friedman (you don't short a country with $2 trillion in reserves) and Steven Rattner ("Will China Stumble? Don't Bet on It" ) keep putting out rah rah China articles that offer very little insight with respect to the challenges ahead. What use is analysis if all you can say is that over the long-term China will be fine, so stop worrying. I just don't get these people. The greatest capital investment boom the world has ever seen is now hitting its first major obstacle, and the best advice that they can come up with is that China has a bright future.
Consider this… China accounts for over 40% of world consumption in Coal, Cement, Iron Ore, Pork, Steel, Lead, Zinc, Aluminum, and Copper.
In cement, China's consumption of nearly 1.8 billion tonnes last year is more than the entire rest of the planet (3.3 billion tonnes globally 2010). And it gets better, China has spare cement production capacity of over 300million tonnes, which is greater than the combined production capacity of India, the U.S., and Japan.
In steel, they have idle capacity equal to total capacity in Korea and Japan. Now, should one be surprised to hear that EUROFER has filed a complaint with the European Commission accusing China of dumping coated steel on the EU market? In the last 7 years, China has gone from .5% market share in Europe to close to 15% in this market.
Basically, think of any capital intensive industry, and you can see the damage done by the Chinese growth miracle.
In shipping, China has over 40% of world shipbuilding capacity and their shipbuilders currently account for almost 40% global volume in backlog orders. Now, are you shocked by the destruction in global freight rates? Or should you be surprised to hear that a Chinese company like Yangzijiang Shipbuilding is making more money lending than it is building ships. (Non shipping related financial assets are now a third of its balance sheet.)
Then you have the wonderful solar industry. I am sure anyone who has followed this space, and the fact that the average stock has lost 65% of its value in the last year, will understand what China means for Solar. With over 70% solar-panel manufacturing output, China basically owns the sun industry. This is of course what you would expect to happen when China's Development Bank lends billions of dollars to a whole host of domestic solar firms. You end up with crazy data points like Chinese firms placing the biggest order for wire saws that Applied Materials (NASDAQ:AMAT) has ever received. But combine this over investment with declining subsidies in the West, and you end up with a huge output gap and a price collapse. PV cell prices are down over 70% in the last year or two. Thanks to China, solar power may no longer need subsidies. Oh, it should come as no surprise that a U.S. solar company has brought an anti-dumping case against China in the last month.
Now onto the future of lighting: LED. This is a capital intensive industry which has recently been Chinafied, and one that I have followed pretty closely. The LED lighting industry is perfect for this note because the Chinafication of the sector is very recent, and as always, quite extreme. There are basically two companies selling the capital equipment needed for LED manufacturing: Aixtron (NASDAQ:AIXG) and Veeco (NASDAQ:VECO). If you are buying an MOCVD reactor you are doing business with one of these two companies, and lately these two companies have been doing a lot of business in China. In the first quarter of this year, 74% of MOCVD shipments went to Chinese companies. This should come as no shock as China's government covers up to half the cost of these $2 million pieces of equipment.
But with the Chinese going crazy in LED, how will the industry fair over the long haul? Based on recent data, things don't look too good. According to IMS research, LED lamp prices in China fell to $11 in November. That's just your usual 60% decline, thanks to an oversupplied market. As you might guess, the stock market is a little freaked about by this news. Aixtron, which has 52% share of the MOCVD market, is now trading at about $10 from the near $45 it was at six months ago. Same goes for heavyweights like Veeco and Cree (NASDAQ:CREE), both of which have seen their share prices collapse over the past several months.
The good news behind all of this is that shipping, solar power, and LED bulbs get cheap. The bad news is that this type of rampant fixed capital investing is the antithesis of sustainable, and all coming to a head at the same time. This means there is a mountain of bad debt hiding in the Chinese financial system that is just waiting to be exposed.
Think about the chain reaction at work here, and you will come to a very simple conclusion; a huge deflationary shock tied to a Chinese led capital investment slow down is around the corner. If I can't sell apartments, LED bulbs, solar panels, cement, or steel and make a profit, because there is too much capacity on line for the current demand, I will start running at a loss. And if this capacity expansion is heavily debt financed, then I will also start struggling to service this debt. The net result of all of this is pretty clear; future capital investment will fall off a cliff. This is real bad news for capital equipment companies selling specialized machinery to China, and for commodity countries providing basic materials. This is also really bad news for any industry in which China has built out significant idle capacity, as Chinese exports are likely to increase.
Now follow the chain. Mining companies will suffer (BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO), VALE), so too will capital equipment providers to these mining companies like a Joyglobal (NYSE:JOY), Terex (NYSE:TEX), Caterpillar (NYSE:CAT)( the recent Bucyrus purchase leaves this company even more exposed), or Komatsu (OTCPK:KMTUF). (Think of JOY and Bucyrus as an Aixtron or Veeco down the road). Then there are the ancillary effects. Property in booming commodity dependent economies (Canada and Australia), currencies in the same countries, and of course, global luxury good retailers.
China's capital investment crash will be felt far and wide, and this isn't gloom doom nonsense. It is common sense. Cap-ex booms don't end with soft landings. They are super cyclical in nature, and at best, can be deferred at a cost. China's 40% of GDP in new credit growth stimulus was the last deferral. The cost of that move is that this time around, things are going to be A LOT more challenging. This is why you have electronic manufacturers in eastern China providing loan extensions to developers and contractors. What is an electronic manufacturer doing lending to a developer? Hmm, what was Damas, a Dubai based jeweler doing speculating on housing? Yep, same script, different area code.
So, unless you have some strange desire to get caught in the biggest cap-ex related slowdown the world has ever seen, I suggest you pay awfully close attention to what is going on in China and how it will affect just about every industry on the planet.
The United States had a very bright future ahead of it in 1929, but that didn't stop the Great Depression from happening.
China will stumble; I can guarantee you that. (Here is a nice little update video on China's Ordos courtesy of Reuters.) As for their reaction and the road to recovery once they do fall, that is something I can't say much about. Only time will tell…..