This article is an update on the Chinese residential real estate market (the previous update can be found here). I've been following China's real estate market (FXI), specifically the residential real estate market, for clues on the possible impact this market can have in several worldwide basic materials' markets.
This impact comes from the fact that China's residential real estate market is incredibly massive (I estimate China has around 48 million dwellings under construction) and also that it's a large consumer of many basic materials, namely steel (and thus iron ore), copper, aluminum, cement, etc. Some of these materials, such as copper and iron ore, have worldwide markets, so any dramatic change in China's consumption of these materials is bound to have a large impact on prices and volumes outside China.
My basic thesis is that China's residential construction market is about to undergo a significant reduction in activity, and will thus consume a lot less of these materials, leading to price and volume plunges around the world. This thesis was initially predicated on the fact that real estate prices in China were already falling, and thus it is expected that activity would soon follow, as is our experience from past real estate booms around the world, with the U.S. being a prime example.
Although the thesis was initially based solely on the price movements, we now know that sales activity is already contracting, and furthermore, as of March we already have the first sign of starts also contracting year-on-year. These observations are made based upon a report made available by the National Bureau of Statistics of China, which focused on real estate development and sales during the first three months of 2012. Given these developments our thesis that residential real estate construction in China will see reduced activity is right on track.
What the data shows
First of all, the data shows that sales of residential real estate continued falling, at a -15.5% rate in terms of residential floor space sold, or -17.5% in terms of value, showing the impact of falling prices. The big novelty, however, relates to the fact that residential floor starts - flat year-on-year back in January/February - is now falling at a 5.2% rate year-on-year. This follows the expectation where we first observe falling prices, then falling sales, then falling starts, and in the end, falling construction activity (which only happens when starts become less than completions). A small observation, though, sales did exceed completions in March, which is normal as the residential real estate market has positive seasonality at this point in the year.
There is still some time to go until starts become smaller than completions. Starts were still running at a 146 million square meters pace in March, versus completions at around 64 million square meters. Starts are already dropping year-on-year, while completions are running at +40% year-on-year, so they're getting closer all the time, but this does introduce a lag.
The thesis that residential construction will see reduced activity remains on track, with the main development being that starts are now already down year-on-year, versus flat in our last update. The predictably reduced construction activity will lead to a lower need for a number of basic materials in China, since this sector in particular is a large consumer of those. Some of these materials have worldwide markets, which will thus see lower demand and significantly lower prices and margins - such is the case of copper, iron ore, steel and aluminum and probably other construction materials (some of them, like cement, are mostly traded locally).
Large quoted producers of the affected materials should see lower revenues and profits when this impact makes itself felt in their markets. As we've seen, there's a lag between prices falling, buying activity falling, and construction activity falling. Some of the stocks that might be affected, by material, are (data sourced from respective websites):
Rio Tinto (RIO), around 45% of RIO's 2011 revenues came from iron ore and most significantly, around 70% of EBITDA was attributed to iron ore. Aluminum and Copper are also significant.
VALE S.A. (VALE), around 72.5% of VALE's 2011 revenues came from iron ore.
BHP Billiton (BHP), almost 50% of BHP's EBIT is from iron ore, which, at a 65% EBIT margin - higher than any other product including petroleum.
There's also another tidbit on iron ore. The National Bureau of Statistics of China reported on the growth rate of major industrial products, one of these being crude iron ore. Again, the Chinese production of iron ore is racing ahead in the first three months of 2012, up 19.2% to 259.6 million tons. Sure, these are usually (but not always) less valuable, lower grades of iron ore. Still, they get turned into steel and should displace imports to some extent, since China's steel production is not growing anywhere near 19.2% year-on-year.
Freeport McMoran (FCX), 78% of FCX's 2011 revenues came from copper.
The impact should be substantial on cement producers. However cement is mostly a local market so only local producers should be affected. I am unaware of any U.S. quoted Chinese cement producers.