China's (FXI) economy is undergoing a transition. It is going from being supported by fixed-asset investment, which accounts for around 50% of China's GDP, to a more consumer-oriented society. Not only is this necessary because an investment-led economy is not sustainable long term, but it's also a requirement for a world that needs various countries to oscillate between being net importers and net exporters. Not that China is turning into a net importer in the short term, however.
Today's large release of data by the National Bureau of Statistics of China continues to support the notion of this ongoing transition:
- Industrial production continued to slow down, now growing 9.2% year on year.
- Residential housing starts -- a large component of investment -- continued to drop heavily, with the January to July totals down by 13.4% and July alone down around 30%. That shows this trend getting worse, as I predicted.
- At the same time, retail sales -- consumption -- while slowing down, kept growing faster than any of the investment aggregates with 13.1 year-on-year growth. As consumption grows faster than investment, naturally the economy transitions toward it having a greater weight.
Hard Landing for China?
The transition I've described does not need to end in a hard landing for the Chinese economy. It can happen, but it's not a certainty. However, even without a hard landing, this transition does have different consequences for many sectors, namely:
- Sectors supplying basic materials to the economy will be affected. Iron ore, steel, copper, and aluminum will remain under pressure as construction drops. This will continue to affect stocks such as Rio Tinto (RIO), given that about 45% of its 2011 revenues and 70% of its EBITDA was attributed to iron ore. Aluminum and copper are also significant for Vale S.A. (VALE), given that around 72.5% of its 2011 revenues came from iron ore. Almost 50% of BHP Billiton's (BHP) EBIT is from iron ore (at a 65% EBIT margin, higher than any other product -- including petroleum). For Freeport-McMoran (FCX), 78% of its 2011 revenues came from copper. This means that these stocks, although they've behaved well recently, are not out of the woods -- weakness will re-emerge.
- Since mining sectors will be hit, suppliers to the mining sectors will also be hit. Joy Global (JOY) is perhaps the clearest pure play in the sector. It will get hit heavily again.
- Likewise, whole countries dependent on selling basic materials to China will be hit again. It's no surprise that Australia's terms of trade have been worsening; those terms of trade are heavily reliant on pricing for iron ore, coal, aluminum, etc. The Australian dollar will be hit again. Australian banks such as Westpac Banking (WBK) will eventually be hit because of the impact of lower mining exports and lower mining investment in Australia's economy.
Not all is negative, however. Companies reliant on China's consumption will probably be favored by the country's continued growth. This includes companies such as Intel (INTC) or the Chinese online gaming companies, which trade at incredibly low earnings multiples, such as Changyou.com Limited (CYOU), Perfect World (PWRD) or Shanda Games (GAME).
The important thing to remember is that at this point, we're not in the presence of an economic crash as much as we're in the presence of an economic transition. A crash would have mostly negative consequences for most of the Chinese equities and those selling into China. A transition has negative consequences for the sector seeing lower activity and pricing, but positive consequences for the sector seeing continued growth.
Recently the market started believing that China's economic growth had bottomed and all sectors would henceforth benefit from renewed growth. However, China's economic numbers tell a different story, with an economic transition that had been brewing now continuing apace.
This economic transition will have winners and losers, which is different from either renewed growth -- with mostly winners -- or a hard landing, with mostly losers.