2016 has been an eventful year for the Chinese capital markets, starting with the introduction and subsequent suspension of its relatively unsophisticated stock market circuit breaker, to the depreciating Chinese yuan, with a bunch of smart money guys like Stanley Druckenmiller, David Tepper, David Einhorn and Kyle Bass jumping into the bandwagon of betting against the Chinese yuan. Even the famous George Soros went on record to say that a hard landing of the Chinese economy is inevitable.
We believe that the Chinese economy is facing significant headwinds - the country's manufacturing PMI stood at 49.4 in January 2016, marking the sixth straight month of contraction for factory activity. This is not surprising, as our anecdotal checks late last year showed that pre-tax profit of private enterprises (mainly manufacturers) dropped by between 25% and 33%. According to World Bank statistics, the manufacturing sector accounts for 36% of the GDP. That might not seem overly high at first, but the ripple effect of a manufacturing slowdown is more profound as a significant portion of the services industry, such as financial services and logistics, is dependent on the manufacturing industry. Even consumer spending is dependent on the manufacturing industry as a major portion of the population derive their income from industries that are in or related to the manufacturing sector.
The Chinese manufacturing sector as being caught between the rock and a hard place. Gone are the days where Chinese manufacturers can tap on a seemingly endless supply of low cost labor. Economic development and China's one-child policy eroded that advantage. As the case may be, China's manufacturing industry have yet to develop the ability to compete on quality or innovation. Case in point: none of the manufacturers in China are able to produce the small rotating ball at the tip of the ballpoint pen - they have to be imported by Chinese pen manufacturers. Chinese brands like Haier (SSE:600690, SEHK:1169), TCL (SZSE:000100) and even Xiaomi are regarded as lower end products compared to their imported peers, even in China itself.
All that being said, we list a few points to the contrary.
- The Caixin/Markit services PMI rose to a six-month high of 52.4 in January 2016, driving the composite index into expansion territory.
- Gross market value (GMV) transacted on e-Commerce giant, Alibaba's (NYSE:BABA) China retail market places rose 23% year-over-year to USD149 billion in the quarter ended December 2015 (mobile GMV accounted for 68% of total GMV).
- GMV transacted on JD.com (NASDAQ:JD), another e-Commerce platform in China, grew by 71% year-over-year to USD18.1 billion in the quarter ended September 2015.
It is interesting to note that the total GMV transacted on Alibaba is larger than the GDP of Austria.
Both land and air logistics seem to be moving along nicely as well.
- The five expressways operated by Zhejiang Expressway Co., Ltd. (SEHK:0576) recorded 5.7% year-over-year increases in average daily traffic volume (full trips) in December 2015; the 16 sections of expressways operated by Shenzhen Expressway Co., Ltd. (SEHK:0548) saw a 12.4% year-on-year increase in traffic (no. of vehicles) in December 2015.
- Air China (SEHK:0753, SSE:601111), China Eastern Airlines (SEHK:0670, SSE:600115) and China Southern Airlines (SEHK:1055, SSE:600029) recorded 6.5%, 5.8% and 14% year-over-year increase in air cargo traffic (RFTK), respectively, driven by 8%, 12.6% and 23.5% year-on-year increase in international cargo traffic, respectively. The only dim spot are declines in regional air cargo traffic (-8.3%, 4.5% and -11.5%, respectively).
The technology sector continues its rapid growth.
- Total revenues at Tencent Holdings (SEHK:0700), a leading technology company, grew by 34% year-over-year for the quarter ended September 2015, as 200 million users bound their bank accounts to the company's payment platforms (QQ Wallet and Weixin Pay)
- Total revenues at Baidu (NASDAQ:BIDU), the leading search engine, increased 36% year-over-year in the quarter ended September 2015, as total activated users on its payment platform reached 45 million, representing a 520% year-on-year growth
We believe that going forward, the Chinese economy will be a tale of two sectors. The manufacturing sector will be pushed towards higher quality, higher technological content manufacturing as low-end manufacturing gets push out to lower cost regions (e.g., apparel manufacturing moving to Southeast Asia). This would result in job loss in lower tiered cities where manufacturing tends to be done (e.g., Zhangjiakou, Anshan, Dongguan).
The services sector, driven by online commerce and technology, will continue to drive economic expansion, predominantly in first tier cities (Beijing, Shanghai, Guangzhou, Shenzhen) and some selected second tier cities (e.g., Hangzhou, Suzhou, Nanjing, Chengdu).
For example, in Donguan, a traditional southern manufacturing city, average home prices rose from RMB9,000 per sqm to RMB10,000 per sqm in 2015. Compare this to the neighboring city of Shenzhen some 70km to the south, where a focus on technology and financial service sectors have driven 8.9% GDP growth in 2015, and home prices to grow from RMB24,000 per sqm to RMB37,000 per sqm.
Do we think that China's economy is challenged? Yes. But based on different statistical indicators, we don't believe a hard landing is in the works.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.