By Gordon Johnson of Axiom Capital
CHINA MACRO ANALYSIS: Growth in China is Slowing... Will it Continue, and What, if Any, will be the Impact to Commodity Prices?
While steel prices have firmed to start this week on rumors that steel mill production cuts, particularly in China’s biggest steel-producing city Tangshan, have failed to meet targeted levels (link), we see this as temporary – steel prices are following iron ore and coking coal prices higher to start the week, driven, we believe, by speculators; because, if more steel supply is coming, the exact opposite should be occurring (i.e., steel prices should be falling).
So why are we so concerned about cooling credit growth in China? Well, with economic growth slowing in China, the question is will it continue into 2018, and will it lead to bulk commodity prices deflating? In short, due mainly, we believe, to slower overall credit growth vs. prior mini-bubbles (i.e., 2009, 2013, and 2016), a material slowdown in economic growth or asset values in China’s market is inevitable – barring another massive ramp-up in credit issuance (which doesn’t appear to be “in the cards” near-term) – it’s simply math.
Stated differently, mathematically explaining why slowing credit growth in China is a big deal, we note that if an economy is 50 and credit is 100, and the economy grows 10%/year, while credit grows 30%/year:
- At the end of year 1, the economy is 55 and credit is 130. Total demand is 55 + 30 (i.e., new credit created) = 85;
- At the end of year 2, the economy is 60.5 and credit is 169. Total demand is 60.5 + 39 = 99.5, up 17.1%;
- At the end of year 3, the economy is 66.6 and credit is 219.7. Total demand is 66.6 + 50.7 = 117.3, up 17.8%;
- At the end of year 4, the economy is 73.2 and credit is 285.6. Total demand is 73.2 + 65.9 = 139.1, up 18.6%.
However, similar to what we’ve seen recently in China, if credit growth were to slow from 30% in years 1-4 to 15% in year 5, at the end of year 5 the economy would be 88.6 and credit would sit at 328.5. That’s total demand of 80.5 + 42.8 (i.e., the change in credit), or 123.4, representing a -11.3% fall Y/Y. Thus, as detailed in Exhibit 2 below, where China’s credit growth has slowed from +20% Y/Y as of 6/30/13 to +12.3% Y/Y as of 9/30/17, we see a material weakening in China’s total demand as fated – we feel the inevitable reckoning here has been delayed by pre-19th Party Congress distortions, which effectively “outlawed” select economic indicators from falling, as well as certain companies from reporting bad results, in an successful effort by President Xi to consolidate his power (via both government mandate and fiscal/monetary stimulus) – yes, you heard that right – link.
In summary, as observed by Tyler Durden, and supported by our work, thanks to ~$4 trillion (at least) in credit creation in 2017 – more than the rest of the developed world combined – China has been the proverbial (and debt-funded) "growth" dynamo behind the recent period of "coordinated global growth". Yet, with the pace of credit growth slowing throughout 2017, and likely to slow further looking ahead, we see outsized risk to both Chinese bulk commodity demand, and, by a process of elimination, global bulk commodity prices.
ANALYSIS: Chinese GDP was recently reported for 3Q17; and, as many expected, at +6.8% Y/Y (Exhibit 1), it was spot on Consensus estimates. However, we contend that the recent slowing in China’s credit growth (Exhibit 2), a sizeable risk to the country’s continued economic growth, is a byproduct of both: (a) more debt in China going toward rolling existing credits and recapitalizing interest vs. finding its way into the real estate/construction markets (we estimate that China’s banking system boasts ~$40tn in debt at present, up from just ~$3tn in 2006 [i.e., +1,233%] – against just ~$2tn in equity and ~$1tn in liquid reserves; by comparison, at the height of the global financial crisis [“GFC”], the US banking system had ~$16.5tn in debt and ~$1tn in equity), and (b) the Chinese government’s crack-down on runaway credit issuance (link).
In short, while not a Consensus call at present, we believe the slowing in China’s Y/Y credit growth (Exhibit 2), more recently, likely means a further slowing in a number of economic indicators crucial to commodity prices – China’s October data deluge, due out in 1-to-2 weeks, we believe will be a negative catalyst for bulk metals prices. Furthermore, with: (a) Y/Y credit growth in China slowing (defined as Total Social Financing [“TSF”] + local government debt issuance), and as a result (b) the partials that contribute to GDP growth in China slowing, (c) deteriorating new construction start growth, (d) falling home price growth, (e) spiking debt costs, and (f) limited signs of cooling steel output, we see the rest of this year being defined by overall headwinds for global bulk commodity prices, driven by a government-coordinated slowing in China’s economy. As this unfolds, we expect a number of bulk commodity prices in China to move lower, spilling over into the global markets.
Yet, with our conversations with a number of pundits leading us to the conclusion that the Consensus among the “smart money” is that bulk commodity strength in emerging markets will continue, we see the potential for weaker commodity prices to surprise many, driving a number of metals and mining stocks lower. On this theme, our top short ideas consist of: FMG (SELL), CLF (SELL), X (SELL), GATX (SELL), TRN (SELL), and to a lesser degree RIO (SELL).
Exhibit 1: China GDP – Quarterly Y/Y % Growth
Exhibit 2: China Total Debt Growth vs. Commercial Bank Asset Growth, %Y/Y
A CLOSER LOOK AT GDP. When observing the partials that contribute to China’s GDP, while mixed, the data that support China’s construction economy were notably weaker. That is, as detailed below (Exhibit 3), for the month of September, fixed asset investment at +7.5% Y/Y was the weakest result since 12/31/99 (i.e., the height of the global financial crisis), followed by industrial production at +6.7%, which has remained subdued for some time, and finally retail sales at +10.3%, marking the only Y/Y “bright spot”. Furthermore, as detailed in Exhibit 4 below, in October, China’s manufacturing PMI tumbled from a 5-year high, due, we believe, to officials: (a) attempting to rein in debt, (b) clamping down on housing market speculation, and (c) focusing on pollution limits.
Exhibit 3: Growth Internals - China (FAI, Industrial Production, & Retail Sales)
Exhibit 4: China PMI Readings Turn Down
WHAT ABOUT CREDIT/DEBT? According to our checks, at the 19th Party Congress a few weeks back (i.e., China’s once-in-every-five-year leadership transition), China’s top policymakers reiterated their efforts to contain excessive risk-taking in the financial system beyond 2017. More specifically, as detailed here, China leadership pointed to a continuation of efforts aimed at limiting debt, with hints of more regulation targeted at the interbank and wealth management product (“WMP”) arenas. And, as would be expected, on the back of these comments, the yield on three-year AAA notes in China – the most common grading for Chinese corporate debt – spiked higher, now up 20bps over just the past 3 weeks; stated differently, over the course of October, the cost of AAA-rated corporate debt in China increased 29bps, or the highest level in nearly 6 months. And, while the spread between these notes and government debt (i.e., the China 10yr bond) has recently climbed to 102bps (from just 86bps in early July), we are still a long way from this year’s peak of 134bps set in May.
In short, while we see an outright cash shortage as unlikely, with waning bond issuance (Exhibit 6) weighing on credit availability in China – following acute support in 2015 and 2016, incremental bond issuance in China has become a headwind to credit growth – we feel the “smart money” should be betting on a continued slowing in China’s economy over the near-term (although, based on discussions with a number of our clients recently, this is not Consensus thinking at present). This will likely invite weaker bulk commodity prices, which contrasts with the viewpoints from many of our peers at present.
Exhibit 5: China AAA Corporate Bond Yield – Moving Higher Since Congress Meeting
Exhibit 6: China Bond Issuance – Sharp Downturn in 2017 (weighing on credit)
SO WHAT? Interestingly, in our discussions with investors over the past several weeks, the response we get to slowing Chinese data is simply… “so what, stocks don’t fall, and China growth will be strong next year”. While, in general, we acknowledge this sentiment is widespread, we notice a number of troubling trends that bear watching, including: (1) China construction new starts (i.e., China residential + commercial + office construction) slowed to +6.8% Y/Y YTD through September (marking the third consecutive month YTD new start growth has fallen Y/Y, and the weakest number in 10 months) – Exhibit 4, (2) completions fell to -1.9% YTD through September Y/Y, or the lowest level since mid-2015, and (3) space sold fell to +7.6% YTD through September Y/Y, or the lowest level since late 2016.
So what’s the big deal you ask? Well, when considering residential + commercial + office construction activity accounts for nearly half of China’s steel consumption, and China represents roughly half of the world’s steel consumption, with growth in these areas in China slowing, it seems that the outlook on global steel demand could be in much worse shape than many steel market pundits are predicting (i.e., Cleveland Cliffs [CLF; SELL], Steel Dynamics [STLD; NC] & Nucor [NUE; NC]).
Exhibit 7: China Residential + Commercial + Office Construction Starts
WHAT ABOUT HOME PRICES IN CHINA? In September, China home prices slowed further, rising +0.19% M/M (or the weakest growth since late 2015) and +6.40% Y/Y (or the weakest growth since mid-2015) – Exhibit 8. Furthermore, when looking at the data segmented by Tiered city, headwinds are being felt everywhere, with Tier 1 cities’ growth seemingly set to go negative Y/Y, Tier 2 not that far behind, and lower Tier cities now beginning to feel the pinch of falling prices – Exhibit 8. And, with the historical correlation seen in falling Y/Y home price growth in China and weakness in bulk commodity prices (Exhibit 9), we see the deterioration in China’s residential values as a harbinger of bulk commodity price deflation ahead. Caveat emptor.
Exhibit 8: Avg. Price Change of New Residential Buildings, by Tiered-Cities, %Y/Y (rhs)
Source: National Bureau of Statistics (NBS), Axiom Capital Research.
Exhibit 9: China New Home Price Growth Y/Y% vs. Iron Ore Port Inventories
HOW DOES ONE GAUGE STEEL DEMAND IN CHINA? In September, amid environmental restrictions and weaker-than-expected demand, Chinese crude steel production was weak (up 5.3% Y/Y to 71.83mt, but down -3.7% M/M). Furthermore, when adjusting for induction furnace production of ~50mt/year (which was shut down in 2017, although these figures were not previously reported in China crude steel output, making 2017 production look higher than it actually is), crude steel production in China was roughly flat YTD through September 2017, and down Y/Y for the month of September 2017. Along these lines, after falling -4.2% M/M in July 2017, September 2017 CISA-member mill inventory is down -9.8% through 9/20/17 M/M (Exhibit 10). Thus, with inventory down M/M, as well as production, we believe demand is also likely suffering at present. That is, in our view, with both crude steel output unexpectedly down in September M/M, and CISA-member mill inventories also falling M/M in September (i.e., displaying, in our view, a lack of confidence by traders inside China on any sustained steel price increase over the near-term), we believe steel demand in China is currently in retreat (a potential negative for steel prices for the rest of this year).
Exhibit 10: CISA Members' Daily Crude Steel Output & Inventory (mn m.t.)