China Slowdown? The Real Risk is Exports

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 28th, 2014

China Slowdown? The Real Risk is Exports

  • While early Q1 results suggest that things look better in Europe, the outlook for China remains decidedly mixed, with escalating debt and possibly escalating bad debt at a time where domestic demand growth is slowing and the nature of domestic demand is changing. A sharp correction in economic growth could lower import demand and quickly increase exports from China, of products we are used to seeing and potentially new products.
  • From the companies reporting Q1 earnings so far the China outlook remains opaque – clearly there are opportunities but perhaps in more higher value added products and technologically advanced areas (to satisfy increasingly sophisticated domestic preferences) rather than across the board.
  • China’s historic exports have been based on cheap labor but also for the most part imported raw materials – at least at the margin. This has been a stabilizing effect on global prices – cheaper from China because of the relative labor costs, not because of cheaper raw materials.
  • With aluminum and TiO2 we have seen China exports based on Chinese domestic production, resulting in meaningful global price weakness, with a new global player often selling at marginal cost. As China rapidly expands its manufacturing base, a slowdown in consumption growth could throw many more products into the export market.
  • It is unlikely that the US domestic market would be the home for these increased exports from China and so in our view it will be the US companies with significant overseas sales that will be more at risk than those more focused on the North American market. In Exhibit 1 we show the large cap companies with the greatest non-North American exposure plotted against current valuation, as well as the same analysis for the mid-cap group.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

The most recent trade data from China showed a surprising decline in exports. In our view, the biggest risk to a number of Industrial and Material sub-sectors today is a slow-down in local demand growth in China and an increase in China exports – but of different products. A slowdown in growth would reduce Chinese imports of raw materials and equipment and this would have a (mostly volume) driven impact on companies with sales in China, either from local production or from imports. However, as China builds its own Industrial and Materials industries, the bigger risk could be exports of surpluses from China and the effect that they could have on global pricing (which would impact more than just those heavily leveraged to supplying China).

Incremental supply from China will only find a home in the global market based on price, and we have seen good examples of this with aluminum and TiO2. Local surpluses of products ranging from plastics to tractors to compressors could result in exports at prices dictated by marginal costs and seriously undermine global pricing. This is not something that Chinese manufacturers could sustain for the long term, but in their mind they might not need to, given that they are generally waiting for China demand to catch up with supply. However increased supply from China – even for a short period would likely be enough to impact global pricing.

At the same time we see China showing some signs of discipline – in some cases trying to deal with overcapacity buy closing older small facilities (aluminum, TiO2, basic chemicals), and looking to improve competitiveness (the Phillips/Sinopec deal for propane). Ultimately we would expect Chinese manufacturing to operate on a “cash cost” or “minimum return on capital” basis, as most companies do in the developed world, but the path to that point will likely involve years of marginal pricing and restructuring forced by bankruptcy. This is how industries evolved and continue to evolve in the developed world and China should be no different. For the last 30 years the very strong domestic growth rate and international growth rate for Chinese manufactured goods has justified dramatic investment growth, some of which would be largely uncompetitive in a developed market. With a slowdown in domestic growth at the same time North America is talking about a manufacturing renaissance and Europe is stagnating, China overcapacity and how companies learn to deal with it could spell trouble for all.

Chinese economic growth slowed in the late 1980s and the late 1990s – Exhibit 2. This was followed by a very bad time to own the large industrial and material sectors (lagged by around 12-18 months). Strong global growth, of which China was a smaller part, prior to these periods, had increased product demand, revenues, profits and valuations (for most sectors to levels more stretched than we see today). Subsequent pullbacks for these groups was significant.

Exhibit 2

Source: World Bank

China’s Economy – From Passenger to Driver

China today has the number 2 economy in the World. In the late 1990s China ranked 7th (behind Italy) and in the late 1980s, 11th (behind Brazil). Countries outside the top five really do not have enough weight to drive a global slowdown alone, and while we think about the Eurozone rather than Italy today, it is really only the Eurozone, the US and China that can materially impact global growth unilaterally. In the economic slowdowns of the late 1980s and the mid-to late 1990s, China was an influence, but more of a passenger. Today China is large enough to drive the bus all on its own.

Exhibit 3

Source: World Bank

You will get as many opinions about the state of the Chinese economy as experts you consult. What they will agree on, however, is the escalating debt, both in absolute terms and as a percent of GDP. Some are more concerned than others about how much of this debt is coming from the “shadow banking” system, the quality of this debt, and whether the system will crash. The real disagreement comes around the subject of whether this matters – whether the government has so much reserves that it can buy itself out of trouble and will continue to do so, or whether this debt bubble will burst with very negative consequences for the economy. The chief economist at IHS pointed out in a recent presentation that no economy has seen debt/GDP grow quickly to a level of debt reaching 2x GDP without a correction, either managed or forced. This is where China is today.

We think that a “shock” like slowdown in China has enough of a probability to require some thought (not a 50% probability, but enough).

Changes in Trade Flows are the Biggest Risk

The aluminum and titanium dioxide industries have experienced firsthand what happens when China has a product surplus. The entry of China into the global market for both products has been significant for the global market structures and in both cases prices have been depressed ever since China’s arrival. Some points to note:

  • In both cases the argument was made that China did not have the production economics to export – or at least many of the new producers did not. Enough exports came to impact global pricing.
  • In many cases export returns are below cash costs for local producers, but the volume and operating rate mentality prevails in China today, and low prices are necessary to force the closure of older and smaller units – even if they are not large enough to materially impact the surplus.
  • China continues to import both aluminum and TiO2.
  • Local producers are watching the rapid growth in domestic demand and in many cases see the need to export as temporary – consequently they become less concerned about who they sell to and at what price. In the case of aluminum, for example, we expect Chinese exports to decline within the next 12-18 months and possibly disappear within 2-3 years.

China continues to invest in its own materials and machinery industries – driven by the strong local demand growth and by the opportunity to either prevent imports from rising further or displace imports. The investment growth rate has not slowed in recent years, and assumes that (requires that) domestic demand continues to grow. A slowdown in growth could leave current producers or new producers with limited domestic demand, even though the country may still be importing on a net basis.

The temptation for any new player is to look for international demand and the only way for a new entrant to make any progress is through price. In almost any industry there are plenty of well recognized trading companies that will facilitate exports, but they will generally do so on a fixed margin and consequently are often indifferent to (or less concerned about) the absolute level of pricing. China’s step change in the international arena for aluminum occurred during the financial crisis and consequently it is hard to judge how much of an impact China was on the subsequent decline, but selling 300,000 plus metric tons per month into the export market has definitely contributed to the downward price trend – Exhibits 4 and 5. China exported as its surpluses grew – Exhibit 6 – felt the slowdown in 2008/2009 like everyone else but then ramped up production and exports as prices recovered helping to create the surplus that has placed downward pressure on prices ever since. Note that China added as much as 25 million tons of aluminum capacity in 11 years! At the same time, China demand for aluminum has grown by as much as 20 million tons and the country should be half of global demand within the next 5 years.

Exhibit 4

Source: Bloomberg

Exhibit 5

Source: Capital IQ

Exhibit 6

Source: Bloomberg, SSR Analysis

Titanium Dioxide is a more recent phenomenon, with China really ramping up capacity and exports from 2010 and helping to contribute to the price collapse of late 2012. China now has a greater surplus of TiO2, as a percent of demand than it does aluminum – Exhibt7. TiO2 demand in China continues to grow quickly and a slowdown in construction could correct this imbalance within 3-4 years.

Exhibit 7

Source: Bloomberg, SSR Analysis

If we look at other materials and machinery, China is dabbling in the export market, but generally remains a substantial net importer. For example, China imports a few hundred thousand tons of polyethylene a year, but imports several million tons. The exports are growing slowly and are not enough to impact the market outside Asia, but the Asia market is already weak and unprofitable for most local suppliers. However, China has significant capacity addition plans for polyethylene over the next 3-5 years, much of it associated with the coal to chemicals projects under construction in the West of the country – note that IHS is tracking 53 of these projects with the expectation that they will be completed (there are others plans that IHS is handicapping and not including). China remains very deficit polyethylene today – Exhibit 8 – but plenty of capital spending and a slow-down in growth could change the picture meaningfully in 5 years.

Exhibit 8

Source: Bloomberg, SSR Analysis

Regardless of the Risk to Pricing – Economic Slowdowns Are Bad For This Group

While the risk of price declines in the international markets – with natural consequences for US pricing – are a real risk of a slowing China, the market will discount the risk early as it has in prior cycles. In Exhibit 6 below we plot both China economic growth and the relative performance of the capital goods sector (relative to the S&P500). The chart shows significant underperformance as Chinese economic growth decelerates. Charts for the other sectors with long history are included in
the appendix
, and while the pattern is not as compelling for the other groups the same general correlation exists.

Exhibit 9

Source: World Bank, Capital IQ, and SSR Analysis

In our view the Metals sector is effectively discounting a slowdown today. Valuations are at extreme lows and anticipate more economic trouble ahead. No other sector has this discount and many are expensive, though none of the global sectors are excessively expensive – the most extreme would be Conglomerates and Chemicals. Capital Goods looks inexpensive today on a sector average basis. We would not focus too much on the Paper and Electrical Equipment sectors as their international exposures are lower than the others.

Exhibit 7

Source: Capital IQ, SSR Analysis

However, prior economic slowdowns have taken these groups well below mid-cycle value – as shown in the Capital Goods index in Exhibit 8. Periods of underperformance are clear in the late 80s, from what had been a period of very high relative value, and again from the mid-90s to 2000, even though the sector was fairly valued at the beginning of the period. The group underperformed again during the slowdown caused by the financial crisis in 2008/9. Similar patterns exist for Chemicals and other sectors and these are included in
the appendix
.

Exhibit 8

Source: Capital IQ, SSR Analysis

A surge in Chinese exports is unlikely to have a material direct impact on the US market. While the US is very used to consumer durables, packaging, toys etc. from China, this would be a difficult market to push large volumes of capital goods or higher value electrical equipment or plastics from non-established suppliers. Price declines in other world regions might impact US pricing, but it is reasonable to assume that China surpluses will impact more seriously sectors and companies with significant non-US exposure. In Exhibit 9 we show sector average non-US exposure and current discount from normal value. Sectors with more that 50% non-US exposure would likely be impacted more meaningfully, which brings us back to Capital Goods, Chemicals and Conglomerates.

Exhibit 9

Source: Capital IQ, SSR Analysis

At the stock level the picture is different, because there are some wide valuation and geographic exposure differences within sectors. In Exhibit 9 we list 9 large and mid-cap names that are expensive, and in our view where current returns do not justify current values (i.e. high levels of investor optimism) and with more than 50% exposure outside North America.

Exhibit 9


Appendix

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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