Key indicators of economic activity in China have continued to weaken since late 2013. This has caused much market concern over the growth profile of the world’s second largest economy, with some fearing that China may be slowing below the Government’s target for 7.5% gross domestic product (GDP) growth. In our view, while we do not expect growth to accelerate at the same pace seen over the past decade, we believe that temporary factors have been afflicting the economy, and activity should normalise in the second half of 2014.
The build-up in inventories in 2013 was always going to be a drag
The strong inventory restocking that took place in the middle of 2013 ensured that manufacturing activity in China maintained its decent pace. However, this came to an end in November, where manufacturing slowed considerably as demand from end-users was met with previously stockpiled inventory. As a result, measures related to industrial output slowed across the board, with the most recent reading of the HSBC PMI manufacturing index falling to its lowest level in 8 months.
China is also in the midst of a property cycle slow down as the tightening of credit conditions on mortgage and construction loans has dominated the news and has subsequently weighed on sentiment and demand in this sector. Given the significant contribution the property sector has made to growth, this will be a key headwind for the economy in the first half 2014. In addition, the deterioration in confidence about China’s growth prospects in 2014 has also resulted in the weakening of iron ore prices.
We forecast better times in the second half of this year
While things are looking down for the Chinese economy we do anticipate a rebound in activity in the second half of 2014 as policymakers will likely embark on new stimulus measures to restore a level of growth consistent with their target of 7.5%. In our view, low profile measures such as increasing expenditure on social housing, railway and environmental protection programs will be implemented first. This should then be followed ‘big ticket’ policy items such as lowering the reserve requirement ratio which will ease credit conditions and impel further credit growth.
China will also likely engage in another inventory restocking phase once its previous stockpiles are run down. This will also be spurred on by a resurgence in external demand given the ongoing recoveries in the US and European economies. Global trade has slowed considerably from pre Global Financial Crisis levels, and the return of international trade will be a key determinant for growth conditions in China.
Where does Australia fit in all of this?
In the past, signs of strengthening Chinese growth and stronger commodity prices provided a massive positive kick to the Australian economy, which was entirely understandable given the abundance or resources Australia had to offer to its emerging world trading partners. Vice-versa, a slowing in activity in China was almost deemed catastrophic for the fate of Australia. Going forward however, with Australian mining companies focused on boosting productivity and cutting costs, it appears Australia’s relationship with China has somewhat evolved.
Given that mining companies have been fixated on cutting costs, the positive leverage to the Chinese economy diminishes if mining companies don’t immediately ramp up investment as soon as Chinese growth strengthens. But the negative leverage arguably remains in place. That is, if the Chinese economy slowed sharply (which we do not anticipate) then commodity prices would fall further and mining investment plans would be curtailed more sharply as cash flows were crunched.
As for the recent slowing in China, markets have clearly responded unfavourably, with the spot prices of some bulk commodities falling since late last year. While this will have implications for the cash flow of those mining companies exporting commodities to the rest of the world, the increase in export volumes should provide somewhat of an offset. The latter is also what matters for real GDP growth – a measure of economic activity that policymakers tend to focus on. Nonetheless, our expectation for the eventual ‘V-shaped’ recovery of the Chinese economy in the second half 2014 will lower the chances that the recent slowing of China will have significant implications for the Australian economy.
FMG Price at posting:
$5.00 Sentiment: LT Buy Disclosure: Held
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