Time To Worry About Chinese Property?

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By Rudi Filapek-Vandyck, Editor FNArena

In China, all paths start and end in the all-important property market.

For Australia, this has been a clear benefit. Both central and regional governments have used land sales and property development to maintain high levels of economic growth and employment, while transforming the country from a largely agricultural oriented population into the second largest industrial economy in the 21st century. And it all went so quickly post 2000.

With some hindsight, those were the good years. Things are changing now in China and as is always the case after twelve years of sheer uninterrupted growth and wealth creation, with change comes danger.

Being worried about developments in China is nothing new. Ever since the country appeared on global investors' radars, sometime in 2004, there has always been a degree of uneasiness about the country's elite, economy or social structure. This year, however, there seems to be a lot more substance to the China concerns. Publicly available data are indicating significant loss of momentum for Chinese property markets and there are media reports about worried local governments, worried property developers and about (more) people worried about a bursting of the "bubble".

Whether there is a genuine "bubble" in Chinese property is very much an open debate on semantics, but what cannot be denied is that property is today at the centre of what makes Chinese society and the Chinese economy hum. Building new roads, airports and shopping malls, including blocks of new apartments and houses, has made up more than 50% of China's economic growth in the past decade. And after such a long period of frenzied activity, and rising prices, just about everyone in China is now interested, exposed and involved.

UBS analysts, while traveling through the country this month, have been publishing local colour and feedback to the investment bank's clientele in days past. One of the observations from their tour reports is that companies in the steel sector, in manufacturing and even in the resources sector have by now ventured out in property development. No wonder, just about every tour report contains a reference such as "we continued to hear about property bubbles".

UBS' designated China economist on the ground recently expressed his gravest concern so far about China and its property markets. His report, "Bubble Trouble: Are We There Yet?", followed hot on the heels of industry data showing construction starts have plummeted by 25% in the first quarter of 2014, accompanied by worrisome media reports about price discounting taking place but without a noticeable response from buyers.

Before we get too worried, consider the UBS report offers a 15% probability that China might suffer a sharp property downturn that could lead to GDP growth dropping towards 5% in 2015. The central idea is that excessive overbuilding is now leading to a sharp reduction in construction starts and this will ultimately lead to a reduction in completions, which will cause reduced demand for steel and steel making raw materials.

Why isn't the percentage higher than 15%?

UBS still believes Chinese authorities have the tools and insights to mitigate a property downturn. A view that is echoed elsewhere. Both local and central governments can relax property policies (a process, it appears, is already taking place) while the central government and PBoC can loosen liquidity and compensate through increased infrastructure investment, which also is happening already.

None of this means UBS' assessment of a 15% probability for grand disaster is accurate or rock solid. As a matter of fact, China watchers at Citi are of a very different mindset. They believe the consequences of a sharp downturn for Chinese property prices and activity will simply be "unbearable" for Chinese government and society as a whole (let alone for foreign derivative number one, Australia). Citi agrees with UBS in that authorities still have the ability to stave off worst case scenarios in the short term, but Citi seems generally less sanguine.

Here's how Citi feels about it: "We believe the physical market has reached a critical point, in the sense that there is a potential for broader-based shrinking of demand, leading to a 'demand cliff' and meaningful correction in the physical market. Rather than just a matter of policy or liquidity-driven weakness (these can be revived by simply loosening), the physical market this time faces a drag not only from recurring factors (those have been seen in the past), but also by some new concerns that lower the strength of demand and visibility."

In more specific terms, one of the concerns Citi analysts have is that when Chinese property buyers change their mindset about price outlook, and start preparing for weakness instead, there is real danger this might initiate a negative spiral that could prove too difficult to control.

More optimistic experts will point out this is not the first time the industry is being confronted with a sudden loss in momentum. It happened back in 2008, when the world was temporarily on its knees, and again in late 2011. It just so happens the Chinese share market has devalued listed property developers back to levels seen on both occasions. But quite a number of analysts agree there's a noticeable reduction in natural buyers this time around. So maybe this time… is different?

Without wanting to sound too alarmist -Citi analysts still maintain China's property markets are more likely to peak in 2015, not this year- Citi suggests the time for decisive supportive action is now, and the window is closing rapidly if, as everyone expects, Chinese authorities want to avoid any kind of disaster stemming from the property market. Even then, the analysts' confidence in a positive outcome (for now) comes with a few caveats.

In the words of Citi experts:

Merely fine-tuning policy by the local governments is insufficient to mitigate a potential serious correction, unless a powerful loosening 'combo' is adopted, consisting of:

– 1) Home Purchase Restrictions relaxation in majority of cities;

– 2) credit easing with more favorable mortgage costs/down payments;

– 3) resetting buyers' pricing expectations with less hostile media reporting.

Citi's conclusion: "Only if all these measures are introduced in a timely fashion can a 'demand cliff' be avoided, in our view. Yet, realistically, a nationwide bull market has ended and many Tier 3/4 markets are structurally withered".

All these have to be in place by late July, or else. But even then, Citi experts state Chinese property has seen its golden era and the outlook is for a peak in 2015, preceded by overall conditions deteriorating significantly this year. What comes next depends on how well Chinese authorities manage the problem and on general health for the Chinese economy overall (see chart below).

Last week, analysts from BA-Merrill Lynch also returned from a China visit. They brought back their own piece of troubling insight: China's high cost producers of iron ore and coal seem poised to surprise through resilience (see also further below). With regards to China's heavy reliance on property, the analysts made two observations:

1. Key buyers of Chinese property are incentivized by capital appreciation rather than yield
2. Economically, the government needs a strong property sector to support the economy as the negative wealth effect amounts to a "too big to fail" scenario

The key question when combining these two is, of course, whether Chinese authorities have not created a monster that might ultimately grow too big to keep in its cage.

Citi analysts seem to think this could be the case, pointing out Chinese property to date has become a 'mega-market' already with total housing value at RMB130-160trn, annual property sales of RMB8trn and land sales of RMB3-4trn. Their view is strongly supported by Tim Carleton, ex-Goldman Sachs and now principal at funds manager AusCap Asset Management. Carleton also traveled to China and last week shared his eyewitness experience and observations with a small group of hedge funds, financial planners and wealthy individuals (plus me).

His personal account of empty roads, near empty train stations and regional airports, empty car parks and queues of apartment blocks -as far as the eye can see- where nobody lives were entertaining and troubling at the same time. As Carleton never tired in pointing out, if this is what has kept China growing on target last year, then consider it needs to be repeated plus some extras this year to keep GDP growing, and next year they have to do it again, plus some.

Two worrisome observations stood out from Carleton's presentation:

1. Chinese investors have been trying to diversify away from pure property speculation through investing in wealth management products and bank products but few realise in both cases the ultimate destination remains the Chinese property market through loans to developers and financing of property and infrastructure projects

2. Chinese investors now have access to alternatives with non-bank lenders offering higher deposit rates well above inflation and banks' deposits

Carleton's concern falls in line with Citi's: what happens if the Chinese property buyer loses conviction that all money spent on property is guaranteed a generator of wealth? How long can the authorities keep this going?

Analysts at CLSA highlighted property prices in China have fallen for the first time in April since May 2012, on a month-to-month comparison, albeit in a modest fashion (CLSA estimates minus 0.3% underlying). Given some 21% of property developments have indicated they intend to lower prices to try to stimulate buyers interest, the correction seems poised to continue, predicts CLSA, with the analysts noting the difference between now and the last price correction in 2011/12 is there's less pent-up demand in 2014. Which is why cutting prices may not work. CLSA reports even property developers themselves are skeptical.

While not anticipating a total collapse in the Chinese property market is on the cards for tomorrow, the AusCap fund managers hold no exposure to resources stocks, and neither to banks, in the Australian share market. Their favourite investments are selected retail stocks, while the largest single stock exposure is with Telstra ((TLS)). Largest short position is with BHP Billiton ((BHP)) (because shorting Fortescue Metals ((FMG)) is considered too risky given the volatility).

Bottom line: even experts who have become increasingly uncomfortable with China's heavy reliance on property and infrastructure spending are still of the view that rising risks are likely to remain in check for the time being, but it should be clear to investors China is rapidly becoming a less reliable, less predictable, higher risk component of the global economy, including prospects for commodities and financial assets. Further developments should definitely be on everyone's radar.

(This story was written on Monday, 12 May 2014. It was published in the form of an email to paying subscribers on the day).

Note The Divergence In US Equities

Yes, the Dow Jones Industrial Average has just set a new all-time high and if we can take guidance from the many equities bulls out there, it won't be the last record this year. But the "Dow" only consists of 30 members and many would agree the benchmark looks quite archaic anno 2014. Those who pay attention to detail have noticed things looking a little less upbeat for the S&P500, and again a little less upbeat for the Nasdaq. It gets downright worrisome if we move our attention to the Russell2000.

The chart below shows the divergence between the Dow and the Russell, in particular since late March.

Another way of looking at it is via the graphic below which shows most stocks in the US are now well below their peaks. While this doesn't necessarily tell us anything about the direction for the three major indices in the US, it does pose a concern and at the very least argues for caution when allocating additional funds in today's markets.

Banks – The Sequel

One observation cannot be left unmentioned regarding the banks in Australia. Usually, when banks report and analysts have to adjust forecasts and valuations post the event, the result is for rising forecasts and rising valuations and price targets. This is not what we've seen in the current reporting season. Any changes for Westpac ((WBC)) barely registered, while National Australia Bank ((NAB)) actually went backwards both in forecasts as in consensus target (minus 0.19%). ANZ Bank ((ANZ)) still enjoyed a 2.7% lift in consensus target. ANZ's experience used to be "normal" for the banks, in 2014 it has become the exception.

As I have tried to explain in weeks past, I believe there's too much gloom-mongering surrounding the banks, but there's no denying the current outlook for bank shares is far, far, far from exciting. That's what you get when high multiples combine with slowing growth and a higher risk profile. But there's little chance of the banks cutting their dividends anytime soon and that, to many a shareholder in Australia, is all one needs to know.

Iron Ore & The Marginal Producer(s)

There's widespread misunderstanding about the outlook for Australia's largest export product, iron ore. Present divergence between price forecasts among stockbroking (and other) analysts is not so much related to projections for Chinese demand, as it is to the resilience of higher cost producers in China. Major suppliers BHP Billiton ((BHP)) and Rio Tinto ((RIO)) have steadfastly held on to the view that from the moment they'd significantly increase seaborne supply, thus putting pressure on price, these higher cost producers would exit the market.

The speed and timing at which these higher cost producers are anticipated to stop producing essentially explains the difference in price forecasts. The bad news is that more and more analysts are coming to the conclusion that any exit from Chinese producers won't be immediate, nor smooth or speedy and may become more of a protracted process with both steel companies and local governments in China supporting local produce to retain a certain independence and to retain employment. Investors will be hoping iron ore is not about to repeat the frustrating exercise that has been dogging coal markets in years past where prices have fallen much more steeply, and have remained much weaker, than anyone had expected.

UBS analysts are currently traveling through China and their feedback is not exactly heartwarming either with Chinese steel manufacturers suggesting present spot iron ore around US$102/tonne is probably "about right" given underlying conditions in China, with some inside the steel industry suggesting total demand in China will probably stay around present levels for the years ahead. No doubt, the industry in Australia, on Friday nights in the pub, has been wondering: where's that Chinese stimulus when one needs it?

Note the average price for China landed iron ore Fe62% is still around US$118/tonne against a calendar year average of US$126/t for 2013, but with the last reported price at US$102.70/tonne, and in the absence of a strong rally soon, the average will be coming down thick and fast. If analysts at Citi and Morgan Stanley are correct, however, iron ore should enjoy a relief rally soon.Will it still inspire for renewed momentum in listed stocks?
 

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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RUDI ON TOUR

I have accepted an invitation from the Australian Shareholders' Association (ASA) to present to members (and others) in Wollongong on June 10. Title of my presentation: The Share Market: Always The Same, Always Different.

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