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surviving a soft landing

The fate of China remains key, not only because it is one of the main drivers of global economic growth, but also because of its impact on the commodities markets.

The much-feared hard landing of the Chinese economy did not materialise as China’s leaders turned to infrastructure stimulus and monetary policy easing. As a result, the economy grew 7.9% year on year in Q4 2012, above the 7.4% rate of Q3 with the recovery led by manufacturing and real estate, which had been significantly affected by the downturn.

Improving fortunes

This upturn has continued into 2013. The January manufacturing PMI held steady at 50.4, while the non-manufacturing PMI rose to 56.2. Given the stable growth and inflation (3.5%) outlook, we expect the Bank of China to maintain its current accommodative stance with the main policy rate left at 6% and reserve requirements steady for the foreseeable future.

The improvement in the Chinese economy also fed into corporate earnings. Profits for the industrial sector rose so substantially in the fourth quarter that full-year growth reached 5.3%, having been in negative territory for much of the year. Earnings as a whole for Chinese equities were flat in 2012 although with significant differences among sectors; technology was at the positive end of the spectrum and materials at the other.

For 2013, earnings growth in China is expected to reach around 10.5%. Much of this improvement has also been reflected in Western companies’ recent earnings’ releases and guidance. Alcoa, the aluminium producer, a bellwether industrial company, recently reported an improvement in China over the previous quarter across a wide range of its end markets (automotive, heavy trucks, drinks cans and commercial buildings).

On the consumer side, Proctor & Gamble announced its markets had stabilised in the second half of 2012 and it expects a stronger 2013. The markets for home and personal care products are growing in high single digits.

Looking ahead, we expect Chinese economic growth to trend back to pre-WTO ascension (December 2001) levels, still higher than Western countries although not as high as in the golden days of 2002-07. In fact, Chinese growth could decelerate later this year once the effect of last year’s stimulus fades.

A balancing act

The question remains whether the much-heralded structural rebalancing aimed at changing the driver of the economy from investment to consumption, from external to internal demand, will take place.

Last year’s increase in government stimulus via infrastructure investment and looser monetary policy made the country even more dependent on credit and investment for growth, and hence made the rebalancing even harder to achieve. Moreover, such a transition requires strong political will, which seems lacking.

A rebalancing may well be years away, although some progress has been made in two areas. Firstly, 2012 saw household income growth increase more than GDP growth thanks largely to rising wages. While this is a positive development, consumption in China is only roughly a third of the economy, compared with more than two-thirds in Western economies. An improvement in consumption can thus only have a long-lasting impact on the rebalancing if it is replicated over many years.

Secondly, since 2007 exports to China’s destination markets have slowed thereby reducing somewhat the reliance of China on exports. We upgraded China to ‘overweight’ in September 2012 and we still see the Chinese equities market as attractive and anticipate modest, but improving earnings growth in 2013.

Valuation multiples are currently hovering around ten times 12-month forward earnings, which in our view is still not reflective of a cyclical recovery. Valuation multiples should continue to expand from particularly bearish levels.

Urbanisation drive

Firm economic growth in China underpins demand for commodities as the country consumes close to 40% of most industrial commodities. The current upward trend should translate into demand growth for commodities for the next six months at least, particularly as the rebound was orchestrated by boosting infrastructure and led by a recovery in manufacturing and real estate. This is most beneficial to base metals and steel.

Chinese base metals consumption generally follows the trend of economic activity. Overall in 2013, demand is expected to grow between 6% and 8%, some 2% higher than last year. New housing construction activity in China has only recently begun and we would expect the greatest impact of the improvement on base metals consumption to lie ahead.

Summary

GDP growth of 7.5% in the fourth quarter of last year showed fears of a hard landing by China’s economy are behind us.

The next challenge is how the country’s new premier will navigate from an economy driven by external demand to one of domestic consumption.

While there are still plenty of positive, short-term investment opportunities, China still has much to do, to assuage longer-term market fears.

Base metals are highly leveraged to new housing construction activity: 40% of demand for aluminium arises from the real estate sector, and 25% for copper, zinc and nickel. Zinc and copper would benefit the most from a continued boost to infrastructure through the build-out of the electrical grid. Aluminium and nickel should also benefit, though to a lesser extent.

Beyond 2013, urbanisation will likely prove the most important driver of commodity demand. Chinese urban population represents just over half the total and is growing at 3% pa. The challenge for the authorities is to accommodate the increased demand for housing as migrants settle into cities, and to provide adequate infrastructure. Urbanisation has been put at the forefront of policy priorities by new premier Li Keqiang.

The pace of migration to cities will be affected by land reform – to allow the sale of rural plots, and reform of China’s household registration system, allowing migrants to settle in cities and use services currently reserved for registered urbanites. While there are opportunities to capitalise on positive growth data and policy movements, fears of economic dislocations may well reappear in the long term unless the rebalancing is managed smoothly.

tom@ybc.tv

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