18 Mar Trouble in China!
Why you should still be careful investing in resource shares.
“Resource shares are so cheap now, should I buy?” I get the question from clients often and the subject is debated in the SPI investment meetings regularly. I have expressed my worries about growth in China a few times on TV and Twitter. A new research report from a major global research house confirmed my fears.
Let’s recap first. We saw a big drop in iron ore and copper prices the last few days as a result of data out of China pointing to a slower growing economy, see graph. Last year in January I was asked on CNBC and Business Day TV what was my biggest worry for the year and I explained that I was very worried about the Rand, especially with the growing Current Account Deficit and outflows on the Financial Account (Capital). This year I explained my worry is a bigger than expected a slowdown in China as a result of their growing twin bubbles and the effect it will have on our resource companies.
Iron Ore and Copper prices:
The twin bubbles I refer to are the Property and Shadow Lending bubbles. The property bubble smells just like the Savings and Loan crisis that hit the US at the end of the Seventies. Texas was full of what they called “see-through” buildings. You could travel for miles on Texas highways and see huge office and apartment blocks standing empty with not a tenant in sight. The result was a major property crash and recession in the US. The same is happening in China with whole suburbs built and left empty. One newspaper reported that an ordinary policeman in China owns 12 apartments, many without tenants, just trying to sell for profit.
The shadow lending bubble again looks much the same as the recent sub-prime crisis that dumped not only the US in a recession, but most of the world with it in 2009. Shadow lending is lending off-balance sheet of Banks, mostly by unregulated credit institutions. Government has little control over it and default risk is big, especially because most of it is invested in property. Total credit in China is nearly 200% of GDP and shadow lending is already 60% of GDP, see graph.
China Shadow Lending and Total Credit as % of GDP:
The bubble will burst and the consequences will be dire for Chinese consumers. The Chinese Government has already spent $340bn to bail out credit institutions. They cannot continue to do that for ever. When it bursts GDP growth can half from previous 10% to 5%. One research study forecasts that copper and iron ore surpluses can increase by 50% and 200% respectively even without the bubbles bursting. That will cause commodity prices to slide as China is a major importer.
It is true that although commodity prices are not low in long-term graphs, resource shares trade at low P/Es. Some slowdown in commodity prices might already be priced in because of the low conviction of forecasting prices and therefore earnings. I still think that given the risks of a bigger than expected slowdown in Chinese growth, resource shares are very risky investments indeed, especially in base metals like iron ore and copper.
Head Sanlam iTrade.