Oct 21

Economic update – China slowdown looms

China’s new leaders, President Xi Jinping and Premier Li Keqiang, seem determined to rein in China’s investment boom to prevent a speculative bubble and to strike a better balance between growth and social and environmental concerns. In the fi rst year of an expected ten year term, it makes sense that their focus is on reform rather than strong growth.

China’s growth is expected to slow to 7.5% this year; the offi cial government target in its 2011-2015 fi ve-year plan is for an average growth rate of 7.0% per annum. Growth is slowing partly because Europe’s recession has crimped exports but also because China’s central bank is deliberately seeking to tighten credit conditions to stop speculative investment into property and other assets.

China launched a credit-fueled investment boom in 2008/09 in response to the Global Financial Crisis (GFC), which saw total debt rise from 160% of GDP to 210% of GDP according to official figures. While these debt levels are manageable, there is a lingering concern that more debt has been accumulated in the ‘shadow banking system’ and that property speculation is continuing. Accordingly, the central bank recently moved to tighten credit conditions more aggressively with a particular focus on non-bank fi nancial intermediaries.

Even if growth slows to 7.0%, this is still a significant growth rate considering China’s annual GDP is now over US$8.2 trillion, ranking it as the second largest economy in the world (after the US at nearly US$16 trillion and excluding Europe as a region rather than a country).

However, China’s growth is likely to be less investment-intensive in the future given investment has grown to over 50% of the economy and China’s new leaders aim to rebalance the economy towards consumption.

A slowdown in investment will obviously reduce demand for steel and other building materials, which will impact many commodities like iron ore, coal, copper and alumina – all of which are key exports of Australia. At the same time that China’s demand for commodities is slowing, global supply is set to increase, so it is likely that commodity prices will continue to weaken and that Australia’s export income will be under pressure.

The rebalancing of China’s economy is important for its long term stability and it will remain an important market for Australia; however it is likely that we have seen the end of the global mining boom. We see a long period of lower commodity prices and reduced mining activity ahead.

A slowdown in mining will obviously be a drag on Australian growth, particularly in the mining states of Western Australia and Queensland, but surely lower interest rates and a falling AUD will offset the mining slowdown?

In the past, the answer would be a resounding yes, but this time other sectors of the economy – such as retail, housing construction and business investment – are only showing modest signs of recovery. Lonsec believes there are a number of reasons for this including:

1 Attitudes to debt have changed post GFC, with companies, households and government all seeking to increase savings and reduce debt levels.

2 Low business confi dence on poor profi t growth and burdensome government policy has led to a focus on productivity measures rather than investment.

3 Job insecurity stemming from business and government reducing employees, in a number of sectors, has led to cautious consumer behavior.

These factors are not going to change overnight but falling interest rates, a falling currency and a clear Federal election result should eventually see the broader economy rebound. Accordingly, we expect the Australian share market to retain an upward trend but recommend investors tilt their portfolios towards financials and industrials.

William Keenan – General Manager Equities Research – Lonsec

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