dear all, please excuse me for forwarding a bullish view. i know, for i feel dirty.
in any case, it is good to consider alternative views every so often, even as we give thanks for being not altogether wrong and missed what would have been the crucially fate determinant bullet as we rise from tying our shoelaces.
cheers, tj
the author is robert hsu google.com
December 2008
My 2009 Outlook on China
We're easily in the midst of the most severe financial crisis since the Great Depression and the greatest economic catastrophe of our generation. This year, a giant financial tsunami shocked financial institutions around the world, and as the waters of destruction rose, almost all asset classes were affected. With the exception of low-yielding Treasury securities, everything from real estate to corporate bonds to international stocks lost value.
All year, we watched this play out as global stock markets plunged with every ailing bank, bankruptcy report and poor economic data report. In September and October alone, global stock markets lost over $9 trillion in value. And investors were left sitting on the sidelines wondering if it all could have been prevented or at least the repercussions minimized.
For the past few months, we've discussed this topic on a number of occasions, and in last month's issue, I even recapped the main events from this year and their impact on the world. As you know, when the financial crisis started heating up, central banks and government authorities needed to take immediate action while the situation was more manageable. But instead, central bankers and government authorities around the world waited and only intervened when the situation spun out of control.
Here in the United States, a near blind faith in free market philosophy led Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke to minimize intervention in the global financial crisis. As a result, investment bank Lehman Brothers collapsed, causing a global financial crisis of confidence as well as a huge domino effect of counter-party losses.
Across the pond, U.K. Prime Minister Gordon Brown and other European leaders -- who had less faith in free markets -- decided to invest government funds directly in their financial institutions in order to guarantee their solvency. This move finally forced Paulson and Bernanke to follow suit and to invest government funds directly in a handful of leading U.S. financial institutions. Along with flooding the U.S. financial system with American funding, Paulson also tried to persuade cash-rich Asian countries to invest in U.S. financial institutions, as well.
But, as I said above, much of this government intervention was too little, too late. As a result, major developed economies like the U.S., Europe and Japan all have likely entered into an economic recession. And the global economic slowdown has curbed the demand for commodities, so emerging markets economies are also feeling the pinch. Due to the commodities' prices collapse and rapid capital outflow, even resource-rich emerging market economies such as Russia and Brazil are rapidly deteriorating. That's why I'm expecting global GDP growth in 2009 to likely be less than half of the growth rate in 2007.
There's no denying that this is going to be a tough investment and economic environment for investors and consumers around the globe. And I'm sure that many of you are wondering how China will fare in a rapidly deteriorating global economy. Or you might be questioning whether China's powerful economic growth engine can prevent the world from going into a global recession. Since these are questions lingering on many of your minds heading into the new year, let's examine these questions and discuss my outlook for China in 2009.
China's Economic Growth in 2009
Just 10 years ago, China faced a similar financial and economic environment during the Asian Financial Crisis in 1997–98. At that time, China's economy was growing between 7% and 9%, making the country a regional force of economic stability. China's ability to maintain the value of its currency and economic growth helped its Asian neighbors recover from the crisis quickly. In the end, this financial crisis served as a bouncing-off point for China -- in the past ten years, China grew from a regional economic power to a global economic power and posted an average growth rate of 9.3%. And as a result, Chinese demand has become a major force in global commodities and trades, as well as the global economy as a whole.
But this time around in the current financial crisis, the picture will likely be different. I expect China to be able to hold its own as the rest of the world slows down, but the country will be unable to provide much help beyond its borders. That's because in the current financial and economic crisis, China is also being affected as its economic growth has slowed from a steamy 11.4% in 2007 to around 9% in 2008. And China's GDP growth rate will likely slow in 2009. I'm expecting 7% to 8% growth, which is below the consensus forecast of 8% and represents a 40% drop from 2007's 11.4% growth rate.
So China's government is focusing on reviving economic growth within its borders. To do this, policymakers need to focus on three things -- exports, domestic investments and domestic consumption. These three components are the primary drivers of growth within China. Let's take a closer look at all three to see how each will push the Chinese economy forward during a time when the rest of the world is plagued by stagnant growth.
Exports
Of China's three primary drivers of economic growth, exports used to be the largest. But in 2007, exports dropped behind domestic investments and consumption. And this year, Chinese exports attributed for less than 20% of China's more than 9% total GDP growth. The rapidly declining growth in Chinese exports was a direct result of a stronger Chinese Yuan (up 7% this year against the U.S. dollar), rising land and labor costs, and declining demand for its products from economically sluggish U.S. and Europe. And these factors caused many low-profit margin contract manufacturers in China to go out of business.
Despite these factors, though, Chinese exports were still able to grow in 2008. But it is likely the yuan's appreciation, rising costs and low demand will weigh heavily on the export sector in 2009. So I'm expecting Chinese export growth to be flat and not contribute significantly to China's GDP. Still, even with a sluggish export sector, China should be able to achieve a 7% growth rate. That's because I'm expecting domestic investment and consumption to pick up the slack and offset much of the loss in exports.
Domestic Investment
In recent weeks, the Chinese government has taken bold steps to rejuvenate its economy through domestic investment. Most notably, on November 9, Beijing announced a four-trillion yuan, or $586 billion, infrastructure spending stimulus plan, which equates to 80% of China's government spending in 2007, and almost a fifth of its gross domestic product last year. This is the biggest stimulus package in Chinese history, and Beijing expects it to support China's economic growth for the next two years.
With the package, China's government pledged "fast and heavy-handed investment" in housing and infrastructure through 2010, and a "moderately loose" monetary policy. As part of the plan, Chinese policymakers are authorizing hundreds of billions of dollars to be spent on new infrastructure projects -- such as railways, ports, roads and power grid construction -- to stimulate the Chinese economy. And China is already greasing the wheels on this plan -- in the last quarter of this year alone, China will deliver 120 billion yuan ($18 billion) of new spending in low-rent housing, infrastructure in rural areas, roads, railways and airports. Investment by local governments and companies in these projects may boost that to 400 billion yuan ($60 billion)!
Now, the key to whether strong domestic infrastructure spending will help the Chinese economy depends on the quality of future projects. We can see the necessity of high-quality projects by taking a look at what happened to Japan during the 1990s. During that time, Japan spent billions of dollars on infrastructure projects, such as roads and bridges, in an attempt to stimulate its economy. But Japan's infrastructure spending failed to accomplish its goal because many of the projects were poorly conceived and had little economic value. For example, politically well-connected construction firms -- many controlled by powerful Yakuza criminal syndicates -- were awarded contracts to build roads and bridges to nowhere. The net economic effect was similar to paying people to dig holes in their backyards, and the huge fiscal spending did little more than put the Japanese government in deeper debt to its people.
Japan isn't alone in its past misguided infrastructure projects. Like other governments, China has also had its fair share of poorly conceived and impractical infrastructure projects. But overall, the Chinese have been more successful than most emerging economies in its infrastructure build-out. And given China's track record, there is no reason to doubt Beijing's ability to get its money's worth in infrastructure spending. In fact, China's policymakers are already planning some projects that are economically useful. These projects include enhanced public transportation systems in highly populated regions and improved power grids to maximize power generation capacity, as well as the construction of more port facilities for shipping and more schools in rural China.
It's important to note that despite the increased spending on infrastructure, prices of raw materials will likely not increase. That's because an increase in public spending will be offset by a decrease in private sector construction spending in this tough economic environment. But I think that China's public sector construction spending should still be sufficient to offset the weakness in private investment spending resulting from a weak real estate market.
Real Estate
Like in the U.S. and much of Europe, overpriced real estate is creating problems for the Chinese economy and reducing private sector construction spending. Although there is a strong underlying demand for better housing, right now prices of new homes are too high for most Chinese families to afford. Except for newlyweds -- as I discuss on the back page -- and others who need to buy a home right away, most potential homebuyers are taking a wait-and-see attitude and expecting prices to fall further. As a result, property prices are indeed falling, and real estate developers are increasingly facing cash flow problems as financing dries up and it becomes more difficult for builders to unload their inventory.
Now, although property prices in China are dropping, the Chinese economy is still less vulnerable to a real estate crisis than the U.S. And the reason why comes back to last month's discussion on leverage -- Chinese homebuyers are less leveraged than U.S. homebuyers. In fact, over the past three years, Chinese homebuyers put up a 30% down payment on average for a first home and a 40% down payment for a second home. So the lower leverage creates a buffer against a drop in property prices. In addition, Chinese homeowners have less incentive to "walk away" from a negative home equity situation because, unlike here in the U.S., they are legally still required to repay loans even after foreclosure.
And the Chinese government isn't sitting on its hands in regards to China's real estate markets, either. As fear of widespread real estate-related bankruptcy spreads, China's policymakers are taking action to protect the economy from a real estate collapse. In order to accomplish this, Beijing's official policy towards real estate has changed from suppressing prices to supporting the property market. So the country's central government is encouraging regional governments that benefit from higher property prices to implement policies that help lift property prices. China's state controlled banks are also expected to make more home loans and accept lower down payments for mortgages -- reduced from 30% to 20% for first-time homebuyers.
I think China's new real estate policies will help prevent the property market from large declines. But it may take a few years for the real estate cycle to turn up again.
So how will China's leading real estate service company -- E-House (NYSE: EJ) -- fare in this type of environment? Well, E-House will benefit as lower home prices drive sales volume higher. That's because, as I said, the underlying demand for housing in China is there; prices just need to drop another 20% to 30% in order to draw out buyers.
As you can see, the Chinese government is taking bold steps in regards to domestic investments to keep the country's economy growing. And China's new infrastructure spending stimulus plan will help boost China's economic growth over the next two years. But this package isn't limited to infrastructure build-outs or real estate support. In addition to spending in housing and infrastructure, the plan includes investments in agriculture, health care and social welfare.
In regards to agriculture, the Chinese government is already starting to experiment with rural land reforms. Currently, farmers are allocated small parcels of land to use for farming, but they do not have any other ownership rights to the land. So new policies are being debated regarding other land usage, leases, and mineral and transfer rights for farmland. These policies will free up huge potential wealth for China's poorest citizens and are certainly positive improvements for the country's rural economy.
The Strength of Domestic Consumption
Over the past couple of years, we've discussed the importance of young, affluent Chinese professionals -- Chuppies -- in China's and the world economy. Since I started writing China Strategy nearly three years ago, Chuppies are finally becoming a mass consumer class. And I believe that the spending from this demographic group will keep China's economic growth engine humming for years to come.
So aside from domestic investment, I think China's domestic consumption will also grow in 2009 -- with the help of the Chuppies. Now, although only 7% of all Chinese earn over $20,000 a year and live a middle- or upper-class lifestyle, that is still 100 million people. And you also need to consider that $20,000 in China is equivalent to roughly $40,000 in purchasing power here in the U.S. and $50,000 to $60,000 in Western Europe. In addition, personal income among this demographic group experienced sharp growth of around 10% in China this year, and it will likely grow again next year.
The highest growth in personal income is occurring in the 20- to 30-year-old segment of the Chinese population -- the Chuppies. Members of this demographic group are perhaps the most fortunate generation in Chinese history. Here's why: These young adults are often the only child in their family, pampered by parents as well as grandparents. And they have only seen times in their homeland improve as China's economic emergence took flight. So they have never suffered the abject poverty experienced by older Chinese generations, and that means they are less afraid to spend, unlike older Chinese.
Many of the Chuppies that I know personally are in this demographic group, and they're Internet savvy, learn quickly and are confident as well as sophisticated. And that's why they've been such a powerful force in the Chinese economy in recent years.
But like consumers in the U.S. and Europe, Chinese consumers are cutting back on unnecessary expenditures. Now, while most Chinese consumers still have money to spend -- since China's average savings rate is over 30% -- I still expect them to cut back on vacations, eating out in mid-priced restaurants, and shopping for gadgets, like cell phones and iPods. Actually, we're already seeing this trend occurring, as my analysts in China have reported sharp declines in spending at restaurants and electronic retail outlets.
To illustrate the spending slowdown in these venues, let's discuss an autumn delicacy in Hangzhou/Shanghainese cuisine -- hairy crabs. During the October to November season, gourmets throughout the Greater China region order live crabs from Yangchen Lake near Shanghai, and have them air shipped to faraway cities such as Hong Kong and Taipei. These crabs are known for their rich, green tomalley, and are often sold wholesale for up to $35 a pound. Prior to 2005, most of the best crabs were shipped to cities such as Hong Kong and Beijing. But in 2006, as people in Shanghai became increasingly prosperous, more of the best crabs were no longer shipped out to faraway cities, and five-ounce crabs in Shanghai restaurants cost between $25 and $35 apiece. In fact, when I visited Shanghai in November last year, many of the city's top restaurants had sold out of their best crabs. Demand was simply too great.
This year, however, the picture is very different. Sales of hairy crabs are down by as much as 40% from last year. In fact, my wife, who just returned from a trip to Taipei, told me that crab prices have dropped from last year's high level. As a result, many crab farms reported sharply declining sales. That's because demand is dropping as foodies who went to restaurants three times a week during last year's crab season, now only order hairy crabs at restaurants once a week.
So, the drop in hairy crab prices and demand shows that Chinese consumers are cutting back on non-necessities like vacation spending and luxury food due to the economic slowdown. As a result, expense accounts for food and entertainment at most private sector companies have been slashed.
Now, I know you're probably wondering how Chinese domestic demand is going to remain robust in this type of environment and how this affects our strategy of profiting from the buying power of the Chuppies. What you need to remember is that the Chinese consumer class is still going to be spending money. As I noted above, Chinese still have the funds to spend -- they're just going to re-prioritize their spending and focus it on more necessities such as health care and kids' education.
That means companies like New Oriental Education (NYSE: EDU) and Mindray Medical (NYSE: MR) will benefit from continued consumer spending in China. On the other hand, though, firms that cater to non-necessities like Focus Media (NASDAQ: FMCN) and Ctrip.com (NASDAQ: CTRP) will likely be negatively affected by this slowdown. And that's why we've shifted our strategy in China Strategy recently to focus more on companies that are benefiting from China's continued consumer spending in sectors like education and medicine, rather than entertainment sectors like the Internet and travel. And that's why we'll also be selling companies that will struggle from a slowdown in the luxury leisure industry. In fact, we've already sold a half position in Ctrip, and I'll let you know what other companies you should be selling in the weeks and months ahead.
The Bottom Line
As you can see, China isn't completely insulated from the global economic slowdown, and the country will likely feel some effects from it in 2009. Also, considering that China's economic growth has surpassed the unsustainable level of 10% a year for nearly five years, it shouldn't be surprising to you that the Chinese economy would slow its growth rate in 2009 and possibly 2010. But with that said, the Chinese government is taking bold steps to stimulate economic growth within China's borders and keep the country moving forward. The $586 billion stimulus package is one way that China is spurring on growth within the country, and I'm expecting similar measures to be taken next year as Chinese policymakers focus on keeping China's economy strong despite the global economic slowdown.
And I think that China's huge foreign account surplus and reserves -- nearly $2 trillion -- will allow it to spend its way out of a severe economic slowdown. Other nations around the globe won't be as lucky, and because of the breadth and severity of the current economic crisis, it will be difficult for China to single-handedly bail out the rest of the world. That's why I continue to think that China is the best place to be investing our money during these tough economic times. The country's combination of domestic spending and government-driven domestic investments should allow the Chinese economy to hold its own against a global recession, and in turn, create profitable investment opportunities.
New Buy: China Aluminum
Now, there's no denying that the rest of this year and next year will be a tough investment environment for most global investors. But as I said, we're going to stay focused on China -- picking up shares of companies that will benefit most from China's continued economic strength. As I already said, China's domestic demand will remain strong and offer plenty of investment opportunities if you know which sectors will benefit the most from recent government policies.
In regards to the $586 billion stimulus package, infrastructure companies will be the primary beneficiaries. That's why I'll be looking for new recommendations in this sector in the upcoming weeks and months. In fact, one of our former China Strategy recommendations will benefit greatly from an increase in infrastructure spending. So in this month's issue, I'd like to re-recommend China Aluminum (NYSE: ACH).
New Buy: China Aluminum
We invested in China Aluminum in the summer of 2006 as an investment in the booming infrastructure sector. We had a nice run with ACH, and sold it for a 285% profit in November of last year to avoid losses in the likely correction of the Chinese stock market that I was expecting. And, I must say, that was good timing. Since we sold ACH, it has dropped 82.5% along with the global markets. Thanks to this sharp sell-off, coupled with the infrastructure support by the Chinese stimulus package, I think that the stock is an attractive buy again.
Based in China -- the fastest-growing aluminum market in the world -- ACH has grown to be the largest producer of alumina and primary aluminum in China. And it is the third-largest producer of alumina and fourth-largest producer of primary aluminum in the world. As a state-owned enterprise that enjoys a government-granted monopoly, ACH has benefited nicely from the increasing aluminum consumption in the construction, transportation, electricity and packaging industries in China.
Just how big are China's needs? China's demand for aluminum rose 43% to approximately 12.4 million tons last year, while global consumption for the metal increased 10% to 37.8 million tons. And China's demand of alumina -- a key raw material in producing aluminum -- rose 29% to approximately 24.4 million tons, while global consumption increased 12% to 74.7 million tons. In all, China currently consumes one-third of the world's aluminum and alumina, and ACH is at the forefront of supplies.
Going forward, I expect China's demand to increase even more, due to the economic stimulus package. With more capital invested in infrastructure, the need for alumina and aluminum will likely rise, and I look for ACH to be a top beneficiary of this.
In addition to its booming business in China, the company is also growing aggressively through expansion and overseas acquisitions. It has acquired alumina supplies in Australia, and has also started to work together with Malaysian and Saudi Arabian companies to build an aluminum plant in Saudi Arabia.
A Great Buying Opportunity
Because of its domestic and global business, China Aluminum's production of primary aluminum and alumina grew 45% and 8%, respectively, last year, with total revenues increasing 17% year-over-year to 76.2 billion Yuan ($11.1 billion). But despite posting solid growth, the stock has plunged this year during the commodity sell-off and correction in Chinese stocks. Now, this just means that we can now invest in ACH's strong fundamentals at a steep discount.
Why is now the right time to act? Because, with China's new stimulus plan, the country's aluminum demand is expected to grow a robust 15% this year, compared with 6% growth worldwide. And I project China Aluminum's production growth to clock in at 20% this year. So I suggest that you get on board now while you have the chance.
ACH is dirt cheap right now, trading at only 8X next year's earnings and 4X trailing 12-month earnings. I recommend that you take advantage of this great buying opportunity. Buy ACH under $12. I'm targeting $20 in the next six to 12 months, which would give us a nice 65% gain
As we discussed earlier, China is on track to continue growing at a steady and robust pace in 2009. As a result, the Chinese and American stock markets are decoupling since stocks eventually follow economic growth. In fact, Chinese stocks have shown signs of firming up in recent weeks -- since Election Day, stocks in Shanghai and New York have decoupled by more than 20%.
And as the Chinese government continues to take bold steps forward -- with actions like the $586 billion stimulus plan -- we're likely to see Chinese stock markets continue to decouple from other global stock markets as their respective economies experience stagnant or negative growth next year. That means companies with a direct connection to the Chinese government, like state-owned enterprises (SOEs), funds that track China's stock markets, and companies in industries tied to the new stimulus package will benefit the most from China's economic growth and government action. So this month's Top Buys are two of our recommendations that fall into this category -- China Life Insurance (NYSE: LFC) and Morgan Stanley China A-Share Fund (NYSE: CAF).
As the Chinese government continues to take action to stimulate economic growth, China Life will likely benefit. This company is an SOE with strong management and limited competition as it controls 51% of China's life insurance market. In addition, China Life's core insurance business is growing by an average of 15% a year. And since it enjoys support from the Chinese government, it will profit from further action by policymakers.
Plus, we need to consider that China Life is able to invest its assets in the Chinese stock market. So as the Chinese government boosts the economy and stock markets, China Life will also see this reflected in its bottom line and share prices. Buy LFC under $55.
Morgan Stanley China A-Share Fund will also benefit from continued government intervention. A significant portion of this ETF is dedicated to Chinese companies traded on the A-share indexes in Shanghai and Shenzhen. So it moves in lockstep with these stock markets, and as Chinese policymakers continue to focus on rejuvenating economic growth and put a solid floor under Chinese shares, we will likely watch CAF move steadily higher in the coming months as well. Continue to buy CAF under $30. |
