A More Cautious Approach Toward Asia and Commodity Prices
"Asia is firing on all cylinders. Consumer spending has more than recovered from Sars. In an increasing number of countries investment too is picking up. China is roaring ahead as a source of demand for both consumer and investment goods and, after a soft summer, export growth has picked up again. Add in a recovery in the United States, our bullish forecast for Japan and some signs of life in the EU and you have an economic environment that is better than has been seen for years and maybe the best since before the Asian crisis", so says CLSA in its fourth quarter Asian Economic Research bulletin, dated September 11, 2003. I agree! Asia is experiencing economic boom conditions although no everywhere and not for every sector of the economy. Moreover, what concerns me regarding the view of CLSA is the statement that the economic environment in Asia "maybe the best since before the Asian crisis". Let us hope that these "boom conditions" will not end the same way they unraveled in 1997!
Over the years, I have been immensely impressed by Chinas economic development, the relatively smooth and peaceful progress of its society post communism and the rise of standards of living in that country. More recently, I have also been impressed by the changes that have taken place in India over the last two years and which are likely to ensure future trend-line GDP growth in the 5-6% range or even higher. But, as the economist Clement Juglar wrote in the 19th century, "paradoxically as it may seem, the riches of nations can be measured by the violence of the crises they experience" and, therefore, I am now more cautious about China's and Asia's economic prospects as well as about the potential for commodities to rise much more in the near term. There are several reasons for this more cautious view.
Whereas CLSA actually predicts economic growth in China to accelerate in 2004, I take a more conservative approach and believe that its growth will slow down considerably or even be temporary interrupted by a mini crisis. In addition, since China's rapid economic expansion had a very beneficial impact on Asia by sucking in imports from the region, I have to assume that any slowdown in its growth rate would also have a negative impact on the rest of Asia as well as on commodity prices.
Let me explain. Unlike in the US, growth in China is driven by net capital formation and exports. Like in the US, growth in China is also driven by strong consumption growth and consumer credit growth, albeit unlike in the US in unsaturated markets. In recent years, China's fixed investment growth has been accelerating and accounts now, according to some experts, for 42% of GDP. Now, let us assume that this figure is grossly overstated and that capital formation only accounts for say 20% or 25% of GDP. The problem does, however, not relate to the size of current capital spending in China, but to the fact that is has expanded rapidly over the last few years and that large over-capacities have come about in almost every sector of its economy (according to Chinese statistics fixed investment growth is up 30.5% year-on-year in the first nine months of 2003). In other words, it would appear that China's current economic boom has much to do with significant over-investments, which were so common in the American economy of the 19th century and repeatedly led to vicious downturns. Now I am the first one to admit that the Chinese learnt very quickly from the US government how to doctor economic statistics and, that therefore, the year-on-year growth in fixed investments could be much lower than Chinese statistics would have us believe. However, if we consider that housing and the construction of commercial structures has been booming and that FDIs were strong, it is possible that fixed capital formation jumped massively in 2003. The fact, however, is that overcapacities now exist and that inventories have risen strongly. In this respect it is interesting to note that Motorola just sold its loss making one billion US dollar waver fabrication plant in Tianjin to China's Semiconductor Manufacturing International Corporation (SMIC) for a 10% stake in that chipmaker (SMIC is only three year old and is China's first made-to-order chipmaker!). I may add that Motorola's MOS-17 wafer-fabrication plant had been running at less than 10% of its capacity, as demand for locally made chips failed to meet Motorola's "great" expectations. That large over-capacities exist is also evident from China's stable or declining consumer good prices given the country's strong growth rates. In the case of China we can really talk about a deflationary boom! But excess capacities aside, which may lead in 2004 to slower fixed capital investment growth rates, or even a slight decline, I have other concerns regarding the Asian region as well as commodity prices. Recently Chinese import growth of 40% year-on-year (compared to 30% export growth) would suggest that some inventory building is taking place. Indeed inventories have been soaring, which is not surprising considering that commodity prices have been rising strongly. Now visualize the following situation. Since industrial production in the industrialized countries is flat to down, there is no doubt that it was the incremental demand coming from China that pushed up commodity prices since 2001. In turn, rising prices did not go unnoticed to China's authorities and corporate sector, which immediately reacted to rising prices by building up their inventories and in the process created higher demand than would have been the case without the inventory build-up! In fact, for China to build up its inventories is more than logical. By doing so, it diversifies it foreign assets out of US dollars, warehousing costs are not a factor, and it reduces the politically sensitive trade surplus. But, the flipside of this is that if industrial production and fixed capital investments slow down the rate of increase in the demand for commodities will suddenly diminish or at worse, Chinese demand could even temporary decline. I wish to stress that in order to get a meaningful slowdown in the aggregate Chinese demand there is no need for capital spending to decline. A slower growth rate or flat fixed capital formation will do the trick via the multiplier, and acceleration principle. I am, therefore, leaning towards the view of the research tem at ABN-AMRO who believes that, "the market is too complacent over China's over-investment problems and the country's need to tighten". According to ABN-AMRO, "some argue that China is not overheated on the ground of low CPI inflation rate. They miss the point that China's current overheating is caused by excessive investment. The resulting excess capacity will be deflationary, rather than inflationary. The market hopes for fine-tuning. This is wishful thinking. The severity of the problem is already well beyond what fine-tuning can solve, and also the system and tools that allow the government to fine-tune the economy simply do not exist. History tells us that China has never achieved fine-tuning&There are two options for the Chinese government: 1) try to engineer a slowdown now and hopefully it will be a soft landing (not fine-tuning), or allow the investment ratio to continue to rise until it blows up."
A slowdown in the growth of net capital formation aside there are other reasons to take a more cautious approach towards China. If, US consumption slows down as the stimulus of the tax cuts and the housing refinancing boom disappear, then export growth not only of China but also of the entire Asian region will cool down. Moreover, Chinese domestic consumption is already showing signs of slowing down somewhat, as at least some markets are becoming increasingly saturated.
Finally, what disturbs me the most is that every magazine or paper I open has some favorable comments about China's economic development and China's positive impact on commodity prices, and that there has been widespread speculation in just about any stock that has something to do with China. Just consider the three Nasdaq listed internet companies, Net Ease, Sohu and Sina which are all up over 2000% from their lows a year ago and combine all that speculators can dream of - high tech, telecommunication and China.
Regarding commodities, I continue to believe that we are at the beginning of a multi year bull market. In other words, after the more than 20 years old bear market, commodity prices have, in my opinion made secular lows and will rise considerably more in the years to come. However, the commodity theme has become rather popular and a meaningful setback would not come as a surprise to me. Prices for industrial commodities such as Steel, Alumina, and Nickel have exploded on the upside, while cotton has doubled over the last twelve months and is now at a five-year high. And while it is possible that the current first leg within a long-term bull market in commodities may have some further upside potential, investors should fully realize that "China and commodities" have become a very well known and popular theme among the investment community!
I concede that I could be wrong about the coming slowdown in Chinese growth. In this case commodity prices will rise further in the next six to twelve months. If, however, commodity prices continue to roar ahead, then the likelihood of accelerating inflation rates around the world is very high unless companies are prepared to accept lower margins as a result of rising material costs. And if inflation should accelerate, higher interest rates will begin to weight on equity markets and contain the current bull market.
In the meantime the investment case for Asia remains intact, although stock markets may be near term very overbought. Thailand is up by 85% over the last 12 months and Indonesia by 113%, albeit from an extremely depressed level. The worst performing markets over the last twelve months are the Philippines - up 22.1%, Singapore - up 23.3% and Malaysia - up 24.6%, all markets we still like on a relative basis. In the case of Indonesia and Thailand, I would wait, as in the case for commodities, for a correction to unfold before making major new commitments. In fact, I believe that emerging markets -following their superb performance over the last twelve months - are due for a significant correction, as the US stock market looks increasingly vulnerable.
The problem I have is that I don't find many bargains today anywhere, except maybe among precious metals, which are partly commodities and partly the only really "hard currencies", whose supply cannot be increased meaningfully. Platinum prices are at a 23-year high. Thus, it is entirely possible that also gold and silver will fly to the upside in the next two years.