China’s ‘DOW’ Is Down 30%…and No One Cares

US stocks rose overnight, with all three major indices rising between 0.7% and 0.85%.

US crude oil was the big mover, up 3%. That’s largely thanks to hurricane season causing havoc in the Gulf of Mexico. As a result, the energy sector was the best performer in the S&P 500.

But the action right now is not in the US…it’s in China. I wrote about this last week. I mentioned Chinese property developer Evergrande and its looming default.

This week, you’ve got more evidence that the stresses in property markets are not isolated events. Based on data released yesterday, China’s economy is slowing sharply. From The Wall Street Journal:

Retail sales, a key gauge of China’s consumption, rose just 2.5% in August from a year earlier, down sharply from July’s 8.5% year-over-year growth, according to data released Wednesday by China’s National Bureau of Statistics. The result marked the lowest pace of growth in a year and missed by a large margin the 6.3% increase expected by economists polled by The Wall Street Journal.

Separate data released Wednesday by the statistics bureau showed home sales by value falling 19.7% in August from a year ago, the largest drop since April 2020—at the height of the pandemic.

Real-estate investment in the first eight months of the year, meantime, increased 10.9% year over year, slowing from a 12.7% gain in the January-July period. Construction starts, as measured by floor area, dropped 3.2% in the January-August period, accelerating from a 0.9% year-over-year decline in the first seven months of the year.

There are a few things going on here. China was the first to recover from the effects of COVID…and now it’s the first economy to show visible signs of slowing. As in slowing a little too sharply.

You can see this most obviously in the price of iron ore. Since the May peak, it’s fallen around 50%. BHP’s share price is off 26% from its peak, Rio is down around 23%, while Fortescue has declined 33%.

In my view, there is a lot more pain to come in the years ahead. For once, I think the government is right. They are budgeting for US$55 iron ore prices next year. Given the price is still around US$120, that’s falls of more than 50% still to come.

The problem for Australia is that at the same time as Chinese demand weakens via reduced activity in the property sector (and curbs on steel output), Brazil’s Vale is coming back into the market. By the end of 2022, it plans to produce 400 million tonnes per annum, up from 300 million tonnes over the past few years.

Before the tailings dam disaster in January 2019, Vale was the world’s largest producer, at 385 million tonnes per annum.

The short story is that iron ore prices are going back to where they came from.

We’ve seen this play out before. The first iron ore boom coincided with China’s first big property development boom, which got underway after 2008.

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As things started getting out of control, China tapped the breaks and ushered in a long bear market. From the February 2013 peak to the late 2015 low, iron ore prices fell a whopping 75%.

Expect something similar to play out this time around. Sure, there will be rallies from time to time (like when iron ore went from a low of US$110 in May 2013 to a peak of nearly US$140 in December), but over the next few years I expect the trend will be down.

On the demand side, China simply cannot afford to keep building property that no one wants. A twitter account called ‘The Last Bear Standing’ has followed the Evergrande story for some time now. Whether they’re right or not in their conclusions, I don’t know.

But they do post some good data on the problems in the sector.

A recent thread suggested that these property developers are hiding losses via a build up of ‘inventories’. A tweet reads:

Inventory includes land bank, work in progress construction and completed inventory. While we can quibble about how much of this is “legitimate”, In EG’s case, the value of their inventory has proved to be zero. Recent reporting says land sale value is down 96% YoY in Sep.’

Evergrande has around US$220 billion in ‘inventory’. As it cannot monetise this inventory, the stated valuation is clearly incorrect. At what price this inventory would clear is uncertain. But what is certain is that it would reveal a company with current liabilities well in excess of current assets (inventory is a current asset on the balance sheet).

That is, it would reveal a company in bankruptcy.

It’s not just Evergrande either. This is a potential problem for many companies in the sector.

What’s interesting so far is that broader global markets haven’t worried about this too much.

Nor has China’s Shanghai Composite Index. It’s back near multiyear highs. Concerns over a regulatory crackdown (of which property is just one sector) seem to have disappeared. Or at least, there are no worries about contagion.

The Shanghai Composite represents around 1,500 companies. Perhaps you could say that it’s more a reflection of China’s broader domestic economy.

The regulatory crackdown, on the other hand, appears to be aimed at keeping Big Tech companies in check and stopping property developers from destabilising the housing market.

But the Hang Seng China Enterprises Index gives you a much better view of the damage caused by China’s regulatory crackdown. This is the old ‘H-Share’ Index, where Chinese companies listed in Hong Kong to get access to foreign capital.

The index contains 50 stocks, representing China’s tech stocks, banks, insurance companies, and property developers. It’s like China’s DOW. And as you can see below, it doesn’t look at all healthy. In fact, prices are approaching the March 2020 panic lows:

China's DOW

Source: Optuma

[Click to open in a new window]

After peaking in March, it’s down a whopping 30%.

So far, the rest of the world is treating this is an isolated event.

The question is, for how long?


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Greg Canavan,
Editor, The Rum Rebellion

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