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Outlook for China & Commodities Daniel Rohr, CFA Director, Basic Materials [email protected] ©2015 Morningstar, Inc. All rights reserved. Key takeaways 3 Long-term outlook We expect GDP growth of no better than 5% over the next 5 to 10 years. 12 Short-term outlook GDP is already growing at roughly 5%. 16 Beijing’s big choices: Stimulus? Reforms? Stimulus would make matters worse. Much-needed reforms will be painful and risky. 23 Equity market rescue The cure is worse than the cold. 29 Currency devaluation Beijing has the motives and means to prevent a sharp devaluation. 39 Global implications of a weaker China How the infection spreads 42 Commodities outlook China ended the last dark age for commodities. It might begin the next one. 2 Long-term outlook We expect GDP growth of no better than 5% over the next 5 to 10 years. 3 Balanced growth of 80s and 90s gave way to investment-led growth in the 00s… 300% GDP Consumption Investment Cumulative real growth 250% 200% 150% 100% 50% 0% 1981-1990 Source: National Bureau of Statistics, CEIC, Morningstar 4 1991-2000 2001-2010 …resulting in growing imbalances. Consumption 100% 90% Investment Government Net exports 14% 2% 3% 15% 15% 38% 39% 6% 14% 3% 14% 80% GDP composition 70% 35% 60% 43% 46% 50% 40% 30% 51% 46% 20% 43% 37% 38% 2006-2010 2014 10% 0% 1981-1990 1991-2000 Source: National Bureau of Statistics, CEIC, Morningstar 5 2001-2005 China’s investment share of GDP is nearly twice the average for its income level. Other countries 55% China 50% Investment share of GDP 45% 40% 35% 30% 25% 20% 15% 10% 0 10,000 20,000 30,000 GDP per capita (PPP) Source: World Bank, Morningstar 6 40,000 50,000 60,000 Excess capacity Diminishing Returns Bad Debt Rebalancing Household Non-financial corporations Financial Government 300 250 Debt to GDP 200 150 100 50 0 1999 2000 2001 Source: McKinsey Global Institute 7 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Russia India Brazil US China’s investment boom outstrips all precedents. China (98-14) Japan (62-81) Korea (84-03) Taiwan (69-88) 50% Investment share of GDP(%) 45% 40% 35% 30% 25% 20% 15% 1 2 3 4 5 6 7 Source: National Bureau of Statistics, CEIC, World Bank, Morningstar 8 8 9 10 11 Years 12 13 14 15 16 17 18 19 20 A “typical” post-boom decade would see China average 4.7% GDP growth… "Typical" post boom Boom Our forecast Boom Post boom Post boom Boom 14.0% 12.0% 12.0% 12.0% 12.0% 10.0% 10.0% 10.0% 10.0% 8.0% 8.0% 8.0% 8.0% Taiwan 14.0% Korea 14.0% Japan China Boom 14.0% 6.0% 6.0% 6.0% 4.0% 4.0% 4.0% 4.0% 2.0% 2.0% 2.0% 2.0% 0.0% 0.0% 0.0% GDP Consumption Investment GDP Consumption Source: National Bureau of Statistics, CEIC, World Bank, Morningstar 9 Investment Post boom 6.0% 0.0% GDP Consumption Investment GDP Consumption Investment …but bigger booms tend to end in bigger busts. Taiwan 8.0% GDP growth in reblaancing 7.0% 6.0% China (our outlook) Japan 5.0% Malaysia Korea 4.0% Thailand 3.0% 2.0% 1.0% 0.0% 25% China (implied) 27% 29% 31% 33% 35% 37% Avg investment share of GDP in boom Source: National Bureau of Statistics, CEIC, World Bank, Morningstar 10 39% 41% 43% 45% Attaining 5% GDP growth in the years to come will require significant reforms. Consumption Investment Government Net exports 16% This is our outlook for average growth to 2022, not a year-by-year forecast. Our outlook is predicated on significant reforms to bolster consumption and improve investment quality. 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Note: Outlook assumes 1.5% investment growth, 7% household consumption growth, 7.5% government consumption growth, and 2% net export growth. Source: National Bureau of Statistics, CEIC, Morningstar 11 2021 2022 Short-term outlook GDP is already growing at roughly 5%. 12 We estimate 1H2015 GDP growth at 4.5%. Consumption (household & govt) Investment Net exports 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Official Note: We estimate 1% investment growth (official: 5.2%) and 7.3% consumption growth (official: 8.2%). Source: National Bureau of Statistics, CEIC, Morningstar 13 Our estimate Cement & steel volumes cast doubt on official investment growth rate. Steel production Cement production Investment (GCF) 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% 2000-2014 CAGR Source: National Bureau of Statistics, CEIC, Morningstar 14 1H2015 Consumption has also slowed more than government figures suggest. Official retail sales growth 1H2015 12.0% Value-added tax 1H2015 10.0% Production growth 1H2015 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% Retail sales (nominal) Retail sales (real) VAT Source: National Bureau of Statistics, CEIC, Morningstar 15 Automobiles Refrigerators Air Conditioners Washing Machines Instant Noodles Beer Soft drinks Cigarettes Beijing’s big choices: Stimulus? Reforms? Stimulus would make matters worse. Much-needed reforms will be painful and risky. 16 Many argue China has “room” to stimulate, citing low inflation. CPI CPI ex. Food and Energy 110.0 108.0 106.0 104.0 102.0 100.0 98.0 96.0 94.0 92.0 90.0 Source: National Bureau of Statistics, CEIC, Morningstar 17 PPI More cuts to reserve requirement ratio (RRR) and benchmark rates are likely… RRR RRR(large banks) Benchmark lending rate (1 yr) RRR(small banks) 24 7.0 22 6.0 20 5.0 18 4.0 16 3.0 14 2.0 12 1.0 10 0.0 Source: People's Bank of China, CEIC, Morningstar 18 Benchmark deposit rate (1 yr) …but the PBoC can’t “push on a string” Loan demand - manufacturing 80.0 Banking Climate Index 75.0 70.0 65.0 60.0 55.0 50.0 45.0 Source: People's Bank of China, CEIC, Morningstar 19 Loan demand - non-manufacturing Falling prices reflect a surfeit of supply, not a shortage of demand Steel production (kt) Excess capacity (kt) Capacity utilization 1,400,000 Thermal power capacity (MWh) 100% Average utilization (hours) 1,000,000 95% 900,000 90% 800,000 7,000 6,000 1,200,000 1,000,000 85% 80% 800,000 75% 5,000 700,000 600,000 4,000 500,000 3,000 400,000 600,000 70% 300,000 2,000 65% 400,000 200,000 Source: China Electricity Council, China Iron and Steel Association, CEIC, Morningstar 20 2014 2015M8 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 50% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 0 1999 0 0 1998 55% 1,000 100,000 1997 200,000 1996 60% Stimulus is a shot of whiskey to cure a hangover. Stimulus Overinvestment Excess supply & Diminishing returns Bad debt accumulates Prices fall & Economy slows 21 Reforms will be necessary, but painful. Example: Credit Status quo ► SOEs and local governments receive preferential credit access. Costs of the status quo ► SOEs and local governments are largely responsible for China’s overinvestment and inefficient capital allocation. ► As long as they carry Beijing’s implicit backing, they will continue to receive preferential credit access. ► Excess capacity and bad debt will continue to build. Benefits of reform ► Allocating credit according to market principles would eliminate the wealth transfer that hinders household consumption and starves private enterprise of capital. Risks of reform ► Removing ► Credit 22 implicit backing would require a major SOE or local government default. would be re-priced on a massive scale. Equity market rescue The cure is worse than the cold. 23 Stock market rout didn't pose a major threat to consumer spending. Real Chinese household financial assets, December 2013 13.0 12.5 12.0 9% 11.5 Retail sales growth Bank deposits 12% Cash Stocks 1% Bonds 8% Insurance Other 7% 63% 11.0 10.5 10.0 9.5 9.0 8.5 8.0 Source: People's Bank of China, National Bureau of Statistics, CEIC, Morningstar 24 Nominal Nominal retail sales decelerated throughout bull market of June 2014 to June 2015. Nor did it hamper corporate access to capital. 70,000 New TSF, YTD June 2015 60,000 50,000 40,000 30,000 20,000 10,000 0 RMB loans Foreign currency loans Source: People's Bank of China, CEIC, Morningstar 25 Entrusted loans Trust loans Undiscounted bankers acceptances Corporate bonds Equity issuance Panicked government intervention failed to prop up shares June 12 Peak 5,166 Shanghai Stock Exchange Composite 6,000 July 8 Intervention 3,507 Sept 30 3,053 5,000 4,000 3,000 2,000 1,000 0 Source: Shanghai Stock Exchange, CEIC, Morningstar 26 China’s equity markets are cheap at a glance, but less so upon further examination Shanghai SEP/E 30.0x Shanghai SEP/Eby sector, Aug 2015 100.0x 90.0x 25.0x 80.0x 70.0x 60.0x 20.0x 50.0x 40.0x 15.0x 30.0x 20.0x 10.0x 10.0x 0.0x 5.0x 0.0x Source: Shanghai Stock Exchange, CEIC, Morningstar 27 Weighted avg 15.8x Financials 7.9x Consequences of Beijing’s failed intervention 1. Intervention casts doubt on key reforms. ► ► 2. Real reform of China's credit and currency markets, which are far larger and more important to the real economy than the stock market, looks increasingly doubtful. Failure to implement key reforms heightens the risk of a debt crisis and diminishes the economy's long-term growth trajectory ► 3. Questionable commitment to President Xi’s pledge to cede a "decisive role" to the market Reforms will be critical if China is to address mounting structural problems and transition to a more sustainable consumption-oriented growth model. Failure to halt the rout risks denting party’s credibility as an economic steward. ► Confidence in the party's ability to manage the economy is partly self-fulfilling. ► So, too, would be a loss of confidence. ► 28 Faltering faith in the government's ability to "deliver" economic growth would have serious realworld implications, including tighter credit, reduced investment, and greater market volatility. Currency devaluation Beijing has the motives and means to prevent a sharp devaluation. 29 30 Source: Bank for International Settlements, CEIC, Morningstar 07-2015 05-2015 03-2015 01-2015 11-2014 09-2014 07-2014 05-2014 03-2014 Japan 01-2014 11-2013 09-2013 India 07-2013 05-2013 03-2013 01-2013 Euro area 11-2012 09-2012 07-2012 05-2012 Brazil 03-2012 01-2012 11-2011 Australia 09-2011 07-2011 05-2011 03-2011 China 01-2011 11-2010 09-2010 07-2010 05-2010 03-2010 01-2010 REER, 2010=100 RMB had strengthened dramatically in real effective terms since 2010 140 United States 130 120 110 100 90 80 70 60 PPP-based analysis suggests RMB could be 30% overvalued. All other countries China Expon. (All other countries) 1.2 1.1 PPP conversion factor 1 0.9 Overvalued vs. USD 0.8 0.7 0.6 0.5 0.4 Undervalued vs. USD 0.3 0.2 1,000 10,000 Log GDP per capita (current int'l $) Source: World Bank, Morningstar 31 Following initial devaluation, PBoC reestablished a de facto peg at 6.40. Onshore OTCdiscount to official fix (%) Offshore discount to fix (%) 3.0% PBoC cuts official fix to 6.23 from 6.12 PBoC says it will take cues from OTC market when setting fix PBoC begins to intervene in onshore OTC market to prop up RMB PBoC and state-owned banks begin to intervene in offshore market 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% 7/1/2014 8/1/2014 9/1/2014 10/1/2014 11/1/2014 12/1/2014 1/1/2015 2/1/2015 3/1/2015 4/1/2015 5/1/2015 6/1/2015 7/1/2015 8/1/2015 9/1/2015 Source: China Foreign Exchange Trading Center, CEIC, Morningstar 32 Beijing is unlikely to ignite a currency war in a bid to stimulate exports. Beijing refrained from devaluing in financial crisis despite net exports being nearly 8% of GDP in 2008. Net export share of GDP(left) USDCNY(right) 10.0% 8.00 9.0% 7.50 8.0% Net exports are now less than 3% of Chinese GDP. 7.00 7.0% 6.50 6.0% 5.0% 6.00 4.0% 5.50 3.0% 5.00 2.0% 4.50 1.0% Source: China Foreign Exchange Trading Center, CEIC, Morningstar 33 10/1/2014 7/1/2014 4/1/2014 1/1/2014 10/1/2013 7/1/2013 4/1/2013 1/1/2013 10/1/2012 7/1/2012 4/1/2012 1/1/2012 10/1/2011 7/1/2011 4/1/2011 1/1/2011 10/1/2010 7/1/2010 4/1/2010 1/1/2010 10/1/2009 7/1/2009 4/1/2009 1/1/2009 10/1/2008 7/1/2008 4/1/2008 1/1/2008 10/1/2007 7/1/2007 4/1/2007 4.00 1/1/2007 0.0% Beijing’s main motives suggest dramatic devaluation unlikely 1. RMB internationalization ► ► ► ► 34 Beijing wants greater share of global trade settled in RMB and more important role for RMB assets in global portfolios. Inclusion in IMF's Special Drawing Rights basket would be a major milestone and would require the RMB's value to be determined by market forces. Freer-floating RMB is a necessary step toward long-term goal of RMB internationalization. Significant (30%+) devaluation would be a major setback. Beijing’s main motives suggest dramatic devaluation unlikely (cont’d) 2. Curtail capital outflows ► Capital has been flowing out of China since summer 2014. 150 Net capital flows 100 ► ► ► Capital outflows undermine the PBoC's RRR cuts, which pump money into the economy. De facto dollar peg exacerbates capital outflows because it shortcircuits the pricing mechanism that normally rebalances capital flows. Beijing hopes modest devaluation will relieve pressure. A large devaluation would risk triggering significant outflows Source: People’s Bank of China, CEIC, Morningstar 35 50 0 USD billions ► -50 -100 -150 -200 -250 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 De-pegging could exacerbate capital outflows in the short term. ► Much will depend on market expectations regarding the pace and magnitude of future devaluation. ► If the market expects a fairly stable RMB, the incentive for capital flight wanes. ► If the market expects the RMB to weaken significantly, capital outflows would surge as investors look to get ahead of the move. ► Beijing is clearly aware of this risk, which is why: 1. PBoC took pains to assert that “there is no basis for persistent depreciation of RMB” 2. PBoC threatened to “severely punish illegal FX transactions…[to] maintain a compliant and orderly capital flow.“ 36 Defending the peg: Beijing’s reserves are massive on an absolute basis… Official reserve assets 4,500 4,000 3,500 USD billions 3,000 2,500 2,000 1,500 1,000 500 0 Source: People's Bank of China, CEIC, Morningstar 37 …but appear more modest relative to the IMF’s reserve adequacy guidelines. IMF’s adequacy guidelines assess reserves against: 1. Export income ► Reflects loss due to a drop in external demand or terms of trade shock. ► Target reserves: 10% of exports (fixed exchange rate) or 5% (floating) Broad money supply ► Captures residents’ capital flight from liquidation of domestic assets ► Target reserves: 10% or 5% of M2 3. Short-term debt ► Reflects debt rollover risks ► Target reserves: 30% of ST debt 4. Other liabilities ► Reflects other portfolio outflows (e.g., equity & LT debt) ► Target reserves: 20% or 15% of other liabilities Source: IMF, People's Bank of China, General Administration of Customs, CEIC, Morningstar 38 M2 STdebt Other liabilities Actual 3,500 3,000 USD billions 2. Exports 4,000 2,500 2,000 1,500 1,000 500 0 Adequate reserves (low) Adequate reserves (high) Actual reserves Global implications of a weaker China How the infection spreads 39 How the infection spreads Chinese economy slows Source: Morningstar 40 Exports to China fall Economy weakens Currency depreciates Capital flight Economy weakens Defaults on USD debt Economy weakens Top exporters to China Exports to China TTM July, billion USD as % GDP Korea 183 13.0% -7.3% Japan 153 3.3% -11.2% USA 152 0.9% -7.2% Taiwan 149 30.5% -3.7% Germany 97 2.5% -13.4% Australia 83 5.7% -25.8% Malaysia 54 16.7% -4.1% Brazil 44 1.9% -23.6% Switzerland 40 5.8% -4.1% Saudi Arabia 39 5.2% -34.2% Thailand 38 10.1% -3.6% Russia 36 2.0% -20.9% South Africa 35 10.0% -40.1% Singapore 30 9.6% -6.8% Canada 26 1.5% 5.6% France 26 0.9% -9.2% Vietnam 22 12.0% 22.1% Angola 22 16.7% -47.7% United Kingdom 22 0.7% -15.3% Philippines 21 7.2% -4.1% Indonesia 20 2.3% -27.4% Chile 20 7.7% -10.5% Iran 20 4.7% -42.5% Note: Red text denotes countries where GDP impact of falling exports to China exceeds 0.5%. Source: General Administration of Customs, World Bank, CEIC, Morningstar 41 % change YTD Commodities outlook China ended the last dark age for commodities. It might begin the next one. 42 From 1980 to 2000, global mined commodity demand grew less than 1% annually. 2000-2014 CAGR GDP: 2.5% Steel: 4.9% GDP Steel 300 1990-2000 CAGR GDP: 2.8% Steel: 0.9% 250 1980-1990 CAGR GDP: 3.2% Steel: 0.7% 200 150 100 Source: World Steel Association, World Bank, Morningstar 43 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 50 Metal prices are back at 1980 levels in real terms. 2000-2012 CAGR Base: 7.9% Precious: 12.9% Base metals & iron ore Precious metals 2012-2015 CAGR Base: -18.2% Precious: -13.0% 250 1980-1990 CAGR Base: -1.6% Precious: -7.9% 200 1990-2000 CAGR Base: -1.3% Precious: -2.2% 150 100 50 Index weights for base metals and iron ore: 27% Al, 38% Cu, 19% Fe, 2% Pb, 8% Ni, 2% Sn, 4% Zn Index weights for precious metals: 78% Au, 19% Ag, 3% Pt Source: World Bank, Morningstar 44 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 0 China ended a 20 year dark age for mined commodities. World with China World without China 8.0% 7.0% Demand CAGR, 2002-2012 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% Source: Various, World Bank, Morningstar 45 China now dominates global demand for most commodities. 2012 2002 50% 45% China share of global demand 40% 35% 30% 25% 20% 15% 10% 5% 0% Coal Aluminum Steel* (thermal) Source: Various, World Bank, Morningstar 46 Lead Copper Zinc Nickel GCF(PPP) Platinum Gold Potash PalladiumGDP(PPP) Oil Diamonds Uranium Iron ore | China’s steel demand has faltered amid the real estate downturn. Chinese steel demand drivers Chinese iron ore supply Wire 10.0% 5,000 4,500 5.2% 5.0% HRC CRC Iron ore (right axis) 160 140 4,000 120 0.2% -1.2% -0.1% -1.8% -5.0% RMB per tonne 0.0% -10.0% 3,000 2,500 2,000 100 80 60 1,500 -10.1% 40 1,000 -15.0% 500 -16.8% 0 -20.0% Floor space started Autos Ships Refrigerators Steel production Iron ore (domestic) Iron ore (imports) Source: National Bureau of Statistics, China Iron and Steel Association, CEIC, Morningstar 47 20 0 USD per tonne 3,500 Iron ore | China’s steel consumption has already peaked. 48 Iron ore | But China’s steel stock will continue to grow…. 49 Coal |Plunging Chinese import demand has dragged down seaborne prices. Chinese coal volume 2008-13 CAGR 2014 7M2015 60% 90 52% Chinese electricity production 50% 80 500 40% 70 60 20% 9% USD per tonne 20%18% 11% 9% 6% 4% 3% 0% 400 50 300 40 30 0% -1% -3% -5% -10% 200 Rotterdam Newcastle Richards Bay Indonesia China domestic (right axis) 20 -11% -20% 10 -30% 100 50 8/1/2015 7/1/2015 6/1/2015 5/1/2015 4/1/2015 3/1/2015 2/1/2015 1/1/2015 12/1/2014 11/1/2014 9/1/2014 Source: China Electricity Council, China National Bureau of Statistics, China General Administration of Customs, CEIC, Morningstar 10/1/2014 8/1/2014 7/1/2014 Imports 6/1/2014 Domestic 5/1/2014 All others 4/1/2014 Coal-fired 3/1/2014 Total 2/1/2014 -40% 0 1/1/2014 0 -34% RMB per tonne 30% 10% 600 Coal | China’s power demand will remain weak amid economic rebalancing. 51 Coal |Coal will continue to lose share in China amid low power demand growth. 52 Copper |Key copper end-markets have weakened in China. 3.80 20% Cu price USD/lb 2013 2014 2015 ytd 3.60 3.40 15% 3.20 10% 3.00 2.80 5% 2.60 2.40 0% 2.20 2.00 -5% Floor Space Under Construction Elec Transmission Source: CEIC, NBS, Morningstar 53 Auto production Copper |Chinese demand surged over the past decade, while falling elsewhere World ex China China Refined copper consumption (tonnes) 25,000,000 20,000,000 15,000,000 10,000,000 5,000,000 0 2000 2001 Source: ICSG, World Bank, Morningstar 54 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Copper |We expect Chinese demand growth to wane amid economic rebalancing 70 China 2013 Cu intensity of GDP 60 50 China 2000 40 30 20 10 0 10,000 20,000 30,000 GDP/capita Source: ICSG, World Bank, Morningstar 55 40,000 50,000 60,000 Uranium | Japan has begun to restart its nuclear reactors 56 Uranium | China’s reactor fleet will quadruple in size in 10 years 57 Uranium | Prices must rise to incentivize new supply 58 Uranium | Uranium is a second chance at the China growth story 59 Agriculture| China now eats more like a rich country than a poor one. 60 Agriculture | India’s caloric gains in the next decade will exceed China’s of the last decade. 61 Agriculture| Africa’s caloric intake will rise by nearly the total caloric intake of the US. 62 Agriculture | Crop yields must rise to meet Indian and African food demand. 63 Agriculture | Potash demand growth to 2025: 2.8% annually (2005-2015: 2.7%) 64