China’s strategy is changing, investors need to prepare
Sinclair Currie, Principal and Co-Portfolio Manager
The rapid industrialisation of China has played a significant role in shaping the current universe of Australian Small Companies. China is now a super power and its’ policies have a broad impact. The 19th National Congress of China’s Communist party held late in 2017 provided insight into the party’s strategic vision for Chinese society and its economy and outlined some evolution in priorities. There is now growing evidence that this evolution has fundamental implications which we believe have altered the outlook for many companies and industries within the small company universe. In this investor update we review some of the changes.
Changing priorities in China has shifted fundamentals before and will do so again
In the 1990’s Australian share investors faced a remarkably different set of investment opportunities. At the time companies such as Sunbeam Victa, Email and Southcorp manufactured whitegoods and appliances in Australia, Newcastle hosted steelworks and four car manufacturers supported numerous ASX listed suppliers. Chinese industry, supported by pro-growth policy, competitive labour costs and vast investment, has now displaced much of this capacity. Many Australian companies were unable to compete and now outsource production to Chinese suppliers. Similarly investors are now conditioned to expect China’s colossal manufacturing sector to supply seemingly limitless capacity – which has kept prices low and competition fierce.
The upheaval and change experienced by Australian industry can be traced back to a development strategy devised by Deng Xiaoping four decades ago. We believe that it is highly significant that having held broadly consistent for so long, these policies were expanded upon in October last year by Xi Jinping (‘Socialism with Chinese Characteristics for a New Era’). The policies pursued under Deng Xiaoping’s original strategy were a significant factor underlying the changed face of Australia’s economy. Given contemporary China’s power and weight we believe Xi Jinping’s recent update will rapidly and persistently resonate across our investment opportunities.
So what has changed and what do we think the implications are?
The speech made by Xi Jinping to the national party congress outlined fourteen priorities for the ‘new era’. The scope of the speech was broad, so rather than provide a commentary on the societal, geopolitical and macroeconomic implications, we will try to focus on the priorities which we see having an impact on Australian small companies. Specifically we think that shifting the development model, driving living standards higher and protecting the environment are all initiatives which have ramifications for Australian companies.
“ Adopting a new vision for development “
The speech highlighted the importance of allowing market forces to determine resource allocation. It outlined an aspiration to prioritise quality (over quantity) and structurally reform the supply side. Specific goals associated with this are cutting overcapacity, reducing excess inventory, deleveraging and lowering costs. On the demand side it states a plan to
“….improve systems and mechanisms for stimulating consumer spending and leverage the fundamental role of consumption in promoting economic growth.”.
We believe the above aspirations have enormous implications for investors in Australian companies. Aggressive investment (often debt funded) in capacity has been a driver of China’s economic expansion resulting in persistent overcapacity. This is possibly best illustrated by observing the steel and aluminium industries where overcapacity has depressed the profitability of firms globally. Moves to cut overcapacity in these industries should be keenly watched by investors as it signals potential for improved returns. We believe this will have the greatest impact on the basic materials sectors (steel, chemicals, cement et cetera). Importantly there are already signs that China is acting on these ambitions with reports of improved corporate profitability, debt swaps and production curtailments. We would highlight a company like Simsmetal as being an ongoing beneficiary.
“Ensuring harmony between human and nature”
The policy statement also explicitly calls for the implementation of ‘…the strictest possible systems for environmental protection’. Pollution is a major issue for China. Industrialisation has seen the nation host industries which incur heavy environmental liabilities and detriment to air quality, water resources and numerous other environmental side effects. A focus on recognising environmental costs has already shifted the dynamics of industries within China and abroad. Evidence the steel industry – scrap metal prices and premiums for high grade iron ore have risen meaningfully as steel makers switched to higher quality inputs in order to reduce emissions.
China is the world’s largest coal producer and consumer. Xi Jinping’s ambition to drive a ‘revolution in energy production’ appears likely to require significant substitution away from coal into not only renewables but other sources (gas, nuclear). Unless China is able to find a way to fill its huge energy appetite with cleaner domestic resources / technologies it seems likely that it will need to look abroad for cleaner fuels. Australian energy companies with operations in China or exporting to China appear well positioned to benefit. Australian gas producers (Beach, Cooper Energy) and companies with Chinese energy assets (Sino Gas) appear well positioned to take advantage of this.
“Ensuring and improving living standards through development”
China is not content to be a low wage economy. It aspires to build its human capital and improve the standard of living broadly, which will require higher wages. A time may come when Australian companies have less to fear from low Chinese wages than from Chinese innovation. On the other side of the equation companies with supply chains heavily dependent on China should not assume low cost supply will be always be plentiful. We believe retailers, brand managers and wholesalers need to have strategies in place to secure the longer term competitiveness of their supply chains.
In conclusion
China’s economic development has been associated with huge changes in listed Australian small companies. Now China’s leaders have provided an update to the development blueprint which has prevailed for forty years. China is now a dominant global economic power and the prioritisation of quality, the environment, supply side reforms and living standards have already begun to shift investment fundamentals, moves which we expect will persist. We believe opportunities and threats will continue to emerge in the energy, heavy industrial and consumer segments.