Strategy & economics
Part 1: Trip to the (smoggy) epicentre of the commodity downfall
Days 1-3: Beijing, Qingdao and Shenyang
China has dominated the headlines in recent months – for the wrong reasons.
On 24 August this year, investors’ concerns about the health of China’s economy triggered one of the sharpest one-day falls that global markets have experienced for many years.
These fears were not unfounded. During the third quarter, Chinese economic growth stood at 6.9%, the lowest level recorded since 2009. Some commentators are concerned that if you look beyond the official figures, economic growth could be even lower.
Following the events over the Autumn and Summer, I took a trip to China to explore sentiment in the region and to hear the views of company management teams across a variety of sectors, especially on industrial commodity. I was surprised by the honesty and bearish tones of many of the teams that I met with.
In Shenyang, a key industrial city of 9.5 million people, I was greeted by smog inside the airport! It turns out you can even find it indoors there! A very negative picture was painted during meetings with two large coal producers. They expect overcapacity in the industry to persist for another two to three years.
In the same city, I met one of the largest state-owned enterprise (SOE) steel production companies, alongside a private steel producer. Once again, I was shocked by the honesty of the management teams. I thought they would have painted a rosier picture for overseas investors but instead spoke of substantial excess supply, which they anticipate will take a long time to clear.
In their view, government policies are not helping at all. Even the decision to accelerate infrastructure projects will not provide a solution because these projects are likely to take at least three years to complete, with only marginal benefit.
There was a marked contrast in tone between the private and SOE steel producers. The latter is loss-making but isn’t motivated to do much about it. The company is unlikely to lay off staff and bank credit remains available for it. It is anticipated that production will fall, but not aggressively, as maintaining market share is more of a priority. In contrast, the private producer is at least making efforts to counter the headwinds it faces.
On the plus side, sentiment in China’s property sector has improved in comparison to last year. However in Shenyang, where GDP growth and demographics are at the bottom of the national rank, I saw lots of construction taking place but was told by the tour guide that the sites are unlikely to be fully occupied.
On to Qingdao, a major seaport and industrial centre on the east coast of China. Here I met with port operator, specialist steel and railway companies.
At the port operator, they noted a substantial fall in bulk imports. Due to the poor iron ore outlook off the back of falling prices, mills are now holding as few days of inventories as possible. Companies also face stricter rules if they want to pledge copper as collateral, which has consequences for financing.
I could see signs of credit strain amongst commodity producers as a result of payment dates being lengthened from 60 to 80 days.
Meanwhile in China's steel industry, the strategy of specialist steel SOEs appears to be to take out smaller players from the market. They don't need to worry about financing and losses due to their SOE status. This also prohibits them from cutting production significantly as it will reflect negatively on the financial statement.
Most mines (up to 90% from what we heard) are loss-making and it is estimated that it will take three years to cleanse overcapacity.
I found the comments of one Chief Financial Officer that I met with particularly interesting; he suggested that the government could resolve overcapacity in the sector by simply paying excess workers to leave the industry.
Steel companies are seeking to diversify and progress up the value chain. This is easier for SOEs because smaller businesses will struggle to access the capital needed.
Following these meetings, and in anticipation of an interest rate rise in the US, I would expect steel prices to continue to fall in 2016.
Fortunately, it isn’t all bad news from China. The biggest combined railway SOE, comprising China’s Southern and Northern railway companies, noted the support of ongoing infrastructure investment.
Railway technology is on a par with Germany and Japan, whilst prices are highly competitive as a result of government support. The speed at which they are testing at the laboratory is more than 600km per hour, so the railway companies are definitely moving up the production value chain.
Unfortunately, my visit to China coincided with the coal heating season, which creates an unbelievable amount of smog. For the cynics out there, this could resonate with the gloomy outlook for the region. Visibility is missing.
My visit to China concludes with trips to Jinan and Shanghai – the final stage of my journey will follow…
Janet Mui, CFA is the global economist at Cazenove Capital, the wealth management division of Schroders. Janet is responsible for the formulation and communication of Cazenove’s top-down views. She is a member of the investment committee that oversees strategic and tactical asset allocation at Cazenove. Janet is also the macro spokesperson and a regular commentator at major media outlets including the BBC, Bloomberg and CNBC.
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