By Antares Equities
In October, we made a research trip to China. We visited three cities - Beijing, Shanghai and Tangshan - and met a wide range of companies. We wanted to assess the improvement in the economy and its implications for Australian resource stocks.
We focussed on the four sectors that together account for most of China’s total steel demand: property, infrastructure, machinery and cars. These sectors matter for Australian resource stocks because they generate demand for steel’s major input: iron ore.
Our findings suggest the recent improvement in steel demand may continue and the iron ore price is likely to move higher in coming months, which bodes well for Australian resource companies. The main risk to China’s recovery is the property market.
Infrastructure has been an area of strength recently, as the central government is very active in promoting projects. In particular, the government is now favouring Public Private Partnerships (PPP) to fund projects, rather than bank debt. This is definitely more sustainable and puts less pressure on the vulnerable financial system. The third batch of official PPP projects was released in October 2016 and, as Chart 1 shows, is larger in both value and number of projects than batches 1 and 2 combined. The government favours these projects as they provide significant employment while helping to build much needed infrastructure such as roads, rail, airports and water treatment facilities.
Chart 1: Chinese PPP are increasing by value and number
Source: Citigroup, October 2016
To put the scale of the projects into context, the three large construction companies we visited collectively employ more than three million people and consume more than 130m tonnes of steel each year (Australia only consumes around 10m tonnes each year!). These companies confirmed that their order books have been significantly impacted by PPP projects, many of which have a three to five year time horizon. This gives us confidence that the economic recovery has some longevity.
And a new funding source has emerged in China that didn’t exist even two years ago – the consumer. Demand from consumers to invest in PPP projects has grown significantly as these projects tend to deliver an attractive return of 6-8% over several years. This may mark a turning point in the long decline of private fixed investment in China. It’s a favourable development for the Chinese economy, as it creates more funding sources and lessens the reliance on debt.
Both the car and machinery manufacturing industries have improved significantly in 2016. Car sales are currently up 30% year-on-year, while sales of excavators (widely used in the construction industry) are up 70% year-on-year. There are similar trends for consumer products such as air conditioners and whitegoods.
Companies we spoke to in these manufacturing industries were generally positive on the outlook for demand and had solid order books.
While the property market has generally done well over the past year, there has been some easing in both sales and prices more recently (see Chart 2). Will the market stabilise or are we in the early stages of a more significant property downturn?
Chart 2: Residential property sales in China
Source: Bloomberg, October 2016
The main concern for the property market is recent government policy changes that could potentially be destabilising. To try to slow the residential property market, the government implemented home purchase restrictions in 21 large to mid-sized cities at the start of October. These include limits on the number of houses that can be owned, higher deposit requirements, limits on the number of houses that can be bought by non-residents and, in some cities, several years’ proof of tax or social insurance payments to be eligible to purchase a home.
A slowdown in the rapid rate of property price growth would affect steel consumption. So the real risk for the iron ore market and Australian resource stocks is that sentiment towards the property market turns negative due to these policy moves, undermining confidence in the sector. While it’s too early to assess the impact of these new restrictions, we’re watching the market closely.
Antares models China’s steel demand as part of our research into Australian resource companies. We’ve now updated our model to reflect our more positive view on the infrastructure, machinery and auto sectors while being aware of the risks in the property market. Our model now suggests around 1.5% growth for 2016 and a similar figure for 2017.
Our visit to China has made us more optimistic on the growth environment and enabled our Chinese steel demand projections to remain above consensus levels. If realised, this stronger steel demand should improve the outlook for iron ore prices going into 2017, suggesting the recent iron ore price improvement may have further to run. This is clearly positive for some of Australia's major mining stocks.
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