China’s property sector has shifted into reverse:
How are you positioned?
Australia is the most China-dependent country in the OECD. Exports to China now make up a whopping 36% of our total exports. 74% of China’s demand for Australian exports relates to iron ore and the largest component of this demand comes from China’s new home development[1].
What’s worse is that any downturn in residential property in China will hit the consumer sector particularly hard. Residential property accounted for around 60% of household wealth in China in 2020, compared to around 50% in advanced economies[2]. As consumer confidence is required for China’s growth prospects to be fully realised, any downturn in residential property values risks a GFC-like outcome for China.
What is the real risk of a GFC-like or Lost Decade-like slowdown in China?
The trade statistics above should overturn any argument that Australia will somehow escape a real downturn in demand for new Chinese property. Yet Australian researchers and the media, while trying to highlight the issue, have diluted its message by using emotive headlines with terms like “Ghost Cities”. The issue of oversupply is limited to so-called Tier 3 cities, but this oversupply is severe, and these Tier 3 cities comprise around 60% of household wealth in China [3], with a particularly high exposure to residential property.
As is our promise, we have gone beyond the emotive headlines and looked at the investment fundamentals. We use this to come up with an investment thesis, ie what to do with your portfolio to respond to such a risk.
Let’s start with the data. The below chart comprises property loan data, both mortgages and non-mortgage loans (the blue and the orange bars), and investment in new property (the grey line). Two key themes emerge from this:
1. Property lending and the quality of loans have fallen sharply
The blue bars below represent mortgage lending (higher quality) and the orange bars represent “other property loans”. In other words, any switch from blue to orange represents diminishing quality. FY17 saw an initial fall in the quality of these loans, but it recovered following a policy boost from the central government. Demand for property loans then ended abruptly in FY21 with the collapse of Evergrande, China’s second-largest developer.
2. Property Development has also fallen sharply
Property development’s contribution to overall GDP growth in China peaked in FY17 at around 17%. The policy change in that year reversed a temporary decline, but the collapse of Evergrande and then Country Garden has seen investment in new property fall and pull the overall economy down for the past 12 months at least.
Demand for new property loans and investment has fallen sharply.
Conclusion: China’s Lost Decade Risk
China’s property sector has run too hot for too long and is now putting the entire growth story beyond the control of Beijing. In short, we believe that China now faces a very real risk of having its own version of Japan’s “lost decade”. This has very significant implications for parts of the Australian economy and investment markets.
We find that iron ore pricing in particularly has already moved from being fundamentally priced to being priced on hopes of policy change. While new sources of demand for steel including that for electric cars could one day replace the property sector, it is our view is that that forecast is based hope, not investment fundamentals. So, unless a new growth engine is found quickly, an economic crisis[4] is brewing in China and the property sector defaults seen recently are just the beginning of this crisis.
Investors are not being sufficiently compensated for the uncertainty that China can recover. In our view, it is really that simple.
The impact on Australian assets
The implications of this conclusion go beyond the mining sector itself. China’s property development sector added around US$2.2 trillion (2021). This makes China’s residential property sector larger than the total production of the Australian economy (at US$1.6 trillion in 2021). A small slowdown in China’s property development equates to a relatively large reduction in wealth for Australians. But that impact on wealth is narrowly felt in Australia, both on the way up and on the way down. The position that investors take now will determine which side of this split they will be.
If you don’t agree with our conclusions here, you should increasingly be able to find assets undervalued by the market, particularly if that market turns on China. This is not a minor issue for the global economy, so whichever direction it eventually moves, the move will be material.
If you need more information on this analysis, Part 2 of this series goes into the sector-based research in more detail; and Part 3 looks at the currency market implications.
An example portfolio for the “Short China Strategy”
The “Short China Portfolio” is a portfolio for people who want to remove China risk from their portfolios. This is not just China-domiciled assets themselves like a conventional “short” portfolio, but removing other major China-linked risks that Australian investors typically face such as Australian assets that will suffer should China suffer a lost decade like Japan.
A shift from equities to corporate bonds is a natural hedge against a Chinese slowdown as any perceived slowdown in China will have an outsized negative impact on Australian equities.
The purpose of the below corporate bond examples is to show the line between assets exposed to a Chinese slowdown and those not materially exposed at all.
[1] Approximately 35-40% of demand for iron ore comes from new housing development.
[2] RBA, 2020
[3] See IMF 2022 Paper, “A Tale of Tier 3 Cities”, for example
[4] The IMF has described the Chinese property sector downturn as a crisis, despite the political backlash that comes with such a term.
Corporate Bond examples that suit this strategy^
* Yields for floating rate notes are a guide only. Returns are subject to movements in BBSW over the life of the issue.
** Yields for Tier 1 and Subordinated Debt (Tier 2) are priced to the call date.
*** Returns and pricing shown are indicative and reflect wholesale market pricing plus Income Asset Management’s bid/offer spread
Craig Swanger,
Chief Investment Officer, IAM
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