The Swanger Series – China: Part 2

China’s demand for new property is likely down and out.

This analysis provides some more detail to “Part 1” of this article, and the conclusion that Australian investors that want to avoid a sudden slowdown in China’s residential property development sector in particular, need to adopt the principles of the “Short China Portfolio”, namely:

1. Shift out of mining, particularly iron ore, copper, and other base metal asset (both equity and bonds) positions; and
2. Shift/stay out of any assets heavily exposed to the health of the Chinese economy overall.

The latter conclusion is due to the sheer size of the Chinese residential property development market. This market’s economic output was around 50% larger than the whole of the Australian economy over the past few years.

Part 1 of this analysis concluded that investors wanting to avoid a sudden slowdown in this market not only needed to avoid Chinese stocks and assets per se, but also avoid significant parts of the Australian economy given the very heavy reliance that our economy, particularly in some states, have on continued growth in China.

Demand for Chinese residential property is down.

Let’s start from the start. Not all data is truthful, as we know. Ironically, some of the data from China is actually brutally honest, more so than from many other parts of the world, but only if you know where to look.

When it comes to the demand for new housing, we use mortgage finance data as a more truthful indicator of demand than figures like the number of empty homes, which tends to be far more subject to embellishment.

This mortgage data is not pretty and shows a once-in-a-lifetime drop in demand for new housing. As shown below, the demand for new property loans grew steadily and conventionally (the black bars show demand for conventional property mortgage finance) until late 2016, and then thanks to more speculative, off-balance-sheet property loans (the pink bars), continued growing until 2019. Demand started to peak with non-balance sheet funding being curbed by Beijing from 2019 but stayed relatively flat until 2021.

Then the property development failures, such as Evergrande, started in late 2021 and were made much worse by the default of the country’s largest property development, Country Garden this year. This created a sudden drop in demand for new housing thanks to social contagion risk, namely that once news of these corporate failures became mainstream, demand for new homes fell.

By late 2023, normal mortgage finance had all but ceased and even “other” property-related loans were negligible. Demand for property finance had gone backwards for the first time in 10 years of very strong growth.

And out for the next decade

Worse still, we believe that the recent gains in iron ore prices have little to do with fundamental demand, and more to do with traders betting that China will aim its stimulus at these other sectors, or even steel production directly. Again, this is hope, not investing, and not something that we support. We are looking for more fundamental indicators of demand from the Chinese economy, and just not seeing these indicators yet.

So, then the real question for Australian investors is what happens to the Australian economy if China experiences a Japan-style economic correction, and which Australian or other global investments will suffer the most.

Japan’s eventual and sharp correction was commonly linked to its property market. However, the impact of their property correction and Japan’s inability to recover also came from the longer-term demographic headwinds. Japan had simply run out of population growth as fuel for its phenomenal economic growth. That meant that once the (easier) productivity gains had been achieved, Japan had to be globally competitive or have enough population growth to sustain some or all of its economic growth. This productivity in turn means globally competitive in terms of both technology and access to capital, which they simply did not have. China has been heavily investing in such capacities, and while they have made gains that Japan did not by their lost decade, it is hard to argue that China has done enough yet.

Japan’s demographic headwinds started in the 1980s and the population started to fall from 2009. Japan has fallen from 28% of Australia’s exports at their 1991 peak to 10% in the 2020 low. China’s population growth also peaked in the 1980s, and its population peaked in 2021, now sliding slowly backwards. China’s population is a massive 1.4 billion people, so they are not going to disappear as a global force any time soon, but the tailwinds of population growth have been lost.

China’s headwinds now are eerily similar to those of Japan. Yes, China has the advantage of learning from Japan’s mistakes. And yes, China has shown the value of a well-managed centrally controlled economy (again, this paper is about investing, not human rights). China has outpaced Japan in terms of technology and capital market growth.

But there is something very inevitable about productivity, population growth and economic growth that China knew it had to address eventually. Japan had around half the 65+ population of Australia in the 1950s but overtook Australia in 1983. China will pass Australia in around 5 years. The impact of low migration (negative in China’s case) and a low birth rate will eventually drag China in Japan’s direction. The only question for investors is whether they are or might be compensated for this additional risk.

Manage your actual China risk; don’t stick your head in the sand.

Hearing about bad news from China and ignoring it is the investment version of sticking one’s head in the sand. You are very unlikely to own Chinese assets directly e.g. Chinese shares. But, if the Chinese economy does slide into its own version of Japan’s “lost decade”, there is no doubt that certain Australian assets will suffer more than others, particularly the heavily export-exposed the WA, Qld and SA economies.

This “Short China” portfolio principle applies to all investors eg if you love Australian banks, you are not being paid to take the nuanced risk that a poorly diversified book of assets heavily concentrated in states with a higher-than-average exposure to China’s economic health (avoid BoQ bonds unless they are paying 0.5% to 0.75%pa more, for example).

Avoiding China does not mean just selling your Chinese domiciled assets. For investors, this means either accepting the risk of a Chinese slowdown will have an impact. Or it means allocating away from the sectors of the Australian economy that will be most impacted. This approach means keeping the same sort of returns overall but shifting risk away from China and towards the rest of the world.

This is the approach taken in the “Short China Portfolio” strategy. Part 1 showed five examples of Corporate Bonds that suit this strategy. Five more are shown below.

This is a broad-based portfolio strategy, and as such has a large number of potential assets that are suitable for executing the strategy. The final area that has not been covered by this paper is the use of foreign currency denominated assets to execute this strategy. Part 3 of this paper covers just that point. 

* 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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