Written By Basilio Chen

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The business cycle downturn in China is now turning into a potential secular downtrend.  The major correction expected is unwinding as we speak.  While China is now large enough to manage the downtrend, other emerging markets in Asia ex-Japan, will see significant impact.

China is still expected to be the bigger contributor to GDP growth in the world along with the USA.  However, China has now join the group of less worst, at least for the foreseeable near term.  In the macro world of economic status, we do have a global slow down and now China is included in it.

Profits are rapidly decelerating

China businesses and the economy is in structural slowdown not just slower GDP.  The profit margins is caving to the cost of debt excess and over capacity over an overall slowing global demand.

Slowing of the the GDP in China is a known theme by now, however, corporate profits are now becoming negative.  Industrial profits declined 8.8% year-over-year in August, while the GDP was reported to be growing at 6.9%.  Profits at the end is more important than sales and GDP.

Consumer Brick and Mortar Giving Way to e-Commerce and Value Added Services

Due to matured penetration on brick and mortars consumer business and the slowing of income across corporate and personal incomes, e-Commerce is the choice for cost savings and convenience.  The current slowdown sets up opportunities in the higher value-added services parts of the economy which have higher margins given lower profit margins. In particular, in the food safety, environmental services, and healthcare sectors.

Asia Chase The Wrong Rabbit

The masses are right at the wrong time! Emerging Economies Are Reshuffling.  Asia ex-Japan in specific positioned on the global economy focusing on China’s strength.  However, not having the size and scale of China, they now developing a systemic problem of enduring weaker growth, big deficits are building up and increasing political tensions is developing.  This is especially true in Indonesia, Thailand and Malaysia.

Size Matters

While all Asian economies ex-japan are highly leveraged in debt and excess – in a slowing global economy with a China slowing, the larger smaller and less sophisticated ones are highly exposed for debt reshuffling.  Corporate and personal credits are at an all times high through out Asia and the risk of a debt bubble contraction is very high now.

Secular Global Slowdown

At the heart of all analysis, the global recession is amongst us.  No matter China’s decades of miracle, with 1.4 billion population, the fact is that the world is much larger what China alone can do.  With all major economies USA, Europe, Russia, Japan and the middle east and smaller ones like Venezuela and Brazil, it become one country against the backdrop of all others.  This graph shows that exports and the general global trade is having major problems from an overextended growth since 1986.  It is now correcting in its own way.

 

 

Here follows some important details:

From the top down, China’s share in global exports  is 13 percent, it’s foreign exchange reserves is 30 percent of global total and the usage of its currency in global capital flows  is around 1-3 percent (still small).

 

The past fuel for growth has been foreign direct investment and the majority of it was into Fixed Assets.  However, Fixed Asset investment has been reduced nearly by nearly 66%.  Fixed Asset Investment has continuously and rapidly come down from its peak in 2009.

Because up until now, gross capital formation accounted for 46% of China’s GDP and as such it was the main driver for growth during the so called China Growth Miracle (from 2000-2011).

 

China’s economy slowing in the older part of the economy – exports and brick-n-mortar retail sales

There is practically no growth in Chinese exports which means profit loses due to high cost of fixed expenses.

 

Here is detailed view to specific areas, some bright ones, others declining including large ticket items like autos.

Consumer behavior is changing due to several reasons:

  • The recent anti-corruption initiatives,
  • A volatile stock market, and
  • Weakened RMB currency

All of these reasons works against consumer purchasing.  Now, prudence – and not excess – is back in fashion when it comes to consumer behavior.  This is especially true for high end products but is it also impacts general merchandise.

Upgrade and Replenish Patterns Versus New Buys is taking place

This graph shows merchandize purchased direct from factory versus in the secondary market.  It also represents further deterioration in domestic demand for factory fresh products.  This further affects factories that already do not have export demand, now have to cope with lack of internal demand.

 

Worst of all, profits are negative. 

The lower GDP growth has been constantly trending down toward 7%, however now profits are turning negative and beginning to erase past gains since 2009 with the peak of profits margins in 2007.

Lower GDP has been catching the headlines for over a year.  The real untold story and what should be told is that the economy and businesses in general are now losing money and prior marginally profitable businesses are now un-profitable.

 

Forecast for China – Continuing Downtrend in GDP Growth

Major forecasting indices point toward secular down trending GDP growth for China down to 6% by 2018. 

The positive part is that the economy is still growing larger compared to USA and Europe in percentage terms year-to-year.  Although, quality of growth has deteriorated into low or non-profit growth.

 

The RMB appreciation to Euro and other major currencies makes Chinese products more expensive

This year, Euro had 2 devaluations with direct consequences to RMB getting over valued in relative terms.  This had the effect of making product and services from China 5-10% more expensive and a disproportionate 30% loss in competitive advantage by China to its rivals.

We would expect the RMB to be readjusted in value over the next 12-18 months.  This chart shows that China’s RMB has gotten consistently more expensive while other major currencies value has been lowered.  This includes USA, Euro, Japanese Yen.

 

Depreciation of other currencies can be expected

While there is a high likelihood China’s RMB would be devalued, there is also the possibility that other currencies will also be devalued.  This includes Euro and other commodity dependent country currencies like Australia and Canada.

In addition, Asian and South Asian countries that are suppliers and partners with China would also be affected by China’s economic slowdown.

 

China is spending its saved reserves

Up to 2011, China’s increased capital from a combination of profits, government revenues, and foreign investments, are beginning to see increasing negative outflows.  A small part of that are counter-directional investment as Chinese are beginning to invest abroad.  The is a growing amount out of the reserves used for non-productive purposes.

How long will the downturn last

Downturns in the emerging economies has average 91 months (according to studies by Bloomberg, MSCI and KKR).

Based on this, the minimum expected time left is 28 months from this writing (2 years and 4 months).

Where to invest in China

In general terms, primary industries are to be avoided: mining, real estate and particularly manufacturing heavy ones.  The Services industries remain attractive due to its higher margin and less dependence on exports and heavy capital burden.

 

Given all the implications of a slower economy, there remains a single clear investment industry in China.  Pollution control and cleaning.