China growth to slow

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The Chinese economy is now dealing with the legacy of a decade of credit-fuelled infrastructure development, which leaves it with an enormous debt burden and substantial amounts of misallocated capital. Going forward, this legacy will, in our view, result in much lower growth and a much more difficult domestic economic agenda.

From the ‘Minsky moment’ comments made by China’s central bank governor, through to the cancellation of several massive infrastructure projects and the crackdown on shadow banking, there have been a number of tangible signals to suggest that the Chinese authorities are no longer prepared to ignore the economic risks that have accompanied several years of unbridled credit expansion.

Against a backdrop of rising trade tensions, the economic implications of this are clearly not positive for China, nor for the rest of the world. Over the last eighteen months, we’ve seen a significant decline in fixed asset investment growth, a steady slowdown in retail sales growth and the lowest level of money supply growth since records began in 1996. Meanwhile, it is estimated that there are more than 65 million empty properties in China, which is equivalent to half of the entire US housing stock.

Policy has been loosened slightly in response, which has been enough to prompt a rapid but speculative stock market recovery. Official economic data appears to have stabilised in recent months, but other, less malleable data points (such as China car sales as an indicator of domestic demand, and industrial production in other Asian economies that are dependent on Chinese growth) provide a better reflection of what is really happening and the numbers remain troubling.

Notwithstanding the recent modest stimulus, China’s long-term structural economic problems remain daunting. Policymakers seem to have acknowledged that they no longer have the firepower to sustain an artificially high growth rate supported by excessive credit expansion. China’s leadership remains intent on reducing debt as part of its longer-term objectives, but one thing is clear from economic and financial history – there is no such thing as a painless deleveraging.

Whichever way China turns now, looks likely to result in either intentional or inadvertent renminbi weakness, which will consequently turn a domestic deflationary problem into a global phenomenon.

Neil's view

An interesting article in the FT today, highlighting the extent of stimulus in China, increasing evidence of policy change and widespread complacency about global growth
20 February 2018

More worrying signs about data integrity and growth in China

Read full article12 January 2018

The winds of change in China also threaten the consensus view that the outlook for global growth is benign and almost trouble free. There was a conspicuous absence of an economic growth target in Xi Xinping’s opening congress address and the remarks made by China’s central bank governor about an approaching ‘Minsky moment’ for a Chinese banking system that has been creating credit at an alarming and increasingly ineffective rate for years are also important. Meanwhile, a number of billion-dollar infrastructure projects have been cancelled and initiatives to tighten Chinese financial regulation have been introduced. All of this points to the inevitability of slower growth from the Chinese economy as it faces up to its massive bad debt problem and exports deflation to the rest of the world via its currency.

Read full blog21 December 2017

The die has already been cast by the credit explosion. It will all be about how Chinese policymakers will manage the downside. But there is no such thing as a painless deleveraging.

Read full article1 November 2017

Joining all the dots here, we are concerned that rampant Chinese credit growth has leaked into commodity markets through some inappropriate infrastructure investment and unprecedented amounts of financial speculation. This has inflated commodity prices to levels that are not justified by fundamentals. This represents a gigantic misallocation of capital and we know from centuries of economic history that episodes like this do not end well. This is why we say that the Chinese credit growth theme that has played out in markets carries considerable risk. We are not prepared to take these risks with our investors’ capital – nor do we believe that we need to in order to deliver attractive long-term returns.

Read full blog15 September 2017

The unsustainable debt burden in China represents a considerable risk

Source: Minack Advisors, Woodford

With the Chinese economy showing signs of a slowdown, the unsustainable debt burden represents a considerable risk. Equity markets have appeared complacent to these risks but we have positioned the funds with them firmly in mind.

Slower credit expansion does not bode well for China's economic activity next year

Source: Capital Economics, Woodford

China’s rapid debt growth by sector

Source: MacroStrategy, Woodford

Chinese money supply growth already slowing

Source: Bloomberg, Woodford

Estimated extent of bad debt problem as % of GDP

Source: MacroStrategy, Woodford

China's Staggering Demand For Commodities

More than half of the world's steel, cement, coal and copper is consumed by China.

Cement

59%

Aluminium

47%

Nickel

56%

Coal

50%

Population

19%

Copper

50%

Steel

50%

Gold

27%

Oil

14%

Economy (GDP)

15%

Rice

31%

Pork

47%

Corn

23%

Cotton

33%

Source and inspiration: Visual Capitalist

How the funds will benefit

The most obvious route back into financial markets here is via a lower contribution to global growth from China and indeed Asia more broadly. This is not priced in. A further market impact should arrive through commodity prices, which will not greet the absence of demand growth from China favourably. Indeed, if the Chinese authorities crack down further on regulation to curb financial speculation on commodities, amongst other things, then the impact on commodity prices could be significant.

The funds have actively avoided exposure to parts of the market that are vulnerable to the slowdown that we expect to see in the Chinese economy.

LF Woodford Equity Income Fund (as at 31 October 2019)

Geographical allocation
Country Fund (%)
United Kingdom 81.95
United States 11.28
Luxembourg 3.76
Switzerland 1.50
Ireland 0.75
Norway 0.75
Sector allocation
Industry Fund (%) Benchmark (%)
Cash and near cash 100.00 0.00
Total 100.00 100.00

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