Consumer Not Immune As Downturn Intensifies

BMI View: The Chinese economy is likely to enter recession over the coming months if it is not already there. The profit squeeze across the entire economy is intensifying as borrowing costs rise, and consumer-focussed industries will not be spared. High household savings rates by no means suggest that consumer demand will remain unscathed as a negative feedback loop of weakening growth and declining asset prices ensues.

If we look at a broad range of indicators within China it is abundantly clear that China's economy is entering recession if it is not already there. Industrial profits continue to decline as margins are being squeezed; rail freight transport volumes are falling; imports and exports are contracting in nominal terms; oil import values are falling; the manufacturing PMI is below 50 and has been for the past two months (using an average of the official and the HSBC indices).

When we look at other indicators around the region, such as Taiwanese manufacturing PMI, the collapse in industrial metals prices, and the contraction in Hong Kong container throughput, it certainly appears as though the much-talked about hard landing is here

Oil Imports And Rail Freight Volumes In Contraction
China - Oil Import Volumes And Rail Freight Volumes, % chg y-o-y (6mma)

BMI View: The Chinese economy is likely to enter recession over the coming months if it is not already there. The profit squeeze across the entire economy is intensifying as borrowing costs rise, and consumer-focussed industries will not be spared. High household savings rates by no means suggest that consumer demand will remain unscathed as a negative feedback loop of weakening growth and declining asset prices ensues.

If we look at a broad range of indicators within China it is abundantly clear that China's economy is entering recession if it is not already there. Industrial profits continue to decline as margins are being squeezed; rail freight transport volumes are falling; imports and exports are contracting in nominal terms; oil import values are falling; the manufacturing PMI is below 50 and has been for the past two months (using an average of the official and the HSBC indices).

Oil Imports And Rail Freight Volumes In Contraction
China - Oil Import Volumes And Rail Freight Volumes, % chg y-o-y (6mma)

When we look at other indicators around the region, such as Taiwanese manufacturing PMI, the collapse in industrial metals prices, and the contraction in Hong Kong container throughput, it certainly appears as though the much-talked about hard landing is here

First Trade Drop Since Global Financial Crisis
China - Total Trade Values (Imports Plus Exports), % chg y-o-y

Profit Squeeze Intensifying, Capex Cuts On The Way

We are also seeing a major profit margin squeeze across the entire economy, combined with a decline in earnings quality, which suggests that further profit declines are to come (cashflows as a share of profits continue to fall suggesting receivables are building). The increase in interest rates facing business resulting from the ongoing credit crunch is adding insult to injury. This should lead to a sharp decline in capital spending as companies struggle to recover their cashflows.

Beijing's reform measures, while positive for the long-term, are also likely to exacerbate the near-term weakness. We have started to see the government withdraw support for companies previously benefitting from implicit backing (the solar and steel industries for example). This will further undermine capex as companies that had previously been running perpetual losses look to shore up their balance sheets in a hurry to avoid bankruptcy. The production of consumer goods will not be spared as the downturn intensifies and unemployment rates rise.

Narrowing Margins
China - Sales And Earnings, Shanghai Industrials Index Components, CNYbn

SMEs Feeling The Pinch From Higher Borrowing Costs

Although interbank rates have declined recently, bank funding costs remain elevated and this is something that is unlikely to change any time soon, in spite of the monetary easing that we expect to come before year end. Anecdotal evidence suggests that small and medium sized enterprises (SMEs) are already feeling the squeeze from higher borrowing costs and are likely to adjust their spending plans down as this persists. As SMEs are more heavily involved in consumer goods production than the investment-focussed state owned enterprises (SOEs), this will further exacerbate the consumer downturn. While not conclusive evidence, the underperformance of the HSBC PMI (which is more heavily weighted towards SMEs) versus the official index, suggests that small producers are feeling the pinch the hardest. When economies go through investment busts, as we believe China is in the process of doing, consumption spending inevitably becomes part of the collateral damage.

PMI Indices Suggest SME Weakness
China - Purchasing Managers' Indices, HSBC Vs Official

Negative Feedback Loop Still Yet To Come

We have previously written about the likelihood of a negative feedback loop taking place, whereby weakening economic activity leads to declining home prices. The resulting bank losses cause credit to become increasingly scarce, which further weakens property prices and further weighs on consumer confidence and economic activity. This is still very much a core view. The spike in funding costs seen in June is likely to be just a precursor to a more systemic and far-reaching drying up of credit that is set to result from the lending boom.

A High Savings Rate Will Not Save The Consumer In The Near Term

If China's GDP by expenditure figures are any gauge, China has undergone a huge consumer boom over recent years. Despite consumption's share of GDP continually falling, it has still managed to grow at an average annual rate of 16% in US dollar terms over the past decade. The consumer story doesn't end there though. From a GDP by expenditure perspective, housing construction is considered as investment. However, it is perhaps more accurate to consider housing as a consumer good (houses are unproductive assets). If we consider housing purchases as consumption, the Chinese private consumption growth rate has been even higher. One only has to look at the sales of luxury goods companies selling into China in recent years to see how the consumer has fared.

Consumer Boom In The Rear-View Mirror
China - Real And Nominal Private Consumption Growth, % chg y-o-y

While it is true that Chinese households save a large portion of their income (estimates put the household savings rate in excess of 20%), this by no means suggests there is a pool of savings waiting to be deployed in the purchase of consumer goods.

Three Reasons Why Household Savings Might Not Be What They Seem

  • Chinese households' savings have been channelled into rather unproductive pursuits over recent years. Savings are only valuable insofar as their ability to generate wealth. If resources are misallocated, little real wealth is created (imagine for instance a household that has all its savings in wealth management products, which are then defaulted on).

  • China's household savings are tied up in the property market to a large extent. Chinese households regard property as a store of wealth, and while this has been the case in the past, it may not be going forward.

  • China's FX reserves are also considered to be a major supporting factor for the Chinese economy, protecting against economic downturns. However, China's official reserves are just one part of the international investment position, which is actually relatively modest and declining relative to GDP. A strong reserve position simply guards against excessive currency weakness, which would otherwise further undermine consumption. So while this is a positive, it is by no means a panacea.

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This article is tagged to:
Sector: Country Risk
Geography: China, China, China, China
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