What are the prospects for China's steel and lithium industries?

China is Australia’s largest trading partner, so any significant changes in the Chinese economy can have big impacts on Australia’s economy, share markets and the wellbeing of everyday Australians. In this podcast Jason Guthrie chats to IML Portfolio Manager Daniel Moore after his return from a research trip to China. They discuss:

• How China’s economy is performing, including on-the-ground feedback
• The recent Chinese stimulus and potential future stimulus
• The ramifications of a second Donald Trump US Presidency
• The Chinese property market
• Chinese steel and lithium industries

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Lightly edited transcript

Podcast recorded on Friday, 15 November.

Jason Guthrie: Hello, and welcome to Navigating the Noise, a podcast by Natixis Investment Managers Australia, where we bring you insights from our global collective of experts to help you make better investment decisions. I’m your host, Jason Guthrie, and today I’m joined by Daniel Moore, portfolio manager at IML. Now, Dan is a regular on these podcasts. He has over 20 years in markets, 14 of those actually at IML, being one of Australia’s longest-standing Australian equity fund managers.

Now, been really looking forward to the conversation today. It’s very timely given the recent US election and a lot of the noise in the markets specifically in relation to China. Now, Dan has actually just returned from mainland China as part of a research trip where I believe he met with a number of companies, management teams, and government officials. Dan, great to have you back on the podcast today.

Daniel Moore: Thanks, Jase. Always a pleasure.

Jason: So, Dan, welcome home. Just back from the research trip – a very interesting time given the recent Chinese stimulus announcements and so much talk around these tariffs given the US election results and a Trump win. Before we maybe get into some of the highlights, it’s been a while since I’ve been back in China. Can you give us a rundown of your trip? How did you actually find things on the ground there and what’s the general mood like on the street?

Daniel: Yeah, of course. No, happy to do so, Jase. It was five days in China across three cities, Beijing, Nanjing, and Shanghai. We had over 20 meetings with all sorts of companies, government officials, did some site visits of some lithium mines and refineries. So, covered a broad spectrum of the economy.

Just, I guess, things I noticed on the street. I mean, I haven’t been to China for a couple of years now, and one thing that was really noticeable was the air quality was so much better than it was last time I went there. Even in Beijing-

Jason: That’s a bit of a surprise.

Daniel: Even in Beijing, blue skies, the air quality was as good as Australia. I was really surprised. And the streets were incredibly clean. I thought I was in Japan or Singapore. I know China’s got these social scoring things they like to measure and they’ve got cameras in and around the streets, and they’re obviously working. It was just every city I went to was very clean.

I noticed lots of electric cars on the road, lots of Chinese brands I’ve never heard of. But I would say the economy felt soft in general. We did a lot of lunch meetings and dinner meetings with different companies and government officials, and most restaurants were completely empty, which was just quite bizarre. So, people are obviously not spending as much money. The hotel rooms were really cheap, significantly cheaper than Australia. So, I definitely got a sense on the ground the economy was pretty weak, but saying that, people were a bit optimistic about the local economy from the stimulus that’s been announced by the government.

Jason: And what do you think they’re actually trying to achieve? So, you spent some time with a number of officials, you said, government officials. What are the main implications from the stimulus that they’ve announced given the softer economy?

Daniel: You have to remember China is a centralised economy, and when the government says they want the economy to grow at 5%, they really mean it. So, what happened was the economy was growing roughly 5% in the first and second quarter of this calendar year, and then in the third quarter it dipped below 5%, and in October it was weakening further, so it was roughly 4.8%, and the government literally decided that’s too slow and the trajectory was negative and they needed to announce stimulus to get it back towards 5%. And they’re pretty adamant about achieving 5% growth next year as well.

And so, the stimulus they have announced is really focused on getting that growth rate back up to five. It’s a bit different to the stimulus they’ve done in the past. The stimulus in the past, particularly around the GFC, and in 2015-16, they were really sort of big bazooka-style stimulus plans where they announced $100 billion packages for infrastructure and shanty town redevelopments for property. It’s not like that. The stimulus they’ve announced is much more incremental and much more focused on the consumer and stabilising property prices, which have been falling, particularly outside of Tier 1 cities have been falling quite aggressively.

Jason: Maybe talking through property a little bit, obviously quite well-publicised around the demographics and particularly the debt problems in Chinese property. Can you give us a sense of the situation there and how do you see things playing out over the short to medium term in property specifically?

Daniel: Yeah. We spent a lot of time talking to people about property. We spoke to some local property experts. It’s not good is the short answer. They’ve built far too much property. There’s roughly two years of completed inventory apartments that is unsold and there’s multiples of that of uncompleted inventory. And demand is just not there, and property prices have been falling a lot. Property prices outside the Tier 1, Tier 2 cities are back to 2015 levels. So, they’ve almost wiped out 10 years of gains.

And that means from an Australian perspective, property starts are very weak. Property starts are down roughly 70% over the past couple of years because there’s too much inventory. And that is unlikely to change in terms of property starts are not going to recover in the next year or two, just because that inventory needs to get worked through. And the Chinese government’s well aware of this, and that’s why the stimulus … is different (to) the past. The stimulus is not about stimulating new property starts, they don’t want to because they know they have too much inventory. The stimulus is much more focused on trying to stabilise property prices. So, they’re trying to buy this excess inventory off developers and they’re also just trying to stimulate the consumer and get a bit of confidence back in asset markets. And so, that’s not particularly steel-intensive, from an Australian resource perspective, that the stimulus measures are not particularly helpful for your BHPs, et cetera.

Jason: Thanks, Dan. So, you probably knew this one was coming, but I think you were actually in China during the US election and the results. How does a Trump victory change things for China, you think? I was looking at some of the numbers earlier, there’s a huge percentage of their exports that obviously go through to the US in comparison to say here in Australia. I know it’s all, I guess, speculation at this point, but what was the feedback from your meetings around the tariffs and the impact on China?

Daniel: Yeah. So, they obviously worry about it. It’s something that they’re planning for, they were expecting tariffs to go up, it didn’t matter who was going to win. The rough estimates, if Trump does go through with the 60% tariffs on Chinese exports, the impact on GDP, the analysis with the people I spoke to was roughly 2% of GDP, which is pretty significant.

It’s a question whether Trump actually does the tariffs 60%, but if he did, the current stimulus measures won’t be enough to offset that. So, the feedback was if that occurred, it’s quite likely the government would have to be much more aggressive with the stimulus, which I would characterise as very incremental at the moment. So, perversely from an Australian resource perspective, the current stimulus is nothing to get excited about. But if Trump announces 60% tariffs, that could lead to stimulus that is more steel intensive. That’s where you get the more bazooka-style stimulus measures because they need to do very significant stimulus to keep growth in the economy.

So, I imagine if Trump does announce 60% tariffs, resource stocks will get hit pretty hard because people worry about the Chinese economy. But perversely, that could be a buying opportunity because that will be much more likely to result in steel-intensive stimulus measures.

Jason: Diving specifically into some of those meetings you had around steel mills and resources in particular, how are they actually tracking today?

Daniel: Yeah. Right now it’s pretty weak. The steel mills, I met with three including Baowu Steel, and they said profitability is the worst on record for the steel industry. Third quarter was the worst quarter industry profitability in their history. Domestic demand is weak and they’re having to increasingly export steel. And the problem with that is now there’s a number of anti-dumping cases being pushed to a number of the countries they’re exporting to. I think there’s four underway in their major export destinations.

So, the outlook is exports might be under pressure next year, so they expect steel demand to be down next year. And currently, the stimulus measures aren’t really leading to domestic steel growth. So, it’s pretty weak at the moment. And despite that, I was expecting capacity cuts for the sector to be on the agenda, but I was surprised that’s not the case. And it’s this perverse reason where a lot of the steel mills are owned in JV with local government authorities, and despite the steel mills losing money, they contribute to GDP and local employment, and so, they will not shut them down. The only reason steel mills will get shut down is if the central government tells them to, and the meetings I had with government officials, that’s not going to happen. Well, at least not over the next 12 months. So, steel profitability looks like it’s going to be weak for at least another year.

Jason: Sure. So, maybe on one of the hot topics and lithium you mentioned earlier, there’s a lot of electric cars on the road there, very clean skies, which is positive to hear. I know you travelled west from the big cities, Beijing and Shanghai, to meet with a number of management teams, and you did some site visits I believe, to lithium mines and some of the refineries. What are your thoughts on lithium at the moment and how are some of our more successful Aussie companies positioned?

Daniel: Yeah. Obviously, lithium company share prices have fallen quite a lot over the past year, and I was really interested if this was a potential buying opportunity, whether we’d see investment get pulled back, we’d see lithium refineries and mines get shut down because of poor profitability. And unfortunately, it wasn’t the case. Almost every lithium company I met was growing, continuing to invest, making substantial investments in mines and particularly refineries. And they’re investing heavily in Zimbabwe and South America as well.

There was only one company I met that had shut down a high-cost refinery. The others had no plans to shut down any production. In fact, they were growing productions. I met two or three companies that were growing production 3 X (times) over the next two years. And their costs have been coming down significantly. The refinery operations are very impressive in China, they can build a refinery and have it ramped up within 18 months, which is several years ahead of anybody’s been able to achieve in Australia. They’re just years ahead of their competition in the refining space.

In the actual lithium mines themselves, so think spodumene or lepidolites, there is a little bit more tightness than there was probably six months ago, because they’ve been building probably more refineries compared to lithium mines. So, there’s potential for a short-term bounce in let’s say, spodumene prices. But there’s still a lot of capacity coming online over the next couple of years, particularly from Zimbabwe, which really surprised me how confident they were to invest in Zimbabwe.

Jason: So, in wrapping up, Dan, where do you think the opportunities are specifically probably in the resource space, given some of the insights you’ve been able to get over the last couple of weeks?

Daniel: Yeah. So, I think I’ll start with the more negative. I really don’t think investing long-term in companies with lithium refineries is a good idea. China is just … they can build these refineries at a third of the capital costs we can here in Australia, and their profit and return hurdles are just so much lower. And they’re continuing to expand. It’s a bit like the steel mill industry where they’ve just built so much capacity and they run at losses and they don’t shut capacity. So, lithium refineries, I’d avoid.

The lithium mines, I think it’s hard to get excited medium term, given all the investment that’s going on in Zimbabwe and South America. In the iron ore space, again, I think for now, I think we’re on the sidelines, but if we saw Trump announce some significant tariffs and the sector fell on that, that I think will present a buying opportunity given that will force the Chinese government’s hand to announce some really big steel-intensive, infrastructure-style stimulus. I think that’s the key takeaway for me.

Jason: Fantastic. Well, thank you, Dan. It’s been great to get a firsthand report into what’s happening on the ground there in China, and importantly how that might impact the future of some of our Australian companies in the portfolios here at IML.

So, thank you to our listeners. As always, we hope you enjoyed the conversation, and please be sure to follow our podcast on your favourite platform. And tune in again very soon to hear more from our global collective of experts.

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