What China's 'rebalancing' will mean for Chinese equities

This is my first China Finance post on TradingFloor.com.  I have been writing a blog called “China Finance” for nearly two years, and I will keep this blog along similar lines. With the help of some of the resources kindly provided by Saxo Bank I will attempt to make the posts a bit more actionable, and with more tie-ins to potential investment opportunities. I will be discussing Chinese equities, both broadly with industry trends and some macroanalysis, and narrowly by  focusing on individual equities where something of interest has occurred.

'Rebalancing" is the word of the moment in China.  The basic idea is to take the Chinese economy from being investment-driven to consumer-driven and everyone seems to agree it is necessary.

Yet no one knows when the central government will start the necessary work to make it happen. They certainly haven’t started it yet, as witnessed by their recent double down on infrastructure investments to the tune of  USD 158 billion. 

This round of investment can only work to buy time for the Chinese government, however. They will have to rebalance at some point, and when they do the companies that benefited from this investment round will be the ones who hurt the most.

That means first and most obvious companies in peril from 'rebalancing' the ones heavily tied to infrastructure investment.

Construction companies could suffer

Zoomlion (HKSE: 1157.HK) is a prime example of this type of company. They are in the construction machine and cement business and as such they are heavily tied to continued government investment in these areas. It's quite difficult to see where their demand will come from once a rebalancing starts. They have also been a slew of reports alleging aggressive accounting practices and far-too-loose credit terms at Zoolion. So the downside risk here is not only that sales might plummet, there’s also significant risk that the historical figures will need some drastic adjustments.

A slightly less-talked-about industry that could also be in trouble is the Chinese banking sector. Already plagued by issues of bad debt portfolios following policy-driven loans in previous infrastructure pushes, the sector is facing some tough challenges - and this latest infrastructure push certainly won’t make things much better.

The rebalancing is likely to add to Zoolion's troubles as it will likely signal the end of their supply of artificially cheap capital. That capital was made cheap partly as a result of the current cap on interest rates on savings. As the government looks to increase the spending power of the population these caps will likely disappear, or at the very least be set significantly higher.

The nightmare scenario from the banks point of view would be to be burdened with this increase in capital cost at the same time as having to cope with the bad debt they accumulated during the investment drives of the past. Overall, this is not a situation that will have an easy fixes.  And the temptations among politicians to force more policy driven loans to “ease the transition” could exacerbate the problem.

Good news for smartphone makers

While rebalancing is bad news for infrastructure companies, it's good news for companies that serve consumers. I believe the current consumer growth markets in China are likely to pick up speed and value in an economy rebalancing away from investment. In other words, I don’t think people will buy different things: I believe more people will buy the same things. Among the real winners in a rebalancing, I think, will be cheap smartphones and other low-price high-spec technology offerings.

As purchasing power among the poorer Chinese increases, the first step into modern society will likely remain the smartphone, as it offers most of the benefits in a price range that will be accessible. Chinese smartphone companies also have the added benefit of a potentially huge export market to other developing nations, something that is seldom priced into Chinese equities.

The leader in this field is the yet-to-be listed Xiaomi, which could be the first successful Chinese IPO in a long time when it decides to hit the market. But until then we do have some other players who are looking interesting.

Having recently come away from an onslaught of short reports, Qihoo 360 Technology Co Ltd (NYSE: QIHU) is a relatively new player in this field but seem determined to break into the market. The potential issue might be their incredibly vocal CEO, who keeps causing controversy by publicly arguing with Xiaomi’s CEO and alienating important partners like Huawei, which manufactures Qihoo's phones.

Another interesting player in cheap high-spec tech could be Tencent (HKSE: 0700.HK), which recently launched a connected TV at a very low price point. Tencent appear to be on something of an empire-building spree as they are using parts of their huge cash reserve to enter new markets from news to hardware. If they can get traction from their cheap Internet TV offering, the next logical step is to expand into more areas of affordable tech.

The market seems to be quite bullish on these two stocks in general, but I think it’s well warranted given the potential upside these and other consumer companies could see from a rebalancing of the Chinese economy.

Conclusions

While the latest batch of infrastructure investments might delay the rebalancing need of the Chinese economy, they cannot change the fact that rebalancing is the future. If anything it’s likely to create more issues with increased bad policy loans as a result.

A rebalancing in China, while undoubtedly painful, does not mean there will not be good investment opportunities in the country. But many companies that have traditionally done well in China will struggle with the decrease in government investment.

Consumer goods should be better off during a rebalancing, and especially cheap high-spec technology, where Chinese companies could look to leverage the lead they are building up not just in China, but in other markets as well.

-------

I will write regularly about Chinese equities, mainly those listed on foreign exchanges. If you'd like to comment on this story or be notified by email whenever a new China Finance story is published, become a member - it's free, and you can use your Twitter, Facebook, Google or LinkedIn login - and "follow" the China Finance blog during the signup process. You can also bookmark the China Finance blog page.