Investors Need to Protect Portfolios Against Real Estate Problems in China

Data from China has not inspired confidence over the past few months.   It was reported on Wednesday that non-performing loans were on the rise and that situation could get worse before it gets better.  Real estate, which some viewed as a ticking time bomb in China, looks like it is getting closer to blow up.  In addition, China has excess capacity in areas like steel where it has over invested and essentially destroyed capital.

Chinese declining growth is note new over the past few months, but it is time every day investor’s look at ways to play it as part of their portfolio and protect against it. If nothing else, shorting China helps hedge the rest of an investor’s portfolio.  China is the largest risk to global GDP growth for 2014 and 2015.

A Real Estate Collapse is the Biggest Threat

A real estate collapse is the biggest immediate threat to the Chinese economy.  While shadow banking, local government debt, and overcapacity are all issues, there are ways the government can likely push back these crisis.  The government does have levers to pull in real estate, but the size of the sector, depth of problem, and need to rapidly reverse its cooling off policy in certain cities are all challenges.

Real estate accounts for a significant portion of investment in China and was 16% of GDP in 2013.  Prices are declining in about half the cities in China.  This discourages new investment, decreases wealth for many families who purchases second homes as a low-risk investment in lieu of savings, and can lead to an increase in loan defaults.

The system in most Chinese cities was dependent upon ongoing migration to the cities.  The number of new builds started to outpace newly arriving workers.  Prices have also pushed many potential buyers out of the market.  In addition, the government has adopted polices to cool off the housing market in many of these cities.  This has caused inventories to build and new investment to drop.

All this said, demand and prices in Shanghai, Shenzhen, and Beijing have continued to increase.  Demand is stronger in the tier one cities, but it may not be enough to offset demand from the rest of China.  As we saw with the US, not all markets were impacted to the same level but all were impacted in the real estate crisis.

The weakening investment in real estate is already spilling into other sectors.  Sectors like construction equipment are of course being hit, excavator sales were down 22% y/y in April.  The problem is also impacting the steel industry and basic materials due to lower demand.    Commodities like copper are taking a hit since housing is a key end market.

Local governments also finance infrastructure projects, the other key area for investment in China, largely through land sales.  A weak real estate market makes selling land tough.  There are other options to finance these projects.   The sale of longer term bonds which are not currently used by municipalities in China or the sale of other state owned assets can replace this source of funding.

Ideas to Play Weakness in Chinese Real Estate

There are different ways to play weakness in China.  First, you could short direct plays like property giant China Vanke (HKG: 1036) or other real estate companies.  Also, using an ETF like iShares FTSE/Xinhua China 25 Index (NYSE: FXI) is a direct China play.  That underlying index has broad sector exposure to the Chinese market.  There are other China ETFs as well.

Construction machinery is another sector that is impacted.  Negative demand is already hitting Chinese firms like Sany Heavy Equipment (HKG: 0631), Lonking Holdings (HKG: 3339), and Zoomlion Heavy Industries (HKG: 1157).  These companies make, bulldozers, cranes, and excavators all used in construction.  Demand was not strong before the turn in real estate and now it is worse.  All these companies lack significant exposure outside of China.

There are other firms to watch as well in construction equipment.  While China makes up a smaller portion of sales, the Japanese companies like Komatsu (NYSE: KMTUY) have a high degree of Chinese construction exposure.  In addition, U.S. firms like Caterpillar (NYSE: CAT) have something to lose.

Perhaps the most at risk group are the commodity plays.  Iron ore miners would get hit by the fall in demand and prices that would follow.   Cliffs Natural Resources (NYSE: CLF) and Vale (NYSE: VALE) are the two with the largest exposure to changes in iron ore prices.

Copper is another big risk since China is essentially the marginal buyer and seller of copper.  Weakness in copper demand in China would cause its purchases to fall but could also lead to it selling off inventories and pushing prices even lower.  Companies with heavy copper exposure include Freeport McMoRan Copper and Gold (NYSE: FCX), Rio Tinto (NYSE: RTP) and BHP Billiton (NYSE: BHP).  The latter two have broad exposure to commodities and Freeport is the most direct copper play

Conclusion

The outcome in China and its real estate market is anything but certain.  The government could engineer a soft landing through policy shifts.  However, the risk of a collapse is there and it could impact global growth in a significant way.  Shorting a China ETF or finding exposure another way could provide some hedge against the declines in stocks around the world that would result from a collapse in China.