By Abraham Bailin
Through sustained rampant growth, China has forged itself a
place as an economic powerhouse in the international community.
Typifying this trend, the past 10 years saw annual real GDP growth
in China consistently range between roughly 9% and 14%. However,
few, if any, economies can sustain such growth forever. Today, we
believe China stands at the precipice of a major economic
A weak global economy has left the traditionally export-driven
nation without a reliable outlet for extrinsically driven growth.
The most recent additions to GDP have come from fixed-asset
investments, but it seems that those avenues, too, have been
exhausted. With the passage of the nation's 12th five-year economic
plan, the shift toward a consumer-led economy is officially
underway. The shift stands to take the wind out of the sails of
commodity inputs relied upon throughout the nation's
Signs of a Turning Tide
In his November 2011 report "
China's Unsustainable Investment Boom
," Morningstar senior securities analyst Daniel Rohr noted that
China's gross capital formation, or GCF (investment in physical
capital), had grown to an astonishingly high 50% of GDP from 35% in
2000. The trend significantly reduced the impact of household
consumption on overall GDP. While the PRC's most recent quarterly
economic data indicate strength in fixed-asset investment,
historically reliable indicators of GCF such as steel and cement
production indicate the contrary. In a more recent piece, Rohr
notes that year-over-year changes in steel and cement production
levels have dropped by over 50%.
The interesting point here is not that infrastructural
investment is a waning driver of growth. China built an expressway
system that rivals that of the United States. The nation
constructed millions of high-end commercial and retail properties
priced so far above the common Chinese people's affordable range
that vacancies have brought about the nickname "Ghost City."
Expansion of supply without a demand to meet it couldn't have
continued indefinitely. The economy is likely to shift further
toward a consumer-driven growth balance. The peculiar point,
however, is that the balance will likely come from a decrease in
investment, not an increase in consumption.
China's Commodity Footprint
The shift toward a more consumer-centric growth balance in the
future carries serious implications for the hard assets that the
nation relied on for growth in the past. China has grown to demand
the largest stakes of a number of commodities and understandably
so. In addition to the infrastructural and real estate boom that
required vast amounts of industrial commodity inputs, China also
maintains the world's largest national population. This means that
national demands for agricultural and energy products are
accordingly lofty. The difference between the segments of
commodities is that those used to satiate the day-to-day
requirements of the populous are much less likely to see a
Chinese-driven change in the near term. Their industrial
counterparts, however, have seen a paradigm shift.
The demand that China provided the industrial metals space over
the past decade was an inherently structural one. The nation staked
its reputation on breakneck growth rates that could be achieved
only through continued development. Such capital formation relied
heavily on metals such as copper and steel. As the nation's fixed
asset investment cycle slows, so too will a demand that had been
baked into industrial commodities markets for at least the past
We mentioned steel earlier as an indicator of the state of
fixed-capital investment. While China is, in fact, a substantial
consumer of the metal, it satiates most if not all of its demand
with its own production. To identify the repercussions of cooling
fixed-asset investment here, we may need to look further upstream.
True, China produces most of its steel, but it does so with
imported iron ore. The nation has long been the top consumer and
importer of the base metal, but the impacts of a shift would be
felt in places such as Brazil and Australia. The world's largest
iron ore producers are Vale, Rio Tinto (both Brazilian), and BHP
Exchange-traded funds likely to be hardest hit by the softening
metal demand are SPDR S&P International Materials Sector (
) and iShares S&P Global Materials (
). Both maintain roughly 20% exposure to the aforementioned firms.
There are several differences between the two, the most striking
being their geographic exposures. While both funds charge around 50
basis points, MXI maintains exposure to both U.S. and non-U.S.
holdings, whereas IRV invests only abroad. The drawback here is
that neither is going to deliver a pure iron-related equity
exposure and will include a mishmash of various materials-sector
Copper is the second metal that is likely to see dampened demand
in the event of a popped infrastructural development bubble in
China. The nation has buoyed in its global share of consumption of
copper and is expected to drive price support for the metal going
forward. Being intimately tied to the health of the construction
sector, such as steel/iron, "Doctor copper" will be adversely
affected by the loss of a structural demand driver like Chinese
ETFs that stand to lose in such an event include First Trust ISE
Global Copper Index (
) and Global X Copper Miners (
). Both are modest-size offerings with less than $50 million in net
assets. They each maintain exposure to the most important copper
producers in the world and understandably share high degrees of
overlap with each other--over 77% from either side. They charge
similar fees of 65-70 basis points per annum and deliver similar
average trading volumes.
Don't Look to a Broad Basket for a Niche Exposure
For those who see storm clouds on the horizon for China, expressing
that opinion through a large marquee-name China index fund may seem
convenient, but there are a number of concerns. Generally speaking,
Chinese index funds do not provide exposure to the broad economy.
They tend to focus heavily on the largest of the nation's firms,
which renders significant exposure to the financial sector and with
it, governmental controls. Take the iShares FTSE China 25 Index
), for instance. The product, which is far and away the most liquid
offering among its peers, maintains over 60% of its assets in the
top 10 holdings. The financials sector account for roughly 53% of
assets at the time of this writing. Basic materials account for
only 10% of the index. If you are going to stick with "broad" China
funds, we recommend SPDR S&P China (GXC). The product invests
across nearly 180 firms, maintains a limited exposure to financials
to roughly 30%, and charges 0.59% to FXI's 0.72%.
Those looking to expand their negative thesis to the broader
BRIC region will find similar problems. The largest BRIC fund is
iShares MSCI BRIC Index (BKF). Of its cohort, it also maintains the
largest weighting toward China--20% of BKF's index is soaked up by
China's four state-run banks alone. While the most prominent
emerging economies weigh heavily on the commodity sector, we would
recommend against using a broad country allocation to capture
movement in the price of the commodity itself.
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
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