Millinium Capital Managers Limited GPO Box 5090 Brisbane Qld 4000 E investorservices@millinium.com.au W millinium.com.au ABN 32 111 283 357 AFSL No 284336

Neill has more than 30 years’ experience of using qualitative and quantitative methods to

assess companies and industries. During 17 years with QIC he managed a $10 billion

Australian equities fund which outperformed the S&P/ASX 200. Neill’s academic

background includes Mathematics, Economics and Latin.

WHEN CHINA SNEEZES, AUSTRALIA GETS PNEUMONIA - 03/07/2014

Comment: Recent official statements indicate China’s GDP growth rate in CY14 will be

about 7.5%. This figure is way above growth rates in the rest of the world, but nonetheless it marks another step down from China’s peak rate of 14.2% in 2007. The long term factors behind slower growth include:

Ageing population: more retirees, less workers.

Rising real wages, as regional and sectoral labour shortages enhance employees’ bargaining power.

Over-capacity in many industries, as a long term consequence of policies that have favoured investment ahead of consumption.

Visible pollution of air, water, soil, food: resistance from consumers and residents increases, and pollution control will mean higher costs for many companies.

Too much debt: China’s debt now exceeds 200% of GDP – higher than countries like Greece, Cyprus, Portugal and Spain which suffered debt crises. Why is slower growth in China important for Australia? Because China now buys 36% of Australia’s exports, and coal and iron ore account for three-quarters of the value of these exports. Taking a wider view, shared supply chains link China’s economy closely to Japan, South Korea, Vietnam, and neighbouring countries: East Asia in total buys 55% of Australia’s exports. China’s slowdown in the last two years has already caused 30%-plus falls in coal and iron ore prices, leading to the collapse of capital expenditure spending in Australia’s mining sector, with consequent job losses. It is clear that, even if China avoids the “crash” which some commentators have predicted, any further slowdown will be painful for Australia.

We must emphasize that, although a crash is possible in China in the next few years, it can still be avoided by prudent economic policies such as the reforms which the Chinese government is currently implementing. After all, China has a lot of room to manoeuvre thanks to its low government debt and high forex reserves: the latest official figure for China’s external financial assets is USD 6.13 trillion. Although there are a number of problems in China’s financial system, we do not expect a re-run of the US housing crisis. Where the marginal US homebuyer in 2006 had loan-to-valuation ratios above 90%, the average Chinese residential borrower has a 30% LVR, and many have no debt at all. Where the ordinary US consumer in 2006 had maxed out his credit cards and drawn down his home equity loan, the average Chinese consumer has very little debt. Systemic risk is contained because the lending banks keep the housing loans on their balance sheets rather than packaging them up into CDOs and selling them off to investors. Most importantly, although apartment prices in China have been rising rapidly for a decade, rapid economic growth has meant that household incomes have been rising faster, with the result that affordability (apartment price divided by income) has been improving in most cities. Nor do we expect China to repeat the US banking crisis, because its banking system is completely different from the US. There will be no “Lehman moment”, because the Chinese government never succumbed to Alan Greenspan’s fantasy that light regulation, bankers’ self-interest and the magic of the free market would prevent bubbles and frauds and insolvencies. In addition to the tight Chinese regulatory framework, the major Chinese banks are not managed by ex-traders in pursuit of multi-million dollar bonuses: they are run by senior members of the Chinese Communist Party (on modest salaries) for the benefit of the Chinese state. Banks will certainly suffer loan losses on commercial and local government debt, but the central government has recapitalized them before and will do so again. For Australians, it is important to understand that Chinese banks are not just highly regulated, they also have much less exposure to property. The typical Australian bank has more than half its loan book in property: by comparison, in 2013 only 14% of the loans in the Chinese banking sector went to mortgages, with another 12% going to developers and construction companies. This limited exposure means that China’s current property downturn will be painful rather than fatal. Since mid-2013 China’s property markets have been in cyclical downswing, after over-building led to an inventory overhang in residential and non-residential sectors. Non-residential markets throughout much of China enjoyed a building boom thanks to cheap money and government initiatives, but demand has slackened and vacancy rates are rising. In most residential markets, prices and new starts have been falling as developers tried to clear excess stock. The effect of the downswing will bring supply and demand back into equilibrium, but at lower prices – perhaps as much as 20% lower. A 20% price fall will bankrupt some smaller developers, but the larger developers will survive. The current downswing may last two years, but long-term prospects for residential property remain strong, driven by improving affordability, ongoing urbanization (albeit at slower rates), and the need to replace low-quality housing stock built before 1990. But in

the next two years, construction volumes must fall. As a consequence, demand for steel will fall, both for direct use in construction and in ancillary areas such as construction machinery. GDP growth in CY2015 may drop below 7%. The impact on the Australian mining sector is obvious. Lower commodity prices mean lower export earnings (only slightly offset by some volume increases), hence lower company profits and cash flow. BHP and Rio will survive with lower profits and tightly controlled costs, but high-cost mines will be shut down, and there will be job losses in mining and in mining services. The resource states of Queensland and Western Australia will go into recession first. For Australia as a whole, higher unemployment and lower exports means falling growth and a drop in real living standards. The rising balance of payments deficit will push the AUD below USD 80c, although it will continue to be buoyed by Australia’s AAA rating and the yield differential against major currencies. Because the unemployed find it hard to keep making mortgage payments, the banks will suffer loan losses on residential property, but their commercial lending books are in good condition thanks to the tighter lending standards adopted in the wake of the GFC. A recession starting in 2015 or 2016 is not factored into most forecasts, but we note that every Australian mining boom has been followed by a recession. Because people forecast the future on the basis of their experiences in the recent past, they never expect things to get as bad as they do. Looking at business cycles in the long term, it is easy to see that the last decade favoured resource-producing economies such as Australia, Brazil and Canada. With commodity prices continuing to fall, we expect that the next decade will favour resource-consuming economies, especially the US and Europe. What should the Australian investor do in order to minimize the effect of the coming recession and the fall in the AUD? Domestic defensive stocks are part of the answer, but the key is to reduce exposure to AUD-denominated assets and increase exposure to the US and European economies because they will benefit from lower commodity prices. Preferred methods include US and European index ETFs or ASX listed companies with US operations. Qualified investors may wish to consider Millinium’s newly launched S&P500 Fund. The investment strategies of Millinium’s Dividend Income Fund (soon to be re-named the Australian Equity Fund) take our macro view into account. The Fund is still weighted toward Australian companies with US exposure. We have reduced exposure to domestic cyclicals and consumer discretionary sectors, and are still watching for the early warning signals of a correction. Just lately, we have begun to consider when to sell out of the banks, on the grounds that the sector is not priced for any downturn in the economy.

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Disclaimer Millinium Capital Managers Limited, ABN 32 111 283 357, AFSL No. 284336. This document and information contained herein it does not constitute personal advice and investors should consider obtaining professional advice that suits their objectives, financial situation or needs. This document may be amended, withdrawn or replaced without notice. This document is intended for the recipient only. Please refer to the Terms of Use on the websi te for full details on the use of this document and our disclaimers. To the extent permitted by law we exclude any damage or expense arising from any person’s reliance.The performance figures for the investment mandates is derived from a portfolio of assets that has been operated by Millinium. All performance returns shown are net of fees and expenses but exclude taxes and buy/sell spreads. Future performance information or up to date returns will change on our website www.millinium.com.au and should not be taken as a reliable guide to future performance of the investment mandates. To the extent, permissible by law, Millinium does not accept any liability for errors or omissions or for the loss or damage suffered as a result of inaccuracies in this newsletter. No guarantees are made on the return of income or capital. Performance information is subject to change without notice.

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