If China’s highly indebted property company China Evergrande Group (OTC:EGRN.Y) has a hard default on its more than $300 billion debt load, and the ripple effect sweeps through the global economy, all bets are off. But it’s likely there will be some intervention: a managed default, government-assisted debt restructuring, or even a bailout.
Given this scenario, how might investors navigate the market? I have two ideas.
Two investing themes
It’s hard to know what will happen with Evergrande. Still, it’s reasonable to assume that the shock effect of its debt repayment issues, the Chinese government’s determination to cool the property market, and a natural correction from a red-hot real estate market earlier in the year will come together to slow China’s construction industry.
As such, there are a couple of themes worth exploring:
- Avoid stocks with strong exposure to China’s construction market, such as elevator company Otis Worldwide (NYSE:OTIS); miners like Rio Tinto (NYSE:RIO); and construction, energy, mining, and materials equipment company Caterpillar (NYSE:CAT).
- In contrarian fashion, start looking at companies reporting rising raw material costs. For example, if China’s construction market is cooling, demand for crucial raw materials like steel and resins will likely slow, and expenses will decrease.
A slowing construction market
China’s property market is cooling. Digging into what Evergrande’s management said in a company update on Sept. 14:
- “… the contract sales of properties of the Group in each of June, July and August 2021 amounted to RMB71.63 billion [$11.07 billion], RMB43.78 billion and RMB38.08 billion, respectively, which showed a decreasing trend.”
- “The Company expects significant continuing decline in contract sales in September.”
Management put this down to media reports “negatively influencing” potential buyers’ confidence in the company, and it said that Evergrande will not experience the usual sequential (August and September) sales growth in China’s property market. However, it’s not clear if this is an isolated issue for Evergrande or, more worryingly, an industry-wide problem.
What we do know is that China’s property market is cooling. Frankly, it had to. As you can see below, the market was running hot in 2021. Indeed, sales from January to August are still up 24% compared to the same period in 2020, and 30% over the same period in 2019.
How it could affect Otis, Rio Tinto, and Caterpillar
A slowing China construction market is not good for Otis. China is the largest market for elevators globally, and it’s a significant part of Otis’ growth plans. In fact, the investment case for the stock rests on growing its equipment market share in China to boost higher-margin services growth. Indeed, management talked of record orders in China (consistent with the hot property market shown in the chart above) and said Otis was winning market share and adding agents to boost growth.
It’s also not good news for Caterpillar and Rio Tinto. Caterpillar generates around 22% of sales from equipment to the Asia/Pacific region. In addition, end demand for its mining machinery and energy equipment is price-led. If a slowdown in China leads to a correction in mining and energy prices, then Caterpillar is less likely to see the long-term growth that investors have priced into the stock.
Similarly, Rio Tinto mines the iron ore used in steel for construction. Iron ore prices have almost halved since the summer and have slumped since the Evergrande news hit, and are now back to the level they started 2021 on. Investors will likely have to dial back expectations for a long-term commodity supercycle to begin in 2021.
Keep an eye on raw materials costs
A correction in certain raw materials, notably steel and resins, would be good news for industrial companies like 3M (NYSE:MMM) or Illinois Tool Works. Many industrial companies will report margin pressure in their third-quarter results.
For example, 3M has had to increase its estimates for cost headwinds a few times already in 2021 and is raising prices to offset them. So don’t be surprised if management reports disappointing numbers in the third quarter. But that could lead to a decent entry point if raw material costs decrease because of a slowdown in China’s construction demand.
It may seem paradoxical, but investors should look at companies complaining about the rise in raw material costs (steel, aluminum, resin, et cetera) in 2021. The idea is that, provided they have made selling-price increases stick, their costs will drop going forward, and profit margins will be in line for an expansion.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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