Monthly commentary - Mackenzie Bluewater Team

Written by the Mackenzie Bluewater Team

China’s Growth conundrum and its impact on Global Growth

For the past two decades, China has ridden a wave of remarkable growth, experiencing a virtuous circle of prosperity that led to rapid economic development. Other nations eagerly outsourced their manufacturing to China, and in return, China constructed sprawling factories and transformed its people into an urbanized workforce. Vast infrastructure projects were undertaken to support this unprecedented surge in industrialization and urbanization. Along the way, China became a voracious consumer of global resources, devouring 60% of the world's annual nickel and cement production, along with around 50% of copper, steel, zinc, aluminum, and iron ore. 

However, the emergence of unforeseen challenges has thrown a wrench into this once-predictable growth model. The COVID-19 pandemic exposed severe supply chain vulnerabilities and mounting political tensions have exacerbated the situation. Consequently, both companies and countries are now actively seeking to diversify their supply chains beyond China including the prospect of bringing manufacturing closer to home.

Adding to China's growth conundrum are demographic hurdles. The effects of the one-child policy are striking. China's population growth, which had been on an upward trajectory, has now reached its zenith and is on a downward slide. The nation is undergoing rapid aging, with the crucial "working age" demographic (those between 20 to 60 years old) tipping into decline. Over the next decade, this group is expected to shrink by approximately 10%, and over the next two decades, it will decline by more than 15%. To put this into perspective, this working-age decrease totals over 120 million people, which is more than three times the population of Canada.  We know from the past three decades in Japan that it is extraordinarily difficult for countries to grow economically when their working-age population is declining. 

In light of these developments, projections that hinge on the past growth model and historical growth rates for China seem excessively optimistic. In particular, we are highly suspicious that forecasts for industrial commodity demand will end up proving significantly overstated.  As a result, we continue to avoid infrastructure commodity related businesses such as metal and mining companies in the funds.

The Chinese leadership are well aware of the growing challenges. In recent years, China has embarked on a transformative journey aimed at ascending the technology value chain. The nation is steadily transitioning from its role as the world's assembly plant to a formidable technology innovator. Two prominent areas of focus have come to the forefront: electric vehicle (EV) production and the development of a domestic semiconductor industry. Yet, these ambitions face significant political roadblocks in the form of export restrictions on next-generation semiconductor manufacturing equipment and escalating trade tensions in the automotive sector.

China's prowess in EV technology is nothing short of remarkable, and if left unhindered by political interference, it has the potential to swiftly dominate the European automotive market. The Chinese EV offerings are not only notably cheaper but also technologically superior to EU domestically produced counterparts. The automotive industry holds immense importance in Europe.  For example, nearly 8% of employed Germans are working either directly or indirectly for the automotive sector. The economic significance of this industry, combined with China's technological prowess, has fueled expectations of a trade dispute. These expectations have materialized with the European Union (EU) beginning the process of formally launching an investigation into the Chinese EV industry in early September.

From an investment standpoint, China has been a formidable engine of global economic growth for the past two decades. However, it is imperative to recognize that economic growth forecasts that fail to account for China's mounting challenges are likely to be overly optimistic. While many forecasters have assumed that China’s challenges will prove short-lived, we believe that they are deeply structural and potentially insurmountable.  The nation is at an inflection point, grappling with the need to redefine its growth model while contending with demographic constraints and geopolitical headwinds.

While the near-term economic environment contains considerable risks, it also contains significant mid and long-term opportunities.  As we have detailed in prior quarterlies, we believe that the global energy transition will prove to be a generational investment opportunity.  The energy transition, a response to climate change, entails a monumental shift from fossil fuels to renewable energy sources like wind and solar power. This multi-decade transformation will ripple through numerous massive industries, from the electricity grid to transportation and manufacturing processes. This is a multi decade investment cycle that will run tens, and possibly into the hundreds, of trillions of dollars globally.

Bluewater's investment approach hinges on identifying key change enablers and Trane technologies is one such company in the energy transition space.

Trane Technologies is a global leader in providing HVAC solutions and services, specializing in climate control and building management solutions. They are a great example of Bluewater investing in "enablers" of energy transition. Approximately 40% of energy consumption in commercial buildings is attributed to heating and cooling, making HVAC a mission-critical product that cannot be deferred, ensuring Trane a consistent source of revenue. The HVAC market is characterized by a small group of dominant competitors, which helps maintain rational pricing.

Looking ahead, several drivers suggest that revenue growth for Trane Technologies will likely be higher over the next several years than it has been in the past:

  • Environmental Impact and Cost Savings: Upgrading HVAC equipment is an essential strategy for building owners to reduce emissions and lower operating costs, aligning with the growing emphasis on sustainability.
  • Reshoring of Manufacturing: The reshoring of manufacturing operations could lead to an uptick in new buildings requiring HVAC equipment, as domestic production creates more demand for infrastructure.
  • Specialized Cooling Solutions: As the demand for energy-intensive facilities like semiconductor and data processing centers grows, the need for specialized cooling solutions will increase, presenting an opportunity for Trane Technologies to provide their HVAC solutions.

In Trane, we have a company that already possesses the characteristics prized by the Bluewater Team, in a unique position to enable important sustainability and energy transition trends over the coming decades.

Bluewater has added value for investors by focusing on the small number of companies that are leaders in their industries, led by best-in-class management teams that grow their businesses at rates superior to the overall economy.  These companies have business models that allow them to weather these types of uncertain environments and increase their advantages over their competitors. All our businesses are highly profitable, generate substantial free cash flow, and have strong balance sheets.  We expect that the earnings power of our companies will be significantly less impacted than the general market.

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