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Opinion

Caterpillar -- China spell is broken

Global construction faces uncertainty if Beijing can no longer wave the magic wand

Hard going for Caterpillar in China.   © Reuters

Bad things come in threes -- a superstition given new resonance for world markets as Caterpillar, Intel and Nvidia suddenly flash corporate warning signs.

China, which just recorded its slowest annual growth since 1990, is at the root of the multiple bad omens coming from these bellwethers. Taken together, their travails suggest the year ahead could be much rougher for multinationals than many Asian punters believe.

Intel's forecast for flat 2019 revenues and profit margins is plenty worrisome. So is Nvidia slashing expected cash flows -- by an eye-popping 19% in the last three months of 2018. Coming a week after Apple's downgrade, Intel and Nvidia are harbingers of an even weaker earnings cycle to come.

Caterpillar's woes, though, point to a much broader challenge that China bulls downplayed in recent years: Asia's biggest economy is losing its capacity to stimulate economic growth, both in the Middle Kingdom and beyond.

On the face of it, investors could make an argument that the Peoria, Illinois giant has things well in hand. Its adjusted profit miss -- $2.55 per share between October and December versus an expected $2.98 -- is surely a downer. Yet Caterpillar also just posted its first fourth-quarter net profit in four years -- a $1.05 billion bounce-back from a year-earlier $1.3 billion loss.

What is more, it enjoyed double-digit sales growth in North America, Latin America, Europe, Africa and the Middle East. Global sales jumped an annualized 11% to $14.3 billion. And looking forward, Caterpillar CEO Jim Umpleby says that "in Asia-Pacific, we expect construction growth in countries outside China."

From Indonesia to the Philippines to Vietnam, developing Asia needs to invest nearly $2 trillion per year on infrastructure through 2030, according to the Asian Development Bank. Who better to ride that construction wave than America's premier maker of machinery, energy and transportation equipment?

China, meantime, is revving up its stimulus engine following its 6.6% 2018 growth rate. In recent weeks, Beijing rolled out tax cuts, loans and regulatory tweaks aimed at wobbly property markets. The next expansionary wave is very dependent on construction.

As the fallout from Donald Trump's trade war hits top-line growth, Beijing is aiming at another infrastructure boom. Case in point: reports local governments will be allowed to issue about $300 billion of special debt to finance new projects. Expect even greater activity in China's cement-industrial complex. All grist, you would think, to Caterpillar's mighty machines.

The problem is that China's growth model is unraveling, as financial markets are signaling. Although investors do not always get things right, they are correct to doubt Beijing's ability to beat the economic odds again.

Since the 2008 "Lehman shock," Beijing has overcome financial gravity by ordering up humankind's most audacious building boom. Cities like Fuzhou, Wuhan and Changchun that most folks outside China had never heard of have been abuzz with giant port, bridge, road and other building projects.

All that construction activity, begun on President Hu Jintao's watch, enabled China to grow 8.7% in 2009 and more than 10% in 2010. Since Xi Jinping took power in 2013, growth moderated year after year. One reason for the downshift: the diminishing returns that affect all maturing economies, especially with regards to heavy investments.

Granted, President Xi assumed power at a moment of stable growth. So stable that he pledged to let market forces play a "decisive" role in decision making. And he pivoted to pushing his Asian Infrastructure Investment Bank and Belt and Road Initiative projects. At home, Xi's Communist Party pumped hundreds of billions of dollars into a "Made in China 2025" vision to dominate global tech sectors.

But then came an "America First" presidency determined to shift the economic advantage back in Washington's direction. As exports weaken, Xi's team is cobbling together a package of roughly $370 billion in public works projects and tax incentives. This, however, lacks the audacity of Beijing's post-2008 campaign.

The vanguard of Hu's initial $595 billion ploy to beat economic gravity amounted to 13% of gross domestic product. Xi's plans are the equivalent of 3% of GDP.

A trio of headwinds explain why Xi may be lowering his sights. One: debt hangover worries. A decade after Hu's borrowing binge, China faces a roughly $34 trillion pile of public and private debt. Today, total Chinese debt is equal to 266% of GDP versus 162% prior to the Lehman crisis. And we do not know what might be hidden away.

Two: the deleveraging drive Xi's team launched in 2013 to prove it is implementing its market liberalization pledges. Regulators and the People's Bank of China clamped down on shadow-banking activity. That chilling effect increased the amplitude of the economy's trade-war downshift. A fresh explosion of debt would set back that progress and risk credit downgrades.

Three: waning faith that old-school stimulus will work in 2019. China's construction activity grew 6.1% in the fourth quarter from a year ago, a two-year high and sizable increase from a 2.5% third-quarter increase. However, GDP growth still slowed. Hence worries that China is at the diminishing-returns inflection point for investment that Japan reached in the 1990s.

Over time, the GDP jolt from giant rail projects and six-lane highways, dams, municipal cultural centers, international airports and white-elephant enterprises lose potency. Boosting GDP requires bigger and bigger doses of stimulus to make its annual growth targets. The PBOC, meantime, could turn the yuan-printing presses to 11, but to what effect?

The 8% drop in Caterpillar's overall Asia-Pacific region sales in the fourth quarter was quite a comedown from the 28% jump in the July-September period. And looking forward, the 9.1% plunge in Caterpillar shares Monday was a reality check for hopes concrete economics will work again.

More growth and productivity improvements might come from unleashing the private sector to innovate and create new jobs. That means tending to China's economic software more than the physical hardware.

Caterpillar represents one of the most diversified bets, literally, on the foundations of the global economy. And yet shareholders seem to be losing faith in their wager if Beijing cannot or will not work its magic any more.

Though Asia remains a rich environment for construction, there will be fewer contracts to go around if the economic wizard at the center has lost some of his powers.

William Pesek is an award-winning Tokyo-based journalist and author of "Japanization: What the World Can Learn from Japan's Lost Decades." He was given the 2018 prize for excellence in opinion writing by the Society of Publishers in Asia, for his work for the Nikkei Asian Review.

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