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Not a straight path

Joseph Mariathasan warns that, while there is much to be optimistic about in China, uncertainties abound – and its own markets may not be the best way to get exposure to its growth

The Chinese economy has become a lynchpin of global growth, and it is not clear that its ongoing shift from a dependency upon exports (battered by the crash in the key markets of the US and Europe) to an economy more oriented to domestic demand will provide growth to lift the developed world out of its current malaise.

And it is not just the developed markets whose future may be dependent on Chinese growth. “In a nutshell, it is hard for emerging markets to decouple from China as they are generally still commodity-driven,” says Keith Wade, chief economist at Schroders
What happens in China affects us all, yet it presents a confusing picture. On the political front, there is a maelstrom of clashing philosophies as departing leader Hu Jintao’s thoughts are added to the canon of Marxist-Leninist, Maoist, ‘Deng-ist’ and ‘Jiang-ist’ dogma, whilst its stock markets, its insatiable demand for luxury brands and its billionaire businessmen suggest that none of the ruling party’s doctrine has any relevance to the lives of its people.

Nouriel Roubini has attracted much attention by suggesting a high likelihood for a ‘hard landing’ for China, possibly as early as 2013. China’s response to the collapse in its export markets was to raise investment in areas like infrastructure. But half-empty bullet trains and motorways with little traffic financed by the banking sector suggest that non-performing loans could become a threat down the line. “Chinese banks are amongst the largest in the world,” notes George Hoguet, global investment strategist at State Street Global Advisors. “Any time you get banks growing that rapidly you are likely to have problems.”

There is much talk of replacing exports by the growth of domestic consumer demand. It is a key plank of policy growth and also a fundamental driver of investment strategies not only for China but throughout emerging markets. Yet whilst there is plenty of evidence of rapidly rising consumer demand, there are also great challenges in maintaining growth through a shift to domestic consumption.

Li Gan, director of the China Household Finance Survey at the Southwestern University of Finance and Economics in Texas, found that the top 10% of Chinese households accounted for 57% of the nation’s total income, 85% of total assets and 69% of savings.
The bottom 50% hold negligible savings. He argues that inequality is the key reason for China’s low consumption rate: China’s rich are already spending what they need and holding on to all the excess wealth. Moving to sustainable domestic consumption means increasing the disposable income of the poor, a redistribution of wealth to increase the spending power of the poor at the expense of the rich. As Wade puts it: “The real problem in China is inequality – they need to try and spread wealth around as much as possible.”

Perhaps it is not surprising that Peter Batey, chairman of China specialist Vermilion Partners, says: “The ruling class feels under siege from without and under pressure from within.” He argues that the regime sees the US seeking to encircle it with its ‘strategic pivot’ to the Pacific and its efforts to warm relations with China’s neighbours, while from within it faces mounting protests from its own people against rising inequality, arbitrary land confiscations and demolition of housing for development projects, environmental degradation, the siting of new industrial plants that might pose public health risks, and increasing corruption. Recent revelations in the foreign press of the wealth accumulated by the families of political leaders, incoming and outgoing, have fuelled this angst.

“Little wonder that Hu Jintao, in his final report to the Party Congress warned that corruption, if not tackled effectively, could bring down the party and threaten the state,” says Batey. Hu Jintao’s warning was echoed by incoming leader Xi Jinping, who, in his inaugural address, focused on corruption, the remoteness from the general public, as well as undue emphasis on formalities and bureaucracy by the authorities.

Despite its problems, there is room for optimism when it comes to China. Wade points out that while there has been a lot of criticism that the new leadership are not reformers, they have enjoyed a post-Cultural Revolution education and are more internationally-minded than many of their predecessors. Moreover, Vermilion argues that Xi Jinping’s background in the market-oriented coastal provinces of Eastern China has given him relatively liberal, pro-reform economic views.

As CIO for Nikko AM Europe, Stuart Kinnersley points out, there are unlikely to be any dramatic developments following the leadership change. Xi Jinping was already part of the existing leadership. Most China commentators see the focus continuing to be on growth, but Kinnersley emphasises that the authorities, despite a slowdown, are under no immediate pressure to stimulate the economy. Moreover, he argues that they have learnt from the mistakes that the developed nations have made over the last decade.

“When you see a property bubble, it is better to prevent it building – as the aftermath can take years to clear up,” he says. He points out that credit has been restricted and the authorities have tried to take the speculative elements out during the last 12-18 months. “I can remember Beijing a couple of years ago when it cost $1m for a small condominium – which is very out of kilter with the general economy,” he adds.

While forecasts of doom for China might attract publicity for economic commentators – and indeed, that is often the rationale for them – the most likely outcome is something like growth rates coming down from 10% to around 7.5%. This may actually be a more attractive rate for the Chinese authorities.

“They are looking at the quality of growth, not just GDP growth for its own sake,” says Kinnersley. “Growth rates below 8% are more sustainable and can be dependent on domestic consumption in a growing middle class rather than just exporting to the rest of the world.”

As China grows richer, it might have no choice but to back-pedal on exports and grow more slowly. Kinnersley points out that labour costs between Mexico and China are now about the same level, making the former a much more competitive manufacturing centre for US goods than the latter.

Bringing all this together, what does it imply for investors? Certainly there are some that see the impact of the recent economic slowdown as the opportunity to build positions exposed to the longer-term growth story that China represents. Neuberger Berman, for example, has seen sophisticated institutional investors such as endowments adding exposure as China has fallen out of favour with retail clients. “We feel the equity risk premium is currently cheap in China,” says Alan Dorsey, head of investment strategy and risk.

And if China’s economy is bottoming out, Bakkum makes the point that investors should not ignore the large parts of the emerging market universe that are China-dependent.
“We have been underweight Brazil for years but are now overweight because of China’s growth prospects,” he says. “Russia is also seeing greater demand from China. We prefer to play the China recovery from markets that will benefit rather than from China’s equity markets themselves, which could easily disappoint.”

As he points out, during the early 2000s China’s stock markets languished thanks to concerns over transparency and governance issues, and investors preferred exposure to China’s growth through sectors such as Australian commodity stocks.

Even now, a large part of China’s market is still made up of financial stocks, and growth driven by government stimulus effected through the banking sectors makes Bakkum wary of a possible proliferation of non-performing loans.

William Fong, a China-focused portfolio manager at Baring Asset Management, is also wary of the banking sector. He picks out not only asset quality deterioration as a factor, but also increased fund raising as a result of Basel III. Furthermore, he argues that the three largest sectors – financials, telecoms and energy – all lack a structural uptrend.
“In a portfolio, we need to look at  companies that can do well in a low-economic-growth environment,” he explains. “That means companies that are launching new products every year, or going into new markets.”

Barings is therefore overweight technology and industrials, such as internet and hardware companies that benefit from more international applications and product launches like the iPhone, alongside companies that can be leveraged by cutting-edge technology (rather than low-end manufacturing). Fong also sees the consumer sector and healthcare as areas where there is potential for domestically-focused firms to offer significant potential for positive earnings surprise.

As an emerging market, China is in a league of its own. India may be comparable in population, and in 1978, per capita incomes in China and India were roughly equal. But China’s conscious decision to integrate into the world economy has led its per capita income to grow to double that of India. It has done a better job of poverty-alleviation, it saves and invests nearly 15 percentage points more in GDP than India, is substantially more open, attracts nearly five times the FDI flow and has a substantially smaller budget deficit and larger foreign exchange reserves. But there are two very important caveats to attach to that. First, macro issues aside, India might still have the more attractive stock market, for various reasons. And second, what China’s authorities are attempting is unmatched in scale and ambition throughout human history.

As Nikko AM’s Kinnersley puts it: “The big risk for foreign investors is always an unrealistic expectation that it will be a straight line path for China to become the world’s biggest economy.”

 

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