Investment committee: What now for downgraded China?

Chairman: Fund Strategy editor Beth Brearley 

Last month Moody’s cut China’s sovereign credit rating for the first time since 1989, taking it to A1 from Aa3, on concerns the country’s increasing debt levels and stalling growth will be detrimental to China’s financial strength.

Moody’s says it expects China’s central government debt to rise to 40 per cent of GDP by the end of 2018, before reaching 45 per cent by 2020. The onus is on China’s authorities to deal with the debt issue without wreaking further havoc in the bond markets or hampering GDP growth to the extent of causing a hard landing.

The ongoing regulatory crackdown on China’s shadow banking business has affected bank shares, with regulation discouraging banks from using loans to invest in bonds also prompting a sell-off in the bond market.

While the stock markets were unfazed by Moody’s downgrade, anecdotally at least investors were wary of a loss of confidence in China’s stability.

In terms of relations between the world’s two largest economies, a new US-China trade agreement has been settled and President Trump has abandoned claims of currency manipulation. However mud-flinging continues, with Senator John McCain recently accusing China of acting like a bully by refusing to enable foreign businesses to compete fairly and making extensive territorial claims, such as in the much-disputed South China Sea.

However, with the US retreating on various issues and controversially quitting the Paris climate accord, thereby potentially making Asia the world leader in managing climate change, is the US stepping back from global economic leadership? And as the second largest economy in the world accounting for 15 per cent of global GDP, will China step up?

John Husselbee
Head of multi-asset, Liontrust Asset Management

When Moody’s downgraded China’s debt, it cited concerns about the country’s financial system and economy. This provoked two reactions: renewed fears about a hard landing and outrage from Beijing.

For us, however, this downgrade falls into the market noise category rather than signals any kind of economic shift.

China has long sought more sustainable growth and excessive leverage is a potential hurdle for a soft landing. The country’s debt as a percentage of GDP has ballooned by close to 15 per cent a year since the financial crisis and it needs to be brought under control.

Another concern is the rise in shadow banking, with local and provincial banks accounting for around half the assets in the sector: a far cry from the days of dominance by the four large state-controlled players. But these four banks remain the lender of last resort for the shadow network so problems in the latter could cause a shock across China’s whole financial system.

China clearly has issues to deal with to ensure its economic stability, but it can hardly be said to be alone.

Ben Stoves
Investment analyst, Rowan Dartington

Chinese growth has been slowing for a long time and we expect this to continue as it naturally evolves into a services-led economy. Stimulus has been increasingly relied upon to meet growth targets leaving a mountain of debt, although this is the case – to some extent at least – in most developed markets now, not just China.

The recent ratings agency downgrade, though the first in decades, does not represent a great shock as it was signposted and China’s economic system is unique given its greater level of government or state control.

For now the markets seem to have come to terms with the idea that the authorities can manage this situation. There’s no question the risk is elevated but the longer-term investment case for China still stands – it’s a huge economy with ever-growing middle class aspirations so arguably the opportunities lie in sectors like consumer discretionary and technology, rather than manufacturing and resources.

Lee Robertson
CEO, Investment Quorum

We don’t expect the downgrade to have any real impact in terms of flows in or out of Chinese bonds. A focus on fundamentally sound companies with stable earnings and cash flow continue to make good investment sense.

Crucially it is important to remember that China remains an investment grade bond market. The renminbi will weather this.

On Hong Kong we feel that this remains the second strongest bond market after Singapore. A few quasi-government entities may suffer a downgrade but we remain broadly positive.

It’s fair to say that the reaction to the downgrade has been muted and after an initial fall the Chinese markets have recovered.

We feel the US/China dance will continue as both superpowers vie for advantage in the region and both will continue to tempt regional players to their points of view.

Fundamentally we feel this is just mood music and the markets remain fundamentally investable albeit with the usual caveats.

Graeme Black

Investment Analyst, Equilibrium Asset Management

The saying “Don’t fight the Fed” could be relabelled for Bank of China. Arguably Chinese stimulation was one of the major factors behind the rally in global risk assets in 2016 amid widespread concern of a slowdown in the world’s second largest economy. An economy that, if you believe the figures, is still growing at 6 per cent plus per year.

The recent downgrade from Moody’s has merely increased column inches regarding a debt pile investors should already be aware of. Ongoing attempts to rein in the shadow banking sector are being reflected in higher lending rates and increasing yields.

The restructure of the Chinese economy and attempts to release the debt bubble will likely dampen growth, however this must be kept in perspective and state intervention shouldn’t be ruled out. Chinese equity remains relatively attractive compared to other markets, although once large SOEs trading on rock-bottom multiples are stripped out the valuations become less compelling. As the market continues to rise, we may look to lock in some of the profits.

James Calder
Head of Research, City Asset Management

Moody’s downgrade is the starting gun to what will hopefully be a long, drawn-out readjustment phase, although the likelihood of severe shocks is increasing.

China’s debt-to-GDP issues have been well flagged as have those of its NPLs, although the extent of this problem is not known. A China collapse would be a global event, of which the upper echelons of the ruling Communist Party of China are bound to be aware.

The advantage with the Chinese system is that the command economy has more available levers than the average central banker, which could lessen or avoid the bursting of a debt bubble. Rebalancing the economy towards the consumer is a start, particularly one that is awash with savings. Therefore, while China needs to address its problems, it should not necessarily put off long-term investors. Our exposure is through generalist active South-east Asia managers, whose advantage over the passive approach is that they are not hamstrung by investing in debt-ridden Chinese state-owned enterprises, which dominate the index.

Redwood JohnJohn Redwood
Chief global strategist,
Charles Stanley

China will continue to grow by around 6.5 per cent this year and will avoid the hard landing or debt crash that some fear.

The authorities have taken some action to curb asset inflation, especially in parts of the property market, and to restrain the associated lending. The potential bad debts in the system are typically ones owed by state enterprises to state-owned banks, allowing the state a number of ways of gradually sorting out the imbalances.

President Trump has agreed to an accelerated work programme to reduce selected barriers to trade and dropped his currency manipulation claims. The US needs China’s help with North Korea and will wish to take ships through international waters where China is building its presence, which may cause spats, but these are unlikely to escalate too far.

We expect some monetary relaxation to avoid a recession as the backdrop to difficult restructuring as China seeks to divert more activity to higher value added and service activities, away from basic industry where it has overcapacity.

Mark Richards
Global strategist, multi-asset solutions, J.P. Morgan Asset Management

We remain vigilant to risks emanating from China, but we do not expect significant downside risks to materialise. Over the past few months, a moderation in leading economic indicators, and significant change in financial regulation, has led to heightened concerns that the economy is at the beginning of another downslope. However, on balance, we do not think that recent regulatory actions aim to slow the broader economy.

We are focused on the targeted nature of the policy moves and note the authorities’ unwillingness to engage in broad tightening measures. The new policies look to address the well-documented high leverage in parts of the economy and improve the long-term health of the financial system.

While the all-important credit impulse is fading, as is almost inevitable following such a surge, other timely barometers of economic health do not paint an overly gloomy picture.

We therefore maintain our pro-risk asset allocation, which includes an overweight in emerging market equities. Financial reforms are welcome in China since they should reduce the systemic risk of a highly leveraged economy. In this context, we underscore that the large cap banks with well-funded balance sheets, representing a large weight in emerging market equity benchmarks, have been little impacted by recent tightening measures.

At the same time, equity indices with greater exposure to companies impacted by tightening liquidity conditions – as well as falling iron ore prices – have delivered notably worse performance.