Schroders’ Le Jéhan: China remains the last decade’s story for now

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Back in February 2012 in this blog we touched upon our caution on all things emerging market related. In particular, we noted our reservations about the outlook for investors in China, despite local markets having peaked over a year earlier and looking optically cheap to some. Sentiment to us still appeared too buoyant, with an all too comfortable belief that emerging market growth would eventually drag the global economy forward as it had for the preceding decade.

Fast-forward 16 months and the consensus looks somewhat different, particularly regarding China. Gradually, the China bears are being afforded more airtime. An over-levered economy, falling exports, wage inflation and productivity declines all add to the growing sense of gloom. Indeed, the ‘economic miracle’ of 10 per cent growth per annum forever is now long forgotten as the throwaway line of emerging market bulls past. Even the Chinese finance minister last week suggested a fall to a once unthinkable 6.5 per cent GDP growth, with some going further to highlight the risks of negative real growth in the coming quarters.

But, often some of the best investment ideas come in some of the most unloved areas. So we’ve spent some time now considering whether it’s now time to revisit this space in a more meaningful way. After all, in the midst of broad, albeit volatile, western market recoveries, China and the related commodity areas of markets are beginning to look more interesting – at least on a valuations basis.

To us, though, China remains the darling of last decade and, as we have mentioned before, the leaders of the last cycle are rarely the leaders of the next. It’s true that the China slowdown story has become more consensual, but the pressures on the Chinese economy look some way from being resolved.

The new Chinese government appear intent on acting early – managing the necessary shift from an industrial nation to a consumer nation more firmly and visibly than their predecessors. They also seem cognisant of the potential problematic after-effects of the huge domestic stimulus program enacted at the depths of the global financial crisis. Last month’s wobbles in the inter-bank lending market highlighting their unwillingness to act as a continued prop to the over-sized banking and shadow-banking sector, where credit growth still runs at an unsustainable 20 per cent of GDP.

But such problems are not solved overnight. Indeed, cracking down on areas of shadow banking may hurt the very companies necessary to lead the consumer led economy of the future, as some such as research house GaveKal have suggested. Let’s also not forget that, throughout this adjustment period, the willingness of a socialist government to subject the Chinese people to the necessary pain cannot yet be taken for granted. Any weakening of resolve may just re-inflate the very bubble that needs bursting.

Related areas of markets around the world suffer on similar inspection. In a strong dollar environment, commodities remain vulnerable. Global mining sectors, so heavily reliant on emerging market growth, look relatively cheap but remain under earnings pressure for now with capital expenditure going forward unlikely to be a key driver.

Investment is a relative art and in our eyes the relative valuations in selective parts of the Western world remain the more attractive on a risk reward basis. Key to our investment philosophy is the recurring idea that risk is a function of the price you pay.

Undoubtedly, the China story is becoming more interesting on a valuation basis, but with questions still abundant and no clear near term backstop to markets as in other regions, the risks do not yet justify more meaningful exposure to us. With embryonic signs of Western growth and still much value on offer in these areas in our eyes, China and the emerging markets remains yesterday’s story – albeit perhaps tomorrow’s but not yet today’s.

Joe Le Jéhan is a fund manager in Schroders’ multi-manager team