The great engine of world growth has malfunctioned. Just 12 months ago, China’s biggest problem seemed to be excessive growth; now, its weakening economic statistics have financial markets nervous.
China is the worst-performing IMA equity sector this year after Japan and this once-loved area is now widely rejected by investors. But are investors interpreting China’s weakness correctly? And even if China economic data is cause for concern, does it disrupt the long-term case for the region?
Certainly, the data makes for disquieting reading. Chinese GDP growth slowed to 7.6 per cent in the second quarter. This may still be a long way from an economic contraction, but the world has grown used to double-digit growth. The government cut its growth target for the year to 7.5 per cent and subsequent figures have showed a continued weakening. For example, value-added industrial output rose 8.9 per cent from a year earlier. This is the slowest growth in three years. Particularly worrying has been export growth. The export figures for August showed a rise of just 2.7 per cent from a year earlier.
This is having an impact on corporate China as well. Recent analysis by the Financial Times showed that a third of China’s publicly-listed companies suffered cash outflows in the quarter to the end of June. It attributed this to the “combined effect of the slowdown in exports, a build-up in stocks and tightening local government finances”.
The effects are also being seen in those companies that depend on China for growth. The Chilean mining group Antofagasta recently reported a fall in first-half profits. There are also reports that the slowdown in Chinese growth is having a negative effect on the Indonesia coal sector, forcing reductions in output and cost-cutting.
The problems have prompted a public relations initiative by the Chinese government. At the Asia-Pacific Economic Cooperation CEO Summit in Vladivostok, Russia, President Hu Jintao said that a slowdown in exports was putting pressure on China’s economic growth prospects. However, at the same time he pledged to boost domestic demand and promote more balanced growth in the country.
The markets were pleased that Hu appeared receptive to further stimulus for the economy, but some commentators have muttered that talk of stimulus appears to show China falling back on government investment as a source of growth, rather than continuing a transition of the economy to consumer-led growth as laid out in the government’s five-year plan in 2011.
The data has made plenty of investors twitchy. Hugh Hendry of hedge fund Eclectica said in his recent letter to investors: “There is a near consensus that China will supplant America this decade. We do not believe this … We are also more pessimistic on Chinese growth than ever. This makes us bearish on most Asian stocks, bearish on industrial commodity prices.”
Albert Edwards, a strategist for Société Générale, said in the French newspaper Les Echos in July: “All elements of a global recession are in place. China may suffer a sharp slowdown, while the Chinese authorities, who see the first signs of deflation, will also lose control over growth. More and more statistics will worry investors in the coming weeks. China’s GDP may slow to 3 per cent or less.”
Marcus Brookes, the head of multi-manager at Cazenove Capital, holds no emerging market exposure in his Diversity fund. He says that China’s weakness is still not fully reflected in market valuations. Until he sees more signs that people are truly bearish about China, he says he will continue to avoid it.
Even before the economic data started to turn down, there were concerns that China faced a “middle income” trap. Fund managers such as Mike Riddell at M&G highlighted the danger of a “Lewis turning point”. This is a phenomenon identified by the economist Arthur Lewis in the 1970s from research done on the economic history of Japan. This study showed that rapid urbanisation led to a growth in manufacturing, which in turn brought fast economic expansion, as has been seen in China.
However, eventually, the phenomenon comes to an end as wages rise and the country’s competitive edge disappears. The consequences for Japan have been well documented. Riddell argued that China had artificially maintained higher growth rates through the expansion of credit and would need to go through a period of adjustment.
This sounds like bad news for China, and certainly there is evidence of significant wage increases in certain sectors.
Faced with this barrage of weak data and poor sentiment, it would seem China is a region worth avoiding. But there is an alternative argument.
The government set out its last five-year plan in March 2011. Among the key points was a reduction in the annual growth target from 7.5 per cent to 7 per cent. The government also wanted to improve the “quality” of that growth, moving the economy from a predominantly manufacturing-led, expert-dependent economy to a greater reliance on consumer spending. In doing this, it put in place a series of initiatives – increasing spending on a social safety net to encourage people to spend rather than save their money, reducing the income tax threshold, cutting import tariffs and identifying key sectors for economic growth.
Therefore, it could be argued, the reduction in growth is simply part of the government’s plan. It is designed to address problems of poor lending practices and excessive credit expansion and redirect the economy towards consumer spending. After all, until relatively recently there were plenty of commentators who were just as troubled by China’s excessive growth rates. The slowdown in commodities demand is simply a reflection that China is now experiencing a different kind of growth – one less dependent on infrastructure building and therefore less commodity intensive.
James Weir, the manager of Guinness Asia Focus fund, says this argument has merit: “This is partly a planned slowdown. The government tried to slow the monetary side of the economy after excessive expansion in 2009. The original expansion was a response to the global financial crisis and designed to get growth back on track, but capital went to the wrong places. It went into the property market, it went into state-owned enterprises, and the government wanted to get it back under control.”
Weir admits that policymakers may have tightened monetary policy too far: “There was around 12-18 months when policymakers were behind the curve – they continued to tighten monetary policy when it was clear that growth was slowing,” he says. “The government tightened for one or two quarters too long and it has been hard for them to get back on the front foot for growth.”
This view suggests that the current problems are largely attributable to a policy error rather than any longer-term structural problems.
Philip Ehrmann, the manager of the Jupiter China fund, also says that some of the slowdown has been engineered, and where it has not, it is not necessarily a reflection of weakness within China. He points out that China cannot be immune to global forces. “The surprises are all on the export side. The country is transitioning from an export to a consumer-led economy. However, in the meantime, domestic consumption is very low and exports still exert a big influence.
“In the current climate it is not difficult to see why exports are problematic. The US may be picking up, but it is not compensating for the weakness elsewhere.”
However, Ehrmann emphasises that the Chinese export picture is nowhere near as bad as in 2008, when swathes of people became unemployed overnight as export orders were cancelled.
He says the debate has been skewed to some extent by the election, which has created some bluster and obfuscation. The transition of power has created an “interregnum” problem, which has halted progress on economic initiatives. For example, he says it has taken a long time for individual ministries to bring out the full granularity of the five-year plans. There is likely to be a pick-up in activity from here.
Gigi Chan, the manager of the Threadneedle Asia fund, says that much of the negative picture on China is coming from commodity producers. “The investment boom prompted significant spending on commodities. We do not expect the next phase of growth to be investment-intensive, so if that is your perspective, then China does have some problems.”
The question is whether this “higher quality” growth is coming through. First, is there evidence that a consumer economy is developing? Certainly, consumer growth is speedy. China’s retail sales grew 13.7 per cent in June over last year (or 12.1 per cent inflation-adjusted). For reference, UK retail sales grew 0.8 per cent over the same period. However, this represents a substantial slowdown in growth over the 13.8 per cent recorded in May and the 17-18 per cent recorded over the course of 2011.
Michael Buchanan, a China economist at Goldman Sachs, says the government is doing a better job of promoting consumer growth than is recognised. He says retail sales figures can be misleading, but data from the national accounts suggests that retail sales continue to grow ahead of GDP.
“The growth rate is phenomenal compared to any other country,” says Buchanan. “The combination of some stimulus to the consumer plus rapid wage growth is helping to deliver strong consumption.”
Equally, he argues, it is not necessarily a probelm if China does slip back into generating some of its growth from government investment. Although the country is investing at a significant rate, higher than the peak rate of all the Asian tigers and Japan since World War II, it is doing so from a position of a current account surplus, rather than – as was the case with many other countries – a current account deficit.
Weir says that higher consumption growth is still a major policy target for the Chinese government. “There are a number of affordable housing projects in place, for example. When people get to buy their own homes, they get a feeling of wealth, they fit the homes out.”
However, Weir admits there are pockets of weakness on the retail sales side. For example, the pattern of consumption in auto sales has changed, moving from mass-market family cars to higher-end SUVs and luxury cars. This is a worry, and something investors need to bear in mind.
The macroeconomic picture is therefore perhaps not as bad as has been suggested. Export demand is weaker as a result of the problems in many developed markets; the development of a consumer economy may not be happening as quickly as economists had hoped; the election has stalled progress on some of the government’s goals; and the government may have to fall back on investment spending to shore up GDP growth in the short term. A “hard landing” scenario remains plausible, but unlikely.
Buchanan concludes: “There is a risk that the banks will need to be re-capitalised if there are too many non-performing loans, and the need to limit future increases in overall leverage may lower growth as a result. However, this is very different from a hard landing scenario.”
For investment managers operating in this environment, selectivity is important. Parts of the Chinese economy are buoyant and other parts are weak. Overall, valuations have fallen significantly, but not universally or – in some cases – sufficiently.
Ehrmann, for example, continues to avoid all exposure to exporters. “Until China has companies that can compete on a global stage rather than simply companies supplying low-cost manufacturing, we are only interested in the domestic economy.”
He points out that as China moves to a consumer economy and tries to rein in investment-led growth, there will be less and less demand for commodities such as steel. He says there are areas in which China is increasingly skilled.
“In this environment, we believe that there is far too much capacity in areas such as steel, so we do not want to own this type of company. They are not profitable enough and the outlook is deteriorating. We would prefer to own companies in environmental transformation, or industrial processes, where China is developing real skill.”
Ehrmann is not widely invested in direct consumer companies. These had a significant boom as investors grew increasingly excited about the rate of consumer growth and became very expensive. Much of this over-valuation has come out of the market now, but Ehrmann says there are still better opportunities elsewhere.
Chan of Threadneedle is similarly selective in her approach: “There is certainly a two-tier economy. The listed universe tends to comprise stodgy state-owned companies that tend to be inefficiently run, but have little competition. Around 60 per cent of the MSCI China is in these types of companies and that part of the economy is going through a significant de-rating, particularly the banks. That has been – and is likely to continue to be – a drag on index performance.”
However, she sees significant opportunities in private companies. She says: “All the banks are lending to the state-owned enterprises. Therefore lots of these businesses have been starved of cash and are still thriving. These opportunities may not be apparent from looking at the index overall.”
Chan says consumption is an important theme in the Threadneedle fund, “but it’s not just handbags”. “It is more about consumer choice and people taking responsibility for their choices, choosing this brand over that brand.” It might be consumers starting to upgrade from unbranded noodles to branded noodles, deciding that they trust certain companies.
She also holds some industrial companies. “China is moving up the value chain, upgrading its technology. There is increasing intra-emerging market trade and they are less dependent on developed markets. Wages are going up and there is a focus on automation.
“The digital superhighway, mobile communications, using the internet are all expanding. There are lots of Kindles, and social media is expanding. China is ahead of many other countries in online advertising, for example.”
While China still lags in some areas, it is trying to forge links with developed market technology companies and harness their technology skills. In other areas, it goes one step further. For example, China is well ahead of developed markets in areas such as renewable energy. It is the leading installer of wind farms around the globe and is also seeing strong growth in solar power.
Unlike the West, China has made renewable energy work. The Chinese pay lower prices for alternative energy – largely because they have scale and lower staffing, building and raw materials costs. Their factories tend to run at higher capacity and they have skilled, low-cost engineers. It is proof that China can trump the West in certain areas.
Ultimately, the poor sentiment towards China is creating opportunities. Gavin Hayes, investment director at Whitechurch Securities, says: “Although the short-term direction of the Chinese economy is difficult to predict, Asian markets are pricing in a negative scenario. For example, having fallen more than 70 per cent since 2009 the Chinese equity market currently trades at a historically cheap valuation of just 9.2 times forward earnings; which suggests there could be compelling value for long-term investors who are willing and able to look past the excessive short-term volatility.”
There are undoubtedly longer-term problems. Richard Titherington, the head of emerging markets at JP Morgan, is clear that this is a cyclical rather than a structural slowdown. However, he does consider that the country may have problems over demographics and the transition of its currency.
“I am not worried in the short-term, but [China] needs to float its currency fully and open its capital markets more widely,” says Titherington. “It needs to develop as its society develops. That means improving the rule of law. There remains a question over whether the Chinese get old before they get rich.”
China has its problems, but the prevailing sentiment seems excessive. Ehrmann says: “The process of going from everyone’s favourite market to a pariah has taken 18-24 months. I am shocked by how quickly it has come to be considered a basket case.”
China may remain unloved for some time, as statistics continue to weaken and investors fall out of love, but the underlying picture is not nearly as bad as some commentators suggest and bearish sentiment towards the region is starting to throw up some opportunities.
Despite Hendry’s scepticism, with respective growth rates of 1.7 per cent and 7.6 per cent, there is nothing yet to suggest that China will not strip the US of its crown of the world’s largest economy in due course.