June 2016

CHINA ROUND-UP: Are investors right to worry about China?

There was panic in the markets after data showed that in 2015, China’s economy grew at its slowest pace in a quarter of a century. But are investors right to be so bearish? YesAlex Wolf, emerging markets economist, Standard Life Investments In China, we expect policymakers to continue walking a tightrope – balancing enough fiscal and monetary stimulus to prevent a sharper growth collapse, while slowly proceeding with supply-side reforms to remove excess capacity. Slowing Chinese demand, which we believe was worse than official data reflected, was one of the largest causes of the emerging market trade and output contraction experienced last year. As such, we see some room for cyclical upside, as policy measures take effect. However, our longer-term outlook on China has become increasingly negative. Our own view is that GDP growth is closer to 5% than the 6.9% reported by the Chinese authorities. Although we believe policymakers will avoid a hard landing, it is becoming more likely that Chinese leaders will not enact necessary reforms quickly, especially of state-owned enterprises (SOEs). SOEs are at the heart of China’s problems, and reforms here would deliver the biggest dividends from a growth and rebalancing perspective, but Beijing has been dragging its feet. SOE reform plans delivered over recent months were received with optimism, but we believe they failed to address corporate governance issues or the reduction of excess capacity through corporate restructuring and closures. Consolidation has been the preferred path, and the government seemed unwilling to sell or reduce state assets in a meaningful way. The plan will lack effectiveness if the focus on addressing loss-making companies and overcapacity is limited to a small number of centrally owned SOEs, and not the mass of locally owned SOEs, where most of the overcapacity and inefficiencies lie. If China growth does disappoint, this could drive continued volatility in global markets. Sluggish growth is priced into markets but a hard landing which impacts on currency, capital flows, commodities and social stability is not. This could result in more aggressive domestic monetary easing, forcing the renminbi lower against the dollar, with adverse implications for global inflation and a blow to emerging markets dependent on robust Chinese demand for manufactured goods and commodities.  NoDavid Raper, portfolio manager, Comgest Growth Greater China The consensus view on China is resolutely negative, with scepticism driven by the slowdown in growth in the country’s manufacturing and exports, ballooning debt levels, underperforming state-owned enterprises and high valuations of small pockets of the Chinese equity market. This negativity was crystallised in the large China sell-off in summer 2015, as well as the difficult start to 2016. While many of these concerns are valid, they only tell one side of the story. There should be a distinction made between the two sides of China: the ‘OLD’ China and the ‘NEW’ China. The ‘OLD’ China is dominated by manufacturing and infrastructure industries, which have been the basis for China’s past success in the export markets and the strength of its infrastructure. The ‘OLD’ China has struggled with the slowdown of global trade and the transition of the Chinese economy. Capacity has to be reduced and productivity needs to be raised for these areas to recover. The ‘NEW’ China, on the other hand, hosts a range of companies, for example in the internet, insurance or gaming space, with high margins, strong capital returns, cash-rich balance sheets and good growth prospects.  In our view, the ‘NEW’ China offers valuable investment opportunities over the next stage of China’s development. NetEase, an online gaming and advertising company, is a stock we are invested in that has demonstrated sustained growth over more than a decade. It has very sound cash fundamentals and was extremely successful in shifting its gaming software franchise from desktop computers to mobile computing, which now accounts for more than 50% of its gaming revenues. We are confident that the ‘NEW’ China will continue to grow and become a more dominant part of the country’s economy. Penetration rates for many consumer goods and services are still rising. At the same time, the sophistication of the consumer has made huge steps forward and the internet continues to revolutionise the sector. One can look at Parkson Retail or Golden Eagle to realize that department stores struggle to stay relevant. Stock-picking skills remain important and it is not good enough to just buy companies exposed to the Chinese consumer. An area of expansion in China is life and health insurance services, which should prove an effective vehicle for Chinese citizens in which to save, as the state pension system is insufficient and ‘out of pocket’ healthcare spending remains elevated. The sector provides more profitability and higher capital returns compared to developed market peers, and regulation is favorable, especially in China. Stock picks in the sector, such as China Life, provide a number of compelling propositions for investors.  We are aware that the magnitude of the transition currently under way in China can lead to bumps in the road, but we believe that these changes offer a wealth of stock-picking opportunities, and should help us to remain comparatively insulated from possible shocks in the economic trajectory while benefiting from its long-term growth drivers. ©2016 funds europe

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