So much so that we recently went out there to evaluate what was happening in China and how the economy was performing. It was obvious by the end of our trip that many economists are right to be worried about certain recent economic data points and, in particular, the rumblings in the Chinese financial sector.
Perhaps our most interesting conclusions were that the world is going to have to get used to a new level of Chinese GDP growth of around 5%, a long way down from the heady levels of 10% growth enjoyed in the most recent decade.
Contrary to these observations, the latest GDP data released in mid-October hinted that the Chinese economy had actually picked up pace with a cyclical improvement in the third quarter.
Growth was confirmed at 7.8% year-on-year. These numbers looked sound, as anecdotal evidence and factual data, such as power supply, had suggested that growth was improving. However, it is our central view that as the Communist Party rebalances the economy away from exports and towards domestic consumption, a new lower level of growth will be found.
Despite this reduced economic power, many Chinese equities are very cheap and we believe a great long-term opportunity is on offer.
Unknown quantities
There is plenty of confusion being generated by the new government.
Although we know that the new administration’s aims are to rebalance the economy, usher in financial market reform and ease levels of social discontent, we do not know how they will do this. Even the keenest and most connected political experts leave Beijing guessing at the plans.
There have been a few targeted measures, such as the warnings and action by the People’s Bank of China in the money markets in the early summer, but we are yet to see a decisive strategy to achieve their aims.
We need to see a clearer vision over the next few months.
All the while they deliberate over their plans it is clear that parts of the economy slowed down far more quickly than most expected, triggering another poor year for Chinese equities and global resources companies who had become dependent on the hungry Dragon’s supposedly insatiable appetite.
Knock-on effects
However, the worst might be yet to come for the economy and, by implication, places like Australia.
If the Chinese Government is serious about shifting the growth model away from fixed asset investment towards services and consumption – as we feel convinced it is – there will have to be a period of readjustment, and this will bring greater short-term uncertainty and greater volatility over growth.
There is certainly room for a greater focus on consumer spending within the economy, as currently that sector of the economy only accounts for 34% of total GDP. That is much lower than the UK, on 65%, and the US on 70%.
This swing will require patience from the Chinese Government, citizens and global investors. On the positive side, in the longer term, the economy should be better balanced and growth more sustainable.
Hamming it up
There are also huge fears in the West about the pending implosion of China’s financial system, brought about by the shadow banking system and insane wealth management products, including a bond which has been backed by ham. (Yes, that’s ham the pork product). Our key take-away was that the Chinese authorities recognise the issue and are moving to address it.
The worst-case scenario that is loved by the western press is unlikely, but undoubtedly losses in the banking sector are going to rise. There is certainly the possibility that the banks will have to be recapitalised, but that will be manageable in a closed economy.
Indeed, we think that when the problem is finally dealt with properly and the losses are acknowledged, it should be a cathartic event.
Contrarian contenders
So how can we possibly claim that the uncertain backdrop I have described is good for Chinese equities? In the short term it possibly is not, and there is a fair chance that the next few quarters could prove tricky and volatile.
However, we would argue that two years of negative performance and a material de-rating of Chinese stocks has now factored in a very bearish scenario. Even if you take the lowly-rated banks out of the equation, then the Chinese market trades on a lowly 9x price earnings multiple.
Add in the banks and it is around 7-8x. Totally hated, generally distrusted and widely shunned by global investors, Chinese equities could prove to be a classic contrarian trade and could well be one of the best places for returns in the remainder of the decade.
We are overweight emerging market equities, particularly in North Asian value markets, such as China, Korea and Hong Kong.
One outcome of the mini-crisis that we endured over the summer is that not all emerging market economies are equal. Clearly the cyclical forces and brittle nature of markets can count against those economies that have current account deficits or unsound finances.
What was amazing was how quickly cash-rich China went from the enfant terrible to the solid rock of emerging markets in a few short weeks, just as the much-revered Indian and Indonesian economies became places to flee. In reality, this was almost purely down to fears over the currencies of these economies where the government is heavily reliant on external financing.
Such economies had benefited from the ultra-loose monetary policy pursued by the US and many worried that as the US started to wind up their QE programme, such dependent nations would struggle.
These concerns still linger, despite the central banks of many countries having stepped into the FX markets to try and shore up their currencies, as well as raising interest rates as another tactic.
Pitfalls and possibilities
The summer events were another unwelcome reminder of the pitfalls of emerging market investing, at a time when none was needed, as assets had already fallen far out of favour over the past few years.
Indeed, you can now buy emerging market companies at almost record discounts to their developed world peers. This to us is an opportunity.
We remain overweight emerging market equities, respecting the long-term, contrarian-valuation opportunity, and are looking to go fully invested versus benchmarks on any further weakness.
Playing the long game
The key lesson we have learnt from previous periods is that you should always invest after precipitous falls and periods of underperformance. As we look forward, this might be wrong on a short-term view, but we expect to be well rewarded in the years to come, particularly from our Chinese investments.
Certainly China and the other emerging market economies have slowed over the past six months, but we do not see this as a case of “game over” and we believe that the valuations of many assets are now easily compensating patient investors for the risks they are taking.
In China’s case, the shift from infrastructure and exports towards domestic consumption should be viewed as an opportunity, rather than as a risk.
