As the world’s second-biggest economy slowed down, it weighed on commodity markets and pushed up risk premia in emerging bond, equity and currency markets. The fear of a potential sharp slowdown in China, temporarily, even led to fears of a global slowdown and weakness in global equity markets.
In our view, markets are generally too negative on China and too short-sighted. Too negative, firstly, because they underestimate the potential for China to act against the cyclical slowdown. Granted, industrial production and exports are weak, but weak trade is a global rather than a local phenomenon. Moreover, retail spending, housing markets and large parts of domestic demand are relatively solid. Importantly, any further weakness is likely to be addressed by a combination of monetary and fiscal easing, and the scope for such measures remains large, due to a healthy fiscal situation and high real interest rates, which can be cut further. As a result, we think that Chinese H-shares (quoted in Hong Kong) should perform well in 2016.
The short-sightedness of markets contrasts with the government’s long-term vision for the country, which remains committed to reform. This different timeframe and thinking pattern makes for a difficult relationship and may continue to lead to some misunderstanding and volatility in Chinese markets.
However, we think that the longer term investment environment, coupled with current attractive valuations, provides long term opportunities. It is these long term opportunities and China’s longer-term transition that we want to focus on below.
The long-term vision
As China’s economy matures, it is natural for its growth rate to slow. What is important is whether the country adapts its business model, in order to avoid the middle income trap. This is what China has in mind and is planning for: to rebalance its economy from being an outward looking, export-led economy, to a more domestically focused, consumption driven economy. Policy makers want growth to stabilise around 6.5% and make it more sustainable at that level, while also introducing more liberalisation.
Such a shift is a tall order, but recently announced measures and some of the agenda points of the fifth plenum (for adoption during the Party’s congress in early 2016) give us a clear indication of some of the focus areas.
We believe that there are a number of measures that will significantly contribute to the expansion of consumption. The relaxation of the one-child policy is a momentous change and even though it will take time to help curb the decline in the workforce somewhat, it should lift certain areas of consumer goods. We see the biggest immediate changes in consumption elsewhere, though. The extension of social security to gradually cover the entire older population may cause the precautionary savings rate to drop, and may boost consumption. One of the areas we are optimistic about is Chinese outward travel. The number of Chinese holding a passport is still below 5%, but as visa restrictions are being eased for business travel, and flight frequencies increase, travel should pick up, in our view.
There are a number of important reform initiatives that fall under the objective of ‘sustainability of growth’. China’s growing commitment to reduce its carbon footprint is important, not just because it is the world’s largest emitter of greenhouse gasses, but also because of a growing interest from the Chinese population in this area. We see the best opportunities in wind and solar energy production, which we think may double and quadruple by 2020, respectively, from the current level. Second, the plenum expressed a clear desire to move its industry up the value chain, by moving from an investment-driven into an innovation-driven economy. To do this, high-school coverage will be improved. Finally, China continues to work on its upstream and downstream network, to ensure access to materials inputs and to its markets for its products. The connections through its New Silk Road are an example of this strategy.
Finally, we believe that currency liberalisation will continue. The fears of a currency war which led global stock markets to tumble in August were misplaced, in our view.
Currency reform is aimed at a wider use of RMB as a trade currency, an investment currency and a reserve currency. For the latter goal in particular, the recent inclusion of RMB in IMF’s special drawing rights (SDR) basket gives it a significant boost, especially with regard to its international usage. We believe that this will further add to the credibility and the use of the currency, and improve its liquidity. Opportunities for investors continue to grow, with the offshore CNH bond market providing a way for foreign investors to diversify currency exposure and benefit from the yield pickup over developed markets, while managing credit risk through a careful selection of Chinese or developed market issuers.
In summary, it is natural for a maturing economy to slow, but the short term cyclical downturn should not be confused with the longer term path that China wants to follow.
We see both short term opportunities (because of an overly cautious consensus view on the economic outlook) and long term opportunities, which tap into the strategic priorities set by the Chinese government.