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Article | 15 February 2018 | Investments
The economic outlook in China is supported by synchronised global growth which is a significant tailwind for a country still largely dependent on exports.
Chinese New Year celebrations have begun with February 16th marking the start of the Year of the Dog. The dog is associated with honesty, faithfulness and responsibility, all characteristics investors would like to see in the companies they invest in.
Last year was an excellent year for investors in Chinese markets, the MSCI China index delivered a total return of 40.7% for sterling investors in 2017 the best annual performance since just before the financial crisis and follows a solid return in 2016 of 20.3%. So can China continue to deliver?
On economic growth China scores well. Not only is it positive but with GDP growth of 6.8% in 2017 it beat expectations. Current forecasts from the IMF are the strong growth is likely to continue through 2018 and into 2019. As such, concerns of a Chinese hard landing have faded and the fears of a slowdown which caused the global market sell offs in 2015 and 2016 have also abated. Longer-term growth is expected to slow, but in a gradual, manageable way as the country’s economy matures.
Business confidence in the country is also positive and consumer spending is growing, in 2017 retail sales grew 9.4%. However, investors should look at the economic growth in more detail. While consumer spending is growing, the country’s population isn’t really saving. The personal savings rate is currently just 0.35%. The issue here is if the Chinese economy slowed down faster than expected, then households could quickly find themselves in financial difficulties and would reign in spending sharply – causing more damage to the economy.
The stock market in China is full of businesses which are effectively state owned. They were being run for the interests of the state and not shareholders. They were inefficient and laden with debts and often they looked cheap on a valuation basis, but they were risky, a value trap. The Chinese government has previously been very inefficient and has supported many of these businesses leading to misallocation of resources, overcapacity and no profitability.
However, the current leadership in China has begun to actively address this issue, liberalising capital markets and introducing private ownership of state owned enterprises as well as shutting down poorly run businesses. This helps reduce overcapacity and refocus management on profitability.
Chinese debt remains a concern. On the surface Government debt to GDP looks fine at around 46% (compared to the US at 105%). But this doesn’t fully reflect the picture. Much of the Chinese debt is not on the Government balance sheet and sits in businesses, including the state owned enterprises and the shadow banking sector. Corporate debt is currently at 160% of GDP and personal debt has been increasing over the past five years, although it is still low. Borrowing has been growing faster than GDP as well. The biggest concern is the rise of the Non-Performing Domestic Loans which have risen sharply in the last five years.
At present China can afford to support itself, with over $3.1 trillion of currency and gold reserves and the country has begun to address the debt issues and reform its financial sector. The warning signal for investors would be if the debt to reserves ratio starts to rise. If the debt becomes too large relative to their reserves then the debt burden would become increasingly unaffordable and then investors would be right to be concerned.
2017 marked a new five year plan with an increased focus on improving the well-being of its citizens, reducing pollution and a continued clamp down on corruption. This has led to a focus on renewable energy and the country has become a leader of innovation as it looks for technological solutions to address its pollution problem. So far this focus hasn’t impacted on the economic performance of the country, but combined with the fact President Li is also reforming the financial system with a focus on lower but more sustainable growth we could see the current levels of growth come down in the future. The government is looking for China to be a leader of innovation and has become a global player in technology, but is also trying to do the same in a range of fields such as healthcare, electric cars and renewable energy.
The economic outlook in China is supported by synchronised global growth which is a significant tailwind for a country still largely dependent on exports. Whilst GDP growth is much stronger than in developed markets investors should remember it rarely correlates with the stock market performance. And if the country doesn’t bring its debt issues under control then the risk of a hard landing could return.
The country is now a leader in various industries and the rate of innovation is impressive, which should help create some exciting investment opportunities. However, the country is still, technically, an emerging market and there is the potential for some bumps along the way as we saw in 2015 and 2016. As such we remain neutral on the region and prefer a diversified approach to investing in China and use broader emerging markets funds. This gives managers greater flexibility, allowing them to move to where the best opportunities exist within emerging markets.