Through 2019, trade tensions are likely to continue. However, any near-term de-escalation has the potential to provide a catalyst for a relief rally.
China’s policymakers are at an important juncture regarding the future of the country and the economic growth model. Arguably the trade dispute, alongside the pressure of high debt levels and demographic issues (among other difficulties), is adding to pressure for the next leg of reform and opening up of markets.
Ironically then, Trump’s actions could speed up reforms, making China more competitive in the process. China’s companies are now arguably strong enough to cope with more foreign competition and that will drive standards up. If this occurs it could be taken quite positively by the market.
Filling the trough
Chinese authorities launched a range of monetary and fiscal stimulus in mid-2018 and this looks tipped to continue well into 2019. Measures so far have included:
We expect stimulus to have a widespread economic effect, helping to mitigate the impact of trade tariffs and stabilise growth. However, tentative signs of a property price correction suggest the risk of a broader slowdown, given the government’s focus on rebalancing the economy away from housing‑related investment. Thus, we remain vigilant observers of Chinese property prices, consumer sentiment and indebtedness growth levels.
China's new 'normal'
In our outlook for 2018, the Year of the Dog, we highlighted China’s emergence as a technological superpower, alongside its growing leadership environmental role. These two themes come together as simply part of China’s ‘new normal’, with a broad focus on reform and quality growth, with social and economic benefits.
A key focus is on China’s switch to a consumer-led growth model, where low penetration levels leave plenty of room to catch up. Industry leaders are seeing market growth and potential market share expansion, while increasing household wealth is driving consumption upgrades.
Figure 2: Consumer industries have great growth potential – Consumer product penetration vs. USA and Korea
Source: UNWTO, CEIC, Euromonitor, IWSR, Canadean, UBS, Goldman Sachs, Bernstein, as of 2016. Data rebased: USA = 100%.
In our piece looking ahead at the Year of the Dog, we highlighted China’s growing environmental leadership role. President Xi, and the Chinese leadership more generally, know that the serious pollution issues damage party legitimacy. They also appreciate the real-world benefits that will accrue to the Chinese economy by a focus on clean energy and environmental protection. Investors will need to monitor this development closely as it generates investment opportunities, not only in restructuring and reform in ‘old’ economy sectors, but also ongoing emerging ‘new’ economy sectors.
Figure 3: China’s emerging environmental leadership could be good for the planet, and provide investment opportunities
Source: BNEF, October 2018
Opening capital markets
The Year of the Pig is likely to be a decisive one in the opening up of China’s capital markets to foreign investors in both equities and fixed income. MSCI is currently consulting on whether to increase China A-shares’ weighting in its major benchmark indices from 5% to 20% in 2019.
Likewise, on the fixed income side, operational enhancements to ease foreign investor access means that Bloomberg Barclays will start including China in the widely followed Global Aggregate Index from April 2019. We think JP Morgan could start including China in the GBI EM Global Diversified Index in the second half of 2019, with FTSE Russell to follow with the World Government Bond Index. The growth of the Chinese bond market has been impressive, indeed, it looks set to exceed Japan’s this year.
Figure 4: China market size to exceed Japan’s this year.
Source: BIS, Standard Chartered Research
Beijing also plans to grant more approvals to global banks seeking majority ownership in their domestic Chinese ventures. The effort aims to deliver China’s commitment on opening the domestic market and accelerate the participation of professional institutional investors to nurture more mature capital markets.
Value or value trap?
Following a significant pullback in 2018, the Chinese equity market currently trades below its 10-year historical average valuation level from both the forward price-earnings and the price-to-book perspective. The valuation discount versus developed markets has widened despite China’s long-term potential under the new growth model outlined above.
Future growth looks set to be increasingly driven by consumer demand and services, led primarily by the private sector. After being bitten in the Year of the Dog, we believe that private company management appears unduly cautious about the future and could use a bit of the porcine optimism and equanimity.
While developed market earnings growth started showing early signs of downside surprise, we believe Chinese corporate earnings will face easier comparison on a year-on-year basis from the second quarter of 2019, as well as support from policy easing.
Figure 5: Valuations are cheap relative to history and the world
Source: JPM, Bloomberg, December 2018. Comprising the JPM GBI Global Index are bonds issued by the governments of Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, United Kingdom and United States of America. For further information on indices, please see the Important information section.
The fattening hog
The long-term investment case for China remains clear and opportunities are emerging in this environment. If we look beyond short-term headwinds, active investors with a disciplined investment process should be able to find quality Chinese companies with good long-term growth potential and decent management.
General risks: The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.
Specific Risks: Emerging markets (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems..
This material is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contain statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual results may differ materially from those stated herein.
All rights reserved. Issued by Investec Asset Management, February 2019.