Break-out Year for China?

Transcription

1 2018 Global Market Outlook Step Forward, Look Both Ways Investment Themes Break-out Year for China? George Bicher Chief Investment Officer, Fundamental Emerging Market Equities Laura Ostrander Emerging Markets Macro Strategist Andrew Xiao, Ph.D., CFA Senior Portfolio Manager, China Equity Watch for mispricing on deceleration fears We think markets are overstating debt fears and underestimating Chinese growth prospects, which may provide a window in 2018 for investors to gain long-term exposure. Own overseaslisted China shares, not local A-shares We prefer offshore Chinese equities because of sector and valuation benefits. Fixed income investors can t ignore China Consider that Chinese government bonds currently offer higher yields at similar ratings to major sovereigns.

2 China s New Year in 2018 will usher in the year of the dog, an auspicious animal in Chinese mythology symbolizing the coming of fortune. Following the consolidation of President Xi Jinping s power at the 19th Communist Party Congress, party leaders may point to this fact as a further sign that the country has turned an important corner in managing an orderly deceleration of growth and transition to a consumer-led economy. Indeed, China surprised skeptics in 2017 with better-thanexpected performance first-half growth was comfortably above the government s 6.5% annual target. We expect China to have another strong year in 2018, and market mispricings might offer compelling opportunities. Notwithstanding the country s high level of debt to GDP, which stood at 257% at the end of 2016, the Chinese government has signaled that it is prepared to oversee an orderly unwinding by reducing industrial overcapacity and housing stock. The rate of overall credit expansion has already begun to slow and the gap between credit expansion and nominal GDP growth has narrowed. We think the fearmongering over China s debt has been overstated and the market has underpriced China s ability to manage its debt and the forces driving growth. Therefore, we think 2018 could offer an attractive entry point for long-term investors. 2

3 Getting Rich Before Getting Old Central to our optimism about the investment case for China is our belief in President Xi s determination to build on previous reforms to boost economic growth. This includes measures to increase productivity, stabilize the financial system and further develop capital markets. All of these will be required to maintain growth levels at or above 6% a government priority in order to meet the 2020 centennial goal of doubling GDP and income from 2010 levels. Further goals are being set to move China from a middle-income country to a high-income one, aimed at ensuring China gets rich before it gets old, given its aging population. Currently, China s GDP per capita is $8,737, putting it in the upper part of the global middle-income bracket of $3,958 $12,235.¹ As 2018 unfolds, ministerial roles may see new faces, which could create uncertainty, and restrictions on information flow and personal liberties may become an issue. But, in general, we expect Xi and his government to continue on a positive path toward reforming the economy and enhancing growth. 1 As defined by the World Bank for 2017 Spend, Spend, Spend While Chinese growth has moderated from extraordinarily high levels, it is unlikely to reduce sharply in 2018, thanks to long-term trends such as the shift away from investment-driven growth toward consumption and services (see Figure 1). Parts of the industrial sector will continue to grow, but not as rapidly as before. However, the arrival of the middle-class Chinese consumer, whose household expenditure is growing exponentially, should help counter this. Figure 1 Consumption vs. Investment as Drivers of GDP Percent CNY Household Consumption Expenditure, Chinese Yuan (CNY) (rhs) Total Investment as % GDP Total Consumption as % GDP Source: China National Bureau of Statistics (NBS) as of September Past performance is not a guarantee of future results. This consumption drive has already had a significant effect on GDP. At the end of 2016, China s nominal GDP was $11.2 trillion, with GDP growth at 6.7% and services as the main contributor (see Figure 2). China s economy is now second in size only to the US at $18.6 trillion and larger than Japan, Germany and the United Kingdom combined. If China grows at 6% or above (current SSGA estimates forecast 6.4%), it adds $670 billion, the size of the Swiss economy, to its nominal GDP. Even at 4.5%, it adds $500-$550 billion. On this basis, we think some of the recent deceleration pricing of China looks overdone and could offer investors a window to gain exposure to long-term Chinese growth. 3

4 Figure 2 Consumption vs. Investment as Drivers of GDP Percent Percent Services % GDP Growth, lhs Manufacturing % GDP Growth, lhs Agriculture % GDP Growth, lhs Real GDP Growth YOY% Change, rhs Source: National Bureau of Statistics of China as of September Past performance is not a guarantee of future results. Figure 3 China s Contribution to Global GDP Growth (Purchasing Power Parity basis) Emerging Europe and Russia 5% LATAM 3% Japan 2% UK 1% Other DM 6% Euro Area 6% China 35% Middle East and Africa 8% Asia (Ex China) 24% US 10% Source: IMF April Past performance is not a guarantee of future results. 4

5 Debt: The Dog That Doesn t Bark Despite these positive macro trends challenges remain for China, in particular the high level of corporate debt. This has accelerated in recent years and yet remains the "dog that doesn't bark." Why? In our view, it is because the Chinese government has a range of tools at its disposal to manage these debts, which often go underappreciated by Western investors used to market-driven cycles. Chief among these tools is China s financial capacity. It has a vast amount of assets to help support a higher debt burden and debt to GDP ratio. Foreign exchange reserves stood at $3.09 trillion at the end of August 2017.² This is below the peak of almost $4 trillion in mid- 2014, but an improvement on the low of $2.99 trillion at the end of January 2017.³ A restricted capital account and the ability to halt capital flight also allow for greater flexibility in using reserves, though China is likely to reduce reliance on these as they can lead to the domestic misallocation of capital. In addition, the government can also coordinate the restructuring of state-owned enterprises (SOE's), thereby keeping aggregate debt at manageable levels, a move that does not align with comparative analysis models used in the West. Furthermore, widespread state ownership of companies allows underperforming sectors more time to turn around. The government may also influence corporate actions that can lead to de-leveraging, (for example, debt and equity swaps), manage capital flows, restrict home purchases and tighten mortgage lending, if necessary. Finally, consumer and central government debt is at a low level and China s debt is largely financed domestically. With inflation low, the People s Bank of China is able to provide liquidity to mitigate any risk-driven credit tightening or rein in leverage as needed. This makes a sudden, overwhelming debt crisis less likely. Instead, we would expect to see a managed tapering of debt accumulation as the government makes further progress on re-engineering the country toward sustainable growth. If this happens, 2018 should bring less reliance on the industrial sector, further restructuring of excess capacity, stabilization of the property market and long-term plans to manage underperforming bank loans. Should the economy take a different path, however, one of the warning signs will be acceleration in the pace of overall credit expansion and the growth of fixed asset investment. 2 Source: Bloomberg. 3 Source: Bloomberg. What to Own? In this environment, we believe it makes sense to focus on key underlying trends rather than own the broader benchmark. The biggest long-term trend, in our view, continues to be consumer spending. Understanding consumer behavior, payment channels and the products needed to satisfy China s expanding middle class should lead investors to robust growth opportunities. The fact that some market participants expect near-term financial dislocation has, in our view, created mispricing of securities and 2018 could be the time to take advantage of this. We believe many of the large Chinese banks are attractively priced relative to their ability to grow earnings, protect their balance sheets and pay dividends. 5

6 Of the two Chinese equity markets onshore and offshore we continue to prefer the overseas China equity market (represented by the MSCI China Index) to the local A-share one (represented by the MSCI China A-Share Index). This is because: a) MSCI China has much higher exposure to high growth and quality IT and consumer companies; and b) H-shares listed in Hong Kong have a lower valuation than their A-share counterparts. In fixed income, China is now the third-largest bond market after the US and Japan. Following the arrival of the Bond Connect link, it will not be long before Chinese onshore bonds are included in major bond indices used by global investors. These bonds, which have a very low foreign investor participation rate of around 2%, offer strong yield enhancement, in our view, compared to other major developed sovereigns. For example, Chinese 10-year government bonds, rated as A1/A+ by Moody s and Standard & Poor s respectively, have a yield of 3.60%, compared to Japanese 10-year government bonds with a similar rating that offer yields of 0.06%. 4 Given the different cycle of the Chinese market, compared to developed markets, these bonds also provide global investors with good diversification. While financial risks have not gone away in China, when viewed in the context of its political and economic structure and the leadership s ambition to de-leverage, they appear more balanced. Given the consumer spending potential of the 100 million-plus (and rising) middle class higher now than in the US and the dominant contribution China is making to global growth (see Figure 3), we believe there is a significant opportunity for investors to gain exposure to the fortunes of China in the Year of the Dog and beyond. 4 Source: Bloomberg as of September 29,

7 Glossary Gross Domestic Product (GDP) The monetary value of all the finished goods and services produced within a country's borders in a specific time period. Shadow Banking The system of non-deposit taking financial intermediaries including investment banks, hedge funds, insurance firms and other securities operators. 7

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