Two events sum up the China dilemma facing investors. Digital commerce giant Alibaba listed in Hong Kong with the auspicious ticker HK:8899, raising the equivalent of $11bn (£8.3bn), but at the same time a crackdown on civil liberties protesters in the territory reminds us that China’s government plays by its own rules. There is always a balancing act between technological and commercial advancement and government prestige.
Despite the ever-present risk of state interference, arguably the trade-off stacks up. Buying into Alibaba means a slice of the Amazon (US:AMZN) of Asia – a company uniquely poised to take advantage of a 21st century consumption megatrend. China’s rise can be described as mercurial and its next phase, under the leadership of Xi Jinping, is taut with risk and opportunity.
Hong Kong flaring up is no surprise. Limitations of the ‘one country, two systems’ compromise reached in 1997, when Britain ceded governorship to Beijing, are exposed in a connected world of social media. Yet dissent is not confined to one westernised enclave – recently The Guardian reported how subversive codes were trending on Weibo (China’s most popular social media network). The target was mobile telecommunications firm Huawei rather than the communist party, but outrage that a fired employee was detained at the state-backed enterprise’s behest speaks volumes.
Coalescence with government has made Huawei enormously controversial in the west and it stands accused of technology theft and espionage (it is suing the Federal Communications Commission for blocking sales of its 5G infrastructure in the US). These issues are central to US President Donald Trump’s trade war with China, which remains possibly the biggest concern for the world economy. As well as the noxious relationship with America, the global significance of China’s companies and the state fund China Investment Corporation (CIC) move the dial for assets you already hold, from shares and bonds to the cash in your bank account.
Measured using market exchange rates, China’s $14.14 trillion gross domestic product (GDP) makes it the world’s second-largest economy. The growth rate has come off its double-digit peak in 2010 and the Organisation for Economic Co-Operation and Development (OECD) forecast this year’s figure will be around 6.1 per cent. Clearly, the trade war is a serious headwind and the Chinese government’s official growth target for 2020 is below 6 per cent. This is bad news for countries such as Germany, which exports capital goods worth billions of dollars to China, so consequences will include the European Union’s anxiousness to do a trade deal with the UK following Brexit.
The growth opportunity too big to ignore
Before examining the game-changing impact on the rest of the world, it’s worth considering the investment angle of China’s domestic transformation. Switch to the purchasing power parity (PPP) measure of GDP, and its economy is already larger than America’s, but the stock market has yet to reflect this global significance. There is a distinction between H-shares, listed in Hong Kong, and A-shares of the mainland exchanges located in Shanghai and Shenzhen. Thanks to its British heritage, Hong Kong has an established equities culture, but the mainland markets only launched formally in 1990 – a decade after former leader Deng Xiaoping’s first reforms began China’s economic miracle.
Including dividends, Chinese A-shares’ compound annual rate of return was 5.7 per cent between the end of 1992 and the end of 2018 – this figure is taken from a study by London Business School professors Elroy Dimson, Paul Marsh and Mike Staunton. The number was less than for the MSCI World index (7.7 per cent in the same period) and the academics include the paradox of government involvement in state enterprises but weak regulation and governance of companies, among reasons for the underperformance. Both observations will concern investors, but as China’s capital markets mature, they get harder to ignore. Opaque reporting and companies’ complex relationship with the government means there is plenty to be said for active fund managers with an ear to the ground. China A-shares are now included in MSCI indices, but passive strategies depend hugely on index methodologies. In the view of Sat Duhra, co-manager of Henderson Far East Income (HFEL): “The real gems in the China market remain the domestic-focused consumption stories which are generating abundant FCF [free cash flow], retain strong balance sheets and aim to increase dividends over time”.
This distinction between businesses with an export focus and those catering for China’s own rising consumption is important. America has placed tariffs on $550bn-worth of Chinese goods thus far and this has had a major impact on the operating performance of technology and industrial companies. Cyclical domestic industries haven’t felt such a pinch and Mr Duhra tells of a positive dividend surprise (the top-performing share in his portfolio this year has been a Chinese beverage company). He says: “China GDP is being driven far more by consumption than it is by net exports.”
Recent data shows retail sales growth slowing, but Yifan Hu, chief China economist, and Kathy Li, analyst, at investment bank UBS see this trend being softened by the strong upward trajectory in consumer staples demand. China has employed a range of fiscal and monetary policy tools to support its corporates, and domestic consumption names will benefit. These tools aren’t without drawbacks, however, and China’s ballooning debt levels are a source of systemic risk both for its economy and other countries.
Fiscal stimulus is focused on infrastructure spending funded by raising the local government bond (LGB) issuance quota to four trillion Chinese yuan (CNY) in 2020, up from CNY 3.1 trillion in 2019. The UBS team estimates that, after a brief deleveraging campaign in 2017-18, China’s macro leverage will have increased to 278 per cent of GDP in 2019 – and it will continue rising. They say this will “provide near-term economic relief, but it will also exacerbate the longer-term debt sustainability risks as the economy continues to slow”.
Going by the Monetary Report from the People’s Bank of China (PBoC), monetary policy is set to remain accommodative. Although November interest rate cuts were mild, UBS interprets the central bank’s actions as indicating a “continued easing bias”. Reducing banks’ reserve requirement ratio (RRR) – the percentage of deposit liabilities that must be covered by assets on their balance sheets – is another tool for boosting money supply in the economy. Slashing the RRR by 150 basis points (a basis point is a hundredth of 1 per cent) in October injected CNY 2.4 trillion in liquidity and UBS expects further action.
The need to cushion the pain from the trade war with America has clearly motivated policy and there will be hope that President Trump’s re-election campaign dissuades him from mutually damaging escalation. In October, the US suspended plans to hike tariffs on $250bn of Chinese goods from 25 to 30 per cent, but UBS describes “talk-fight-talk” as the new paradigm of Sino-American relations. By the time this issue hits the shelves markets will have reacted to a 15 December decision on another $150bn tranche that includes consumer goods.
Appraising the challenge of splintering supply chains, UBS posits a choice may arise for companies between leveraging China’s comparative advantage in labour, infrastructure and advanced industrialisation and America’s core high technology and innovation output. Of those two lists, America’s strengths look harder to defend and sensitivity about alleged technology theft must be looked at in this context. Ultimately, the economic struggle is the battleground of a geopolitical rivalry that western politicians failed to manage when in the ascendancy.
No tightening of the belt on the road to expansion
China, by contrast, has always played a long game. On becoming General Secretary of the communist party in November 2012 (and assuming the ceremonial office of president a few months later), Xi Jinping made projecting the nation’s power and prestige a cornerstone of his strategy. Flagships are the Belt and Road Initiative (BRI) and the 21st Century Maritime Silk Road. Inspired by the historic trans-Asian trade route, the stated aim is to build an infrastructure and development highway that supports the next phase of Chinese expansion.
The Asian Infrastructure Investment Bank was created to finance Xi’s long-term vision of establishing the world’s largest ever trading network by 2049 – the centenary of Chairman Mao Zedong’s revolutionary triumph. Lending by the bank is controversial – Sri Lanka’s Hambantota port effectively passed to Chinese control on a 99-year lease in 2017, ironically echoing the sort of deals the British used to subject China to in the 19th century. Potential military applications of these sorts of facilities will also concern the west.
Thirst for Chinese investment from Europe’s weak southern economies has caused consternation in the EU, although even German cities have benefited. It’s also somewhat hypocritical for northern Europeans to berate their southern partners given few have fully rebuffed overtures from Huawei to install 5G infrastructure, which the US is convinced is a Trojan Horse for spyware.
For investors in Europe and emerging markets, China is integral. The weakening demand for consumer products seen in the last few months is hurting German auto manufacturers and it could also affect luxury businesses such as Burberry (BRBY), whose recent success owes much to China’s growing affluence. The prominence of China’s role in local capital markets must impact banks such as HSBC (HSBA) and Standard Chartered (STAN) that operate extensively in Asia, and insurer Prudential (PRU) has recently altered its entire corporate structure to pivot towards the region.
Belt and Road will make emerging markets even more beholden to China, as the CIC is responsible for ever more development stimulus and the Asian Infrastructure bank is the financier of the partner states’ contribution to projects. Debt markets will become bound to the fortunes of Chinese lenders, which is why some of China’s domestic fiscal and monetary policy response to the trade war has potential for contagion if it goes wrong.