Exploring how the investment case for China has changed with a weaker renminbi and why investors should look to harness the strength of the Chinese consumer for growth opportunities.
China’s economic performance in 2015 has been weaker than the ruling Communist Party would have liked and the accuracy of gross domestic product (GDP) data is increasingly being questioned as the slowdown unfolds. China is trying to rebalance its economy away from infrastructure investment-led spending to domestic consumption but this is occurring at a challenging time as the nation juggles the competing needs of growth, economic reform and deleveraging. During the transformation phase, China’s growth will necessarily weaken. Recently, the Communist leaders have stepped up fiscal stimulus measures in order to improve growth, while at the same time reducing their own GDP growth target to 6.5% over the next five years.
State-led economic support
In efforts to boost investment expenditure, the authorities are calling on the lending power of policy banks such as the China Development Bank. These banks have no depositors and are 100% owned by the state. They are therefore able to lend at low rates to fund public infrastructure improvements and projects such as urban redevelopments.
In terms of subsidies, the focus will be on consumer-orientated industries. This year the government has cut tax on small cars to spur auto sales and eased mortgage requirements to bolster the property sector. Among the sectors earmarked for development are technology, services, healthcare and transport.
Meanwhile, on the monetary side, following six rate cuts since November last year, real interest rates are still at elevated levels, meaning there is room to further lower policy rates. As China spends its foreign exchange reserves supporting the renminbi (RMB), we expect further cuts to the banks’ reserve requirement ratio (RRR) to offset the enforced liquidity drain.
Bond market boon
China’s bond market was non-existent ten years ago but is now the third largest in the world, at around US$4.2 trillion (RMB 35.9 trillion), according to Goldman Sachs. One of the key aims for developing the bond market is to reduce the reliance on banks to finance the corporate sector.
The currently strong bond market is driven by the expectation of lower rates and healthy investor demand meeting limited issuance. Consequently, many companies are able to refinance offshore US$/HK$ debt with RMB debt, which has the dual benefit of reducing their overall interest cost and better matching their cash receipts. For example, property developer Shimao recently issued a US$6bn 5-year bond with a coupon of only 3.9%. This new financing avenue is benefiting companies that require large amounts of capital to fund operational activities such as property developers.
A modest short-term rebound?
Stimulatory policies and a possible uptick in the manufacturing purchasing managers’ index (PMI) survey may prompt a market bounce in the coming months, partly because global sentiment towards China is as negative as we have ever witnessed, and any improvement might be a positive surprise. This view is supported by the fact that recent rate cuts have helped revive money supply growth*, an indicator of economic activity, and the stability shown by the renminbi and the Shanghai market since the summer panic.
*real narrow M1 (coins and notes in circulation and other money equivalents that are easily convertible into cash).
Long-term investors need to accept slower growth and target their investments
Current stimulatory measures appear to be little more than a ‘sticking plaster’ as the old engines of economic growth in China - exports, government and private sector investment – are not running as strongly as previously. Unfortunately, questions around the validity of economic data means the consumption side of the economy, which appears robust, is not able to inspire confidence. For example, cinema receipts, air travel and online shopping revenues are likely to be inaccurately recorded in GDP and retail sales numbers.
The diverging fortunes of manufacturing and services PMIs provide an indication of where to look for investment opportunities - the consumer-driven economy (see chart). Companies in these industries are particularly well represented within US-listed Chinese shares (ADRs). Examples include e-commerce giant Alibaba, online travel agent C-trip and education company New Oriental. Many of these consumer service companies are asset light and generate strong cash flows, an ideal position to be in during a slowing economy. Additionally, these companies are, in a move we wholeheartedly welcome, being included into the MSCI China indices from December 2015. This development will improve the quality of the index by improving its breadth and reducing the weight of state-owned enterprises.
Services sector strength reflects strong consumer demand
Source: Markit, Caixin. Monthly PMI data December 2012 to October 2015.
Summary: look beyond the macro, focus on the micro
We are mindful that the investment case for China changed in two significant ways in 2015. First, the renminbi is on a depreciating path and this is a new headwind for sterling or US dollar- denominated investors. Second, President Xi’s reform agenda is looking less convincing as it has reached a stage that requires the Communist Party to give up more control – a dynamic that is just not in its DNA. We are carefully watching the repercussions of a slowing China, focusing on how slower growth will impact debt servicing by local governments and state-owned enterprises in particular.
We have long known, however, that Chinese equity markets are emotional places full of noise and news, making them dependably, if not regularly, irrational. In these times it pays to quietly accumulate well run businesses that scared investors are indiscriminately selling, as we were able to do in the middle of 2015.
As we have been cautious on China’s economic performance for a number of years now, the weaker economy is not a surprise to us and consequently we have not built a portfolio that needs 7.5% GDP growth or the renminbi to be at particularly elevated levels. We remain very comfortable investing in high quality growth companies plugged into the consumer economy, many of which are trading, in our view, on very attractive valuations.