Intellectual Capital

China Equities

China: Yesterday's Story or More Compelling Than Ever?

Eric C. Moffett, Portfolio Manager, Asia Opportunities Equity Strategy

Executive Summary

China currently finds itself at an uncomfortable juncture, troubled by slowing growth and falling markets and locked in a trade dispute with the U.S. With some suggesting that China is at risk of becoming “yesterday’s economic success story,” what does the future hold for investors?

Faced with slowing economic growth, protectionist trade policies, and an uncomfortably high debt burden, some are suggesting that China is at risk of becoming “yesterday’s economic success story.” This raises questions about what the future holds for China and, similarly, for investors in China.

GDP Growth is Key, but Maybe not the Kind You are Expecting

The macro outlook in China continues to dominate investor thinking, with concerns laser-focused on the country’s slowing economic growth. China’s economy is currently growing at a little over 6% p.a. While it has decelerated from the double-digit growth of a decade ago—levels unlikely to be seen again—it is still solid from a global standpoint.

However, what matters most for many domestic stocks is not so much national GDP growth, but the GDP growth of households. Here, data shows that disposable household income has increased significantly over the past 10 years, despite the slowing economy (see graph below). There are two reasons for this: demographics and policy. In terms of demographics, the pool of working age people in China has been stagnant for some years, but spending by this group continues to grow. China factory owners, for example, are contending with progressively higher wages every year, to attract, and then keep, new recruits.

On the policy side, the government has made a priority of delivering meaningful wage increases every year over the past decade, across every province in China. The approach is not popular with businesses, but the government’s aim is to deliver more money into the hands of minimum wage earners and thereby help to underwrite a consumption boom.

The income growth contributes to improved affordability for working-class families across a range of consumables, including holidays, insurance, health care, and medical services. And this increased spending is exactly what is happening across a demographic of hundreds of millions of people.

China’s Household Income Continues to Rise

As of December 31, 2017

Sources: Haver, China National Bureau of Statistics, OECD.

The Trade Narrative has Shifted, and not in China's Favor

The China/U.S. trade war remains a key concern for investors in China, and prospects of improvement appear slim, certainly for the remainder of the Trump administration. Over the last six months, the narrative from the U.S. has shifted markedly. Originally simply seeking a better deal, and being apparently open to negotiation, the U.S. has more recently taken a harder line, notably extending sanctions to the “China 2025” industries, i.e., the high-tech sectors at the heart of China’s plans to become a developed, self-sufficient country.

It is highly unlikely that China will want to be subordinate to a western power intent on containing its modernization progress. It may well be hoping that the Trump presidency lasts only one term and, thus, be prepared to wait. However, in the meantime, there appears little scope for the current trade tensions to ease.

Despite this, it remains an ongoing misconception that China’s economy is dependent on exports. Indeed, net exports accounted for only around 2% of total GDP last year. This is largely because the “value-add” in China is surprisingly quite low. The iPhone1 is a great example of this. While the phones are manufactured in China, only about 4% of the value-add happens there. Most of the components come from elsewhere, and the profit is largely captured by Apple in California.

Significantly, China trades far more with other emerging market countries than it does with the G3 (Europe, Japan, and the U.S.). As such, the U.S. has less leverage today than it did 15 years ago when trade was heavily weighted to the G3. This mitigates the pressure on China to react. The Chinese government also has numerous levers at its disposal, such as industry subsidies and tax rebates, to help soften the impact of trade tariffs.

Opening Quote [It] remains an ongoing misconception that China’s economy is dependent on exports. Indeed, net exports accounted for only around 2% of total GDP last year. Closing Quote

China's "Debt Mountain" Needs to be Viewed in Context

Investors also see China’s substantial debt stockpile as a primary risk. It is true that, over the past 10 years, nonfinancial corporate debt to GDP in China has risen from 100% to 165%, with some commentators nervous that this level is simply unsustainable. However, it is crucial to keep in mind that interest rates in China have plummeted over the same period. Ten years ago, the corporate borrowing rate was in double digits. Today, it is between 4% and 5%. Corporate interest relative to GDP, which is the key systemic risk indicator, is currently at 7%, the same level it was 10 years ago.

As the rate cycle turns, China is likely to feel the stress but, unlike some other major markets, there is no pressure to raise rates anytime soon. There are no signs of inflation currently, and the impact of tariffs is likely be deflationary. All of which suggests that the level of debt is not yet a major concern.

The Inefficiency of the China A-Shares Market Appears Compelling

While Chinese equities have underperformed all other major markets, year-to-date, in 2018,2 there is a lot to be excited about in this market. Valuations look very cheap, which is partly a reflection of the slowing growth/trade sanctions headwinds. However, a quick comparison shows the MSCI World Index3 is currently trading at a price/earnings ratio of nearly 20 times, well above the China A-shares market at 12 times earnings. This represents crisis-level valuations for an economy that is still growing faster than most places in the world.

Opening Quote The China A-shares market is trading at 12 times earnings. This represents crisis-level valuations for an economy that is still growing faster than most places in the world. Closing Quote

In the 15 years that I have been investing in emerging markets, I have never seen greater inefficiencies than I see in the China A-share market today. This is partly due to it being a very deep market. There are a lot of well run, profitable companies, but many remain hidden from the gaze of foreign investors. As a retail-driven market, information is not often published in English, nor are investor roadshows a feature of corporate activity, meaning that only a small percentage of the market is owned by foreign investors (see graph below). This represents an attractive environment for finding mis-priced opportunities.

Of course, poor quality companies in the A-shares market are present, particularly down the market cap spectrum. However, it is possible to find blue chip companies, growing by around 15% a year, at very reasonable valuations. This level of growth may be less attractive to local investors, but for the astute investor these are quality companies, with sound balance sheets and good dividend profiles.

China A-Shares Represent a Huge Opportunity Set to Explore

As of June 30, 2018

Source: BofAML.

"Cheap Manufactured Goods and Copied Intellectual Property"

This is another misconception that no longer describes modern China. As wages have risen, China has become less competitive and has moved out of a range of manufacturing areas. Much of the manufacturing capacity concentrated in Southern China, for example, has been either closed or moved away. China is now moving up the value chain, with a growing amount spent on research and development (R&D) in high-tech areas like artificial intelligence. R&D expenditure has risen to OECD levels of 2%–2.5% of GDP.

Electronic payments is one area that China is making great strides in terms of innovation and progressing up the value chain. Few people in Beijing or Shanghai now carry cash, with mobile devices the preferred mode of payment, via service providers like Alipay and Tenpay. China has effectively skipped the credit card phenomenon and gone straight to electronic payment processing. As a result, the progress in this area is well beyond many major markets, including the U.S. This represents a potentially powerful trend that can be directly accessed through the parent Internet companies of these service providers, such as Alibaba Group and Tencent Holdings.

When it comes to applying new technologies, China is a fertile testing ground, as new ideas and products can be rolled out to millions of people in a relatively short time. Good ideas quickly stand out and are widely adopted, while the bad ideas disappear just as quickly.

Crisis-Level Equity Valuations

I continue to believe that growth in China is still strong. And if you look at household GDP growth, it is still very strong. Meanwhile, from a market perspective, valuations are not only undemanding, they are currently at crisis levels where the domestic A-shares market is concerned. That is not to say that they can’t go lower still, but when I look at the Chinese A-share market today, I see some of the greatest inefficiency I’ve ever seen.

The specific securities identified and described above do not necessarily represent securities purchased, sold or recommended by T. Rowe Price. This information is not intended to be a recommendation to take any particular investment action and is subject to change. No assumptions should be made that the securities identified and discussed  above were or will be profitable.

1The trademark displayed is the property of its respective owner. T. Rowe Price is not endorsed, sponsored, or otherwise authorized by or affiliated with the trademark owner represented by the trademark displayed herein.
2Source: FactSet, as of October 20, 2018.
3Source: MSCI, as of October 20, 2018.
Copyright 2018 FactSet. All Rights Reserved.

 

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of November 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets.

Unless otherwise indicated, all data is sourced from FactSet—Copyright © 2018 FactSet Research Systems Inc. All rights reserved.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

T. Rowe Price Investment Services, Inc., Distributor.

© 2018 T. Rowe Price. All rights reserved. T. Rowe Price, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

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