Emerging Markets

Taking Stock of Better Quality Growth in China

In this issue of Insights, June Lui, Portfolio Manager, BMO Global Asset Management (Asia) Limited, goes beyond trade rhetoric, headlines and geopolitical friction to discuss where Advisors can find better investment opportunities in China.
March 2019

June Lui

CFA, Portfolio Manager, BMO Global Asset Management (Asia) Limited

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In this issue of Insights, June Lui, Portfolio Manager, BMO Global Asset Management (Asia) Limited, goes beyond trade rhetoric, headlines and geopolitical friction to discuss where Advisors can find better investment opportunities in China.

 

Over the course of a few months, the escalated and de-escalated talk on U.S.-China trade tariffs has taken a rather interesting turn. What started out as a volley back and forth, with President Donald Trump announcing plans to raise tariffs on US$200 billion in Chinese goods if no deal had been reached by March 1, has recently turned to what U.S. trade representatives have cited as “substantial progress” in talks in Washington.

But this trade war is not about the U.S. trade deficit itself. The overall picture is that a political rivalry has developed – not just in trade and economic power, but also in technology and political status around the world.

Nevertheless, China’s economy has slowed in recent years, and its resulting eagerness to keep gross domestic product (GDP) steady has given the U.S. a few more bargaining chips.

 

Deleveraging and the slowdown

In fact, some of the slowdown within the Chinese economy is self-inflicted. Since 2008, the government has infused trillions of RMB liquidity into the economy; however much of the money was used in low-efficiency state sponsored projects, creating little economic value and casting doubt on the quality of loans made to these projects. When state officials realized the need to clear up these bad debts, they started a campaign of deleveraging that came into effect about three years ago.

While this was the right direction to take, it should be noted that curbing the use of credit put a brake on macro growth. As the trade war commenced, external shocks from the newly imposed tariffs and uncertainty on negotiation amplified the deceleration, leading to a realization among senior leaders in the Chinese Communist Party: that deleveraging – despite its potential benefits – should be put on pause for now.

 

The growing middle class

The top policy priority for the Chinese government is to maintain stable employment and household income growth. Strong economic expansion and urbanisation in the last few decades helped fulfill these objectives by lifting GDP per capita to approximately US$9,500, thereby elevating more than 500 million people into the middle class by 2018.¹ However, the high savings ratio of this population means its potential spending power is tremendous.

What is important for your clients to know is that despite any eventualities that come with a trade war or disruptions in supply chains, the Chinese government has already drafted a plan for boosting domestic consumption over the long term, by cutting taxes for individuals and corporate entities. Given the embedded strength of household savings, it is possible for this support to increase spending and loosen purse strings to offset any external threats that tariffs or trade wars may have in the short term.

In fact, levering domestic consumption growth is the key to China’s economic evolution – and our investment thesis. We believe generic consumer sentiment might suffer in the short term because of trade war rhetoric or poor stock market performance, but China’s long-term secular growth drivers – particularly rising income levels for an increasingly aspirational urban middle class – remain very much in place.

 

Manufacturing and technology transformation

In addition to high personal spending, China is benefiting from a cash infusion, a trend toward quality over quantity and unparalleled spending on a world-class technology sector. Why is this important?

Well, China’s export dependence has fallen significantly in recent years. As the country took steps to divest its low-end manufacturing, allowing countries like Cambodia or Vietnam to take on those roles, total exports dropped from about 36% of China’s GDP in 2006-07 to closer to 17% today.² While these exports are still a meaningful contributor to China’s economy, it is clear that domestic consumption – especially of new technologies – has become more important, as reflected in the growth of companies like Tencent, Alibaba and Baidu.

The movement away from low-end manufacturing was driven by the fact that labour costs have been increasing in China. Younger generations born under the one-child policy are becoming more educated and unwilling to work in sweatshops. Most of the new jobs created in recent years have been in the service sector and technology industries. This skilled labour force, together with the billions of dollars invested in research and development of technology, has enabled the upgrading of the manufacturing capability. The tech sector is booming and in many respects, China is the “new silicon valley,” especially in terms of commercial applications. Between 2003 and 2013, China’s research and development investments grew an average 19.5% per annum, much higher than that of the United States.³ China will continue to develop its high-end tech sector and encourage more private sector involvement.

China's Economic Journey - GDP Transformation

China's Economic Journey - GDP Transformation

Source: LGM Investments & World Bank data as at 01.06.2017. CAGR – Compound Annual Growth Rate.

The next decade is about Quality
In the last two decades In the next decade
Growth driver – low cost exports Growth driver – domestic middle class consumption
Indiscriminate growth – the rising tide lifts all boats Slower growth – survival of the fittest
State sector dominance – rampant capital misallocation Private sector growth – better returns on capital
Debt explosion since 2008 – rising systemic risks Key policy priority – to de-risk and de-leverage
Closed capital accounts – limited investor choice Liberalisation – improving access and better choice
Institutional immaturity – erractic controls and policy-making Better regulatory framework – more orderly markets
Corporate governance and minorities – ignored or scorned International engagement – global best practice adopted

Source: LGM Investments

Portfolio perceptions

It is our belief that China, which represents more than 17% of the global GDP, is underrepresented in most global investor portfolios.⁴ We also believe the country’s slowdown in growth will lead to better quality of growth, as entrepreneurs gain more sophisticated management experience and production moves up the value chain. As such, it is a good time to increase investment exposure into China with a truly bottom-up approach, focusing on the best opportunities in the domestic economy, rather than a more traditional approach of buying through index-tracking solutions, which mostly consist of low-efficiency, state-owned companies.

BMO Greater China Class focuses on high-quality companies that generate growth from within the domestic market. Our goal is to identify risk-adjusted assets with sustainable and growing cash flow streams over the long term, which is why the Fund looks at areas such as the consumer sector, health care, clean energy and financial services, but holds no exposure to any Chinese banks.

BMO Greater China Class A Performance (%)
YTD 1 yr 3 yr 5 yr 10 yr Since Inception
7.80 -1.09 18.97 10.30 11.83 10.83

Source: BMO Global Asset Management, as of February 28, 2019.

Rigorous risk assessment is vital to our stock-picking success. We assess opportunities in the growing domestic China market, while at the same time carefully scrutinizing the risk level that comes with issues such as corporate governance, accounting standards and market structure. We’re confident that our Fund is managed in the best interest of shareholders, as it has delivered better performance than the benchmark, with less volatility.

¹ Trading Economics, China GDP, 2019.

² “China’s Annual Trade Surplus With U.S. Hits Record Despite Trump’s Tariff Offensive,” The Wall Street Journal, January 13, 2019.

³ National Science Board’s (NSB), Science and Engineering Indicators 2016 (Indicators), January 2016.

Trading Economics, China GDP, 2019.

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