SPECIAL REPORT: China
In this article we look at the prospects for China. This includes the current issues involved with the Government’s Covid strategy. But more importantly the longer-term issues of sustaining growth when faced with some challenging demographic trends. China is the second largest economy in the world (GDP of US$15 trillion not far behind the United States with U$21 trillion). So its performance has implications for all (not the least Australians given China is our largest trading partner taking 43% of our exports).
For those concerned about China’s regulatory or political risk there are ways of playing the growth in this economy indirectly as we currently do. China is a one of the largest markets for robots, mobile phones, commodities, aircraft, automobiles and medical devices. We regard China stocks as an important part of our investment universe and indeed have held a China ETF, which performed particularly well through 2020. Presently our strategy is exposed to China’s post Covid economic recovery through our holdings in robotics, semiconductors, travel services and industrials.
Long has it been said that if you could sell a pair of socks to everyone in China you would be rich. For many years that was not the case, a result of a mixture of politics and economics (the two of course were linked). But how that changed. First it was the ascension of Deng Xiaoping to leadership and the shift to more market-based economic policies. The Chinese economy got turbo-boosted by the entry into the global trading system in 1994. Even over the past fifteen years when the global economy has been hit by the GFC, the European debt crisis and a pandemic the Chinese economy has done better than virtually every other economy. But things might be changing again.
China and COVID
Up to this year, China had a ‘good’ pandemic. By shutting its borders it had (largely) been successful in keeping COVID out. The economy was powered by strong demand for exports and ongoing infrastructure and residential construction spending. Freedom of movement allowed consumers to spend and the lack of COVID cases meant they had the willingness to spend. But the greater contagiousness of the Omicron variant has changed everything.
There are good reasons as to why China continues to follow a zero-case strategy. The vaccines it has used are not as effective as the ones used in many developed economies. It has an aging population, one where a significant proportion of older people (the most vulnerable to the virus) are unvaccinated. China is full of many large, densely populated cities, making the spread of the virus easier. Its health system is not as advanced as in the developed economies.
China has an option to import the vaccines that have largely proven to be effective in other countries. So far they appear reluctant to do so, perhaps hoping that China will be able to develop its own more effective vaccines. It will also need to develop strategies to increase the proportion of its older population that have been vaccinated. The consensus view (at least outside of China) is that there will be no move to change the current COVID strategy until at least the next leader is determined in October.
Omicron is a highly contagious variant of COVID, a large proportion of the population have not had the virus and the Government appears determined to maintain its current strategy. They have ramped up their testing procedures in the hope to stamp down on any outbreaks quickly. Nonetheless, there must be a high chance of further lockdowns in China over the next 6-12 months. This suggests that economic growth over that period could be both volatile and at times weak.
The issues associated with COVID will mostly likely be short term (1-2 years). The Government will provide the fiscal and monetary support necessary to ensure economic growth rebounds strongly. And even within the next year or so China will likely have periods of strong growth as the virus wave subsides and lockdowns are ended.
China’s bigger issue is how strong its' economy can sustainably grow
But Chinese economic growth is clearly on a downtrend. In 2007 Chinese GDP grew by over 14%. By 2019 GDP growth had slowed to just over (a still more than respectable) 5%. As with all countries the pandemic then significantly influenced growth rates (although China did better than most). But once the pandemic is comfortably in the rear-view mirror, forecasters (such as the IMF) expect further slowing in Chinese GDP growth in coming years
The main reason is that potential economic growth in China (how fast the economy can grow over time) is slowing. In the main this reflects the rapid slowing of its population growth. A key factor was the one child policy that ran from 1980-2015 (although other large East Asian economies such as Japan and South Korea have a similar demographic problem).
It is estimated that China’s population will start to decline sometime between 2024 and 2034, with a peak population estimated to be around 1.4b. Everyone agrees that the population will then decline substantially, although how much is a matter of dispute (estimates vary that population will fall to between 0.9-1.25b by 2100).
One outcome of a rapid slowing of population growth is that there is also a rapidly aging population. The result is that China’s labour force is already starting to decline.
The Chinese Government is keenly aware of this demographic time bomb. In recent years it allowed families to have two children, and then more recently up to 3 children (even more recently families that have three children will be allowed to have a second house).
To date these new policies have had negligible impact. Globally all Governments have found it difficult to boost birth rates. This reflects urbanization (it is more expensive to bring up a big family in the city and there is less need for an extra pair of helping hands) and increasing female education (women wish to concentrate on developing a career than raising children).
What else the Government is trying to do?
The trend towards urbanization of the Chinese economy (the proportion of the population that live in cities) has helped boost economic growth over the past couple of decades despite the slowing population growth. The proportion of people living in the cities rose from 18% in 1978 to 60% today. This has meant a huge number of people have moved from working in small scale agriculture to large scale manufacturing and construction, a trend that has boosted productivity growth.
China’s current urbanization rate is well below that of most developed economies that typically range between 70-95% (Australia is at 86%). So in theory this trend still has years’ to run. But the process of urbanization is being constrained by Government policy of household registration (households are only able to receive government benefits from the region that they were born).
Given the speed of the increase in urbanization the household registration policy has to date had only limited impact. But a further increase in urbanization will be necessary to keep Chinese economic growth strong over the next 1-2 decades. And so policies that act to restrict people movement will likely need to be changed. The Government has already made some changes to the household registration system although almost further changes will likely be necessary.
Productivity growth in China has been high in recent years although it has been largely driven by extremely strong investment. There remains scope for China to boost productivity growth. Chinese spending on R&D is high by global standards (2.2% of GDP in 2019). In 2020 China had more patent applications than in the US, Japan, Korea and Germany combined.
But abstracting from the strong investment, Chinese productivity performance has been unimpressive. According to the Lowy Institute, total factor productivity growth (productivity driven by a certain amount of input) is below the level seen in other Asian countries (such as Japan and South Korea) at the same stage of economic development.
Changing composition of economic growth
The strong reliance on investment as a driver of economic growth is causing problems for the Chinese economy. By some estimates, construction is somewhere between 20-30% of GDP. The large amount of investment spending has meant rising debt, particularly for households, firms and some parts of the banking sector.
In recognition of this concern the Chinese Government has been trying to re-orientate the Chinese economy around consumption growth and reduce reliance on the construction sector. They have had some success. The Chinese consumer is now the largest consumer in the world accounting for around 38% of GDP. The services sector is now over half of the economy.
Nonetheless, that switch towards consumption is far from complete. Consumer spending accounts for around 46% of GDP in South Korea and 52% in Japan (in the US it is 67% and 53% in Australia). The lower proportion of consumer spending mainly reflects the very high rate of household saving ratio in China (it has started to decline). It is generally thought the high level of saving is due to the lack of a government social safety net requiring households to save to meet their education and health needs.
Consumer spending in China is also constrained by the high level of income inequality (lower-income households are more likely to spend, higher-income households to save). These problems have also been recognized and the Government is looking to boost spending on education and health to reduce the desire of households to save.
Financial market pricing
The Chinese economy is going through a rough patch. But financial markets have already priced a weak outlook. Both the price-to-book and price-to-earnings ratios for the Chinese equity market trade are currently trading at a discount to the global market. Mainly this reflects company fundamentals. The profit margin outperformance for listed Chinese companies has narrowed. The return on equity of Chinese companies has declined to be a bit below the global average.
This weakness could be attributed to the Chinese economy being at a cyclically weak point at the same time as many developed economies are doing well. But that the Japanese and Chinese markets are trading at broadly around the same valuations suggest financial markets might also be already taking a downbeat view of China’s long-term prospects.
China should remain part of investing landscape
The combination of a weaker economy and rising geo-political tensions has seen some international investors’ become more cautious about investing in China. But there remain good arguments for China to remain part of the investment portfolios. The Chinese economy is likely to be the largest economy in the world (by some measures it already is). The Chinese equity market is currently cheap. Over the past forty-five years the Chinese Government has had a good record at running a strong economy. And the highly regulated financial system means the Chinese economy has less financial links to developed economies and therefore provides some diversification benefits. China also provides exposure to a number of structurally strong growing sectors, including aged care, health, consumer staples and discretionary and some areas of IT.
ETF Investing Strategies
Using ETFs to gain exposure to the China Story makes sense particularly if one wishes to avoid taking on a lot of stock or industry specific risk. There are several specialist China ETF funds. In fact, on US exchanges there are 54 listed China ETFs with a total market value of US$25bn. The largest two are iShares MSCI China ETF (MCHI, market cap $6.4bn) and KraneShares CSI China Internet ETF (KWEB, market cap $6.1bn). Chinese stocks also have a 26% weighting in the largest (US$77bn) emerging markets ETF, VWO (Vanguard FTSE Emerging Markets ETF). If we include Taiwan, the weighting increases to 42%. However, despite China’s significant relative share of the global economy, Chinese stocks only represent 2.8% of the MSCI All Cap Global Equities.
For those concerned about China’s political risk there are ways of playing the growth in this economy indirectly. China is a one of the largest markets for robots, mobile phones, commodities, aircraft, automobiles and medical devices. We regard China stocks as an important part of our investment universe and indeed have held a China ETF, which performed particularly well through 2020. Presently our strategy is exposed to China’s post Covid economic recovery through are holdings in robotics, semiconductors, travel services and industrials.
Top 10 China ETFs Listed on US Exchanges
The Eight Bays Global ETF strategy is a portfolio of Exchange Traded Funds (ETFs) designed to complement domestic equity portfolios by investing in global growth industries and equities not available on the ASX. Due to the depth and liquidity of the US ETF market, we invest only in ETFs listed on US exchanges. The portfolio has a bias towards industry ETFs with sound growth prospects and attractive structural characteristics. The portfolio holds between 5 and 15 ETFs and any given time with a maximum cash weighting of 20%.
We believe that industry factors are the primary driver of shareholder value over the longer term. Industry dynamics such as growth rates, fragmentation, concentration, disruptive forces and regulation are the major drivers of equity performance. We believe the most cost-effective way to invest in attractive industries is via an appropriate ETF.
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DISCLAIMER : This report is intended as a source of information only. No reader should act on any matter without first obtaining professional advice which takes into acount an individual’s specific objectives and financial situation