China 2.0: a new economic dawn

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    Viraj Patel, October 2014

China’s growth story may be on the wane, but its equity markets still look a good bet as the central government’s plan for economic modernisation takes hold.

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Cheap valuations provide an attractive strategic entry point for investors who are able to withstand the near-term volatility prompted by the overhaul. Investing in sectors that are likely to profit from reform initiatives may be a valid interim strategy.

A path of slower growth will avoid economic catastrophe

After three decades of remarkable growth, China is in the midst of an economic transition that is now entering its most defining stage. While much of the recent slowdown is structural – reflecting the economy’s natural convergence towards high-income status – rising vulnerabilities in financial and real estate markets pose a genuine risk of destabilising future growth. Policymakers must take complex steps to address these imbalances, intentionally accepting slower but safer growth in the near-term, while accelerating a new wave of reforms, as outlined in the Third-Plenum blueprint, to reinvigorate the Chinese economy.

The credit-fuelled investment growth that steered China in the aftermath of the 2008 global financial crisis was primarily responsible for generating the market inefficiencies and excessive build-up of leverage currently plaguing the economy. The focus of the new government has been to repress non-bank financing by imposing restrictions on shadow banking activities; the consequence of which has been a slowdown in lending growth and a sharp tightening of credit conditions, as new sources of funding have yet to be established.

With banks cautious about new lending given the amount of nonperforming loans sitting on their balance sheets, economic growth in the second half of this year is likely to remain fragile. (Figure 1) Initial signs of this theme may already be playing out: value-added industrial output grew by a mere 6.9% in August from a year earlier, the lowest reading since 2009.1 A further headwind to growth stems from China's property market, with the new home price index falling for a fourth consecutive month in August,1 as smaller cities continue to grapple with excess supply. The looming challenge is for the sector to endure a necessary correction, while avoiding a sharp slowdown that could spill over to the rest of the economy.

Figure 1: Slower lending is a drag on economic growth Figure 2: Internal migration could lead to higher incomes

Reforms offer greater upside potential to long-run growth

In the absence of any external shock to the economy, concerns over a “hard-landing” seem overstated in light of China’s policy buffers. While credit booms of this size have previously led to sharp corrections, a key distinction is the government’s capacity – and most importantly, willingness – to prevent a loss of confidence or a sudden stop that could intensify the aforementioned vulnerabilities of the economy. With low public debt, moderate foreign debt exposure, large foreign exchange reserves, high domestic savings and controls to limit the exodus of capital, the likelihood of an abrupt adjustment in the Chinese economy is low.

Nevertheless, the outlook for Chinese growth is nearing a crossroad, and government officials are faced with an important policy decision: (1) to stimulate near-term activity with broad-based monetary easing, which risks compounding the economy’s overreliance on credit and capital accumulation or (2) choosing to accept a slower growth path, ensuring that any forthcoming economic progress is achieved in a sustainable manner. Following a recent communiqué from Premier Li, the focus seems to be shifting towards the latter option.

The “mini-stimulus,” introduced in April to ensure that economic growth of 7.5% would be met this year, seems to have run its course, given the latest batch of data. Yet in September, Premier Li played down the importance of this target, stating that the government will refrain from relying on monetary stimulus to spur one measure of the economy. Confidence in reviving economic activity was largely focused on the swift imposition of structural reforms that would facilitate the transition towards a more stable growth path.

The growth of Chinese consumerism may provide a boost to domestic industries

The cost of this approach – a protracted slowdown in the near-term to historic lows – may not be detrimental provided that the economy continues to create enough jobs and uncovers new sources of productivity growth through the reform-based agenda. The shift towards a more consumption-based economy and, for example, renewed emphasis on the labour-intensive service sector, would boost household incomes and expenditure. Furthermore, employment growth, one of the government’s biggest concerns, remains robust: China’s year-to-date job creation is close to the 10-million full-year target.2 Thus, when reconciling a deceleration in growth with the potential for economic development, as further urbanisation of the population would generate (Figure 2, prior page), investors have sufficient reason to remain positive about the long-run trajectory of the economy.

Managing the transition to the “new normal” of lower growth requires policymakers to balance immediate considerations with their vision for sustainable economic progress. Policies need to be supportive, but in a manner that expedites this goal. Implementation of reforms – and the subsequent adjustment process – may be costly in the short-term, but will undoubtedly help to secure a brighter, more prosperous future for China.

Reforming the strategy for Chinese equities

In an environment where the composition of economic growth is gradually changing, a viable equity strategy may be to target those sectors where reform-based policies are likely to have the greatest impact. A managed slowdown should not be a major concern, given the imperfect relationship between stock markets and the state of the economy. This is of particular significance for China, where the state-owned nature of the largest companies is somewhat responsible for the disparity between economic growth and corporate earnings. (Figure 3) These enterprises typically issued more shares as they grew, thus diluting the benefit of higher profits for existing shareholders. Eliminating these structural impediments is one potential way for Chinese equities to command higher valuations in the future.

Figure 3: EPS and GDP growth has deviated since 2013 Figure 4: Earnings continue to surprise on the downside

While such changes may take some time to feed through – more so if implementation proves to be sluggish – continued pledges by officials to stand by their Third-Plenum agenda could see sentiment towards Chinese equities shift to a more upbeat outlook, even before the reforms come into force. This story, coupled with the government's targeted easing measures, partially explains the summer rebound in Chinese stocks: from late March through the beginning of September, the aggregate equity index had rallied by more than 20%.3 But, while analyst expectations of future earnings have been moving in the right direction, reported results continue to surprise on the downside. (Figure 4) As previously argued in the wider context of emerging markets, without any discernible progress, a reform-related rally for domestic equity markets is likely to be short-lived. Investors are only so willing to reward markets and governments for the promise of future change.

A slowing China strengthens the case for officials to press ahead with structural changes. (Figure 5) Successful reforms are likely to be the most potent long-term driver for equity performance, with the potential upside for Chinese stocks characterised in our three reform-based themes.

Figure 5: China’s “Super Six” structural reforms to watch

Reform Theme 1: The rise of the Chinese consumer
From an investor’s perspective, the domestic consumption story remains attractive as urbanisation and land reforms look set to boost household incomes over the medium-term. Changes to the country’s hukou law would give migrants access to public services in smaller cities, therefore increasing the mobility of the labour force. The freedom for workers to move to more productive areas of the economy would generate higher-value goods and services. With Chinese consumers boasting one of the world’s highest savings rates,4 their increased purchasing power is positive news for those companies that benefit from domestic demand.

Therefore, the investment case for China’s consumer markets remains very much intact. Sectors such as consumer goods, technology and healthcare are likely to observe a period of strong earnings growth, justifying their relatively expensive valuations. While the aggregate retail outlook looks mixed, the combination of growing Internet access and rising incomes has produced a pocket of opportunity in the e-commerce industry. In August, online retail sales rose by 55% from a year earlier,5 highlighting a significant change in the spending habits of Chinese consumers. This trend, which is likely to spill over to other related sectors, resonates well with the government’s aim to foster consumption growth.

Reform Theme 2: Managing the creative destruction of SOEs
Significant reform and deregulation announcements about state-owned enterprises (SOEs) have appeared periodically throughout the year. These have often reflected the state’s intention to level the playing field for the private sector, while ensuring improved efficiency for those strategically important firms that the government will retain control over. Many SOEs have made positive changes to their shareholding or management structure, progress that has largely been overlooked by the market. The reforms resemble those implemented in the late 1990s, when the initial transition towards a market economy led to a surge in productivity growth. Similar gains could reap long-term benefits for both state-owned and private sector businesses.

However, the process is unlikely to be a swift transformation: the government will have to carefully streamline SOEs in a manner that does not thwart the overall reform progress. Allowing these inefficient businesses to fail without enabling the private sector to pick up the slack would only magnify the economic slowdown. To some extent, the drive towards mixed ownership captures this idea. From an earnings perspective, officials are making progressive steps in corporate sector reform, with a particular focus on tackling corruption and refining corporate governance. If successful, this should lift the competitiveness and profitability of SOEs while allowing growth of the private sector, thereby improving the aggregate return on equity. (Figure 6)

Reform Theme 3: Brokers and insurers set to gain from financial reforms
The Third Plenum’s initiative to broaden capital markets will likely see Chinese brokers – in particular those with a presence in both Hong Kong and China – benefit from increased trading volumes and new business opportunities. Brokerage firms with cross-border capabilities, of which there are only a few, may gain a competitive advantage and thus the ability to exploit pricing power. The state’s focus on financial development and innovation, within a relatively immature industry is in effect likely to spur investment banking activities on the mainland over the coming years.

In a similar vein, the insurance sector looks set to expand from the reform of pension and life insurance products. The government unveiled targets for the sector earlier this year, hoping to boost its overall contribution to the economy, in addition to tackling the reliance on risky shadow banking.

Is it time to enter the dragon?

From a valuations perspective, Chinese equities are cheap, on both an absolute and relative basis. The broad index is trading at a price-to-book ratio of 1.5 – around 32% below the 10-year historical average – and at a 45% discount to US equities. Within the emerging markets universe, Chinese stocks are one of the most oversold (though not to the extent of Russia) and currently 20% cheaper than their Asian counterparts.6 These valuations, while attractive on the surface, are somewhat skewed by the deeply-discounted banking sector (Figure 7).

However, moves to rebalance the economy may result in a structural re-rating of the overall equity market: a more sustainable growth outlook would alleviate the negative sentiment towards Chinese assets, therefore causing risk premiums to fall. There are initial signs that banks are tackling the issue of nonperforming loans through asset sales, capital raising and renewed dealings with “bad banks”; the forthcoming introduction of deposit insurance is also likely to provide some stability to the financial system, pushing sector valuations higher.

As officials facilitate the transition towards a lower growth rate, any short-term volatility in headline data is likely to feed through to the stock market. The recent weakness in activity has weighed on Chinese equities, with the index falling more than 9% since peaking in early September.7 In contrast, there are key events in October that could provide some support. The opening of Shanghai’s stock market to foreign investors is a step in the right direction for capital markets, while the Fourth Plenum is widely expected to shed more light on reform policy and economic targets, setting the tone for investors’ expectations in 2015.

The slowdown in China is not indicative of a deteriorating economy, but a by-product of a much needed transition from an investment-led, commodity-intensive growth model to one that is more consumption oriented. Enacting the reform blueprint – and enabling an economic overhaul – would not only improve the quality, but also the long-term sustainability, of growth. The shift in sentiment, added to the realisation that quality supersedes quantity, may improve the outlook for earnings and steer prices higher.

The re-rating process is likely to be gradual, but factoring in all the above elements, the strategic case for China remains in place. Successful reform implementation will be the catalyst for unlocking value in Chinese stocks, though it is difficult to gauge the exact timing of this. At this juncture, equity markets in China remain an attractive opportunity for those investors with a long-run investment horizon and willingness to overlook near-term volatility.

Figure 6: China’s return on equity remains subdued Figure 7: Banking sector weighing on absolute valuations