We have never before experienced a period when global investors have been so pre-occupied with, and focused on, what is going on inside China. For the first time ever, investors are looking to the Chinese market for clues as to what may lie ahead for global markets. Many have wondered whether the recent drop in Chinese stocks has signaled the start of a slowdown in China’s economic recovery and particularly whether the decline indicates trouble for global equities.
Back in February, while the S&P 500 suffered another significant fall, the Chinese market held up well. The Chinese A-share market (locally listed shares as opposed to the Hong Kong listed H-shares) has led the rest of the world in the post crash rally, as can be seen from the following chart:
[Source of graph: Lipper]
Therefore, it is all too natural for investors to feel increasingly worried as Chinese stocks have tumbled in recent weeks. Prior to the recent drop, the A-share market had recorded a 103% gain, and even at the end of August, this market is still up 56% year to date versus a more restrained 19% for the US market. It is interesting to note that on Thursday 16 July China became the world’s second largest stock market when it finally overhauled Japan.
This increase in stock market value has not happened for mysterious and unknown reasons. Back in 2008, whilst western politicians were still debating the necessity of stimulus packages, China had already moved decisively to implement policies aimed at confronting the global crisis. Whilst western governments have had to borrow to fund their policy reactions, China has simply dipped into its massive foreign currency reserves which have topped $2t (that’s $2,000,000,000,000!). The results have been impressive – China’s economy grew by 8% between April and June; take off a bit for dodgy numbers and that’s still astonishing.
The Chinese equity market has reacted to these initiatives and bottomed earlier than most western markets. The government inspired liquidity boom has led to credit creation and a surge in the money supply. This liquidity surge has clearly been translated into an asset boom, with stocks and real-estate prices leading the way. Although Beijing has maintained that it will continue to pursue policies aimed at stimulating growth, the authorities are clearly becoming concerned about the pace of asset market gains and the potential for a speculative frenzy. It therefore seems inevitable that Beijing will begin to scale back credit expansion, especially when one considers that both retail sales and fixed asset investments are booming, having grown by 18% and 30% respectively this year. All of this points toward a reduction in the need for the current hyper-simulative package and the recent fall in bank lending could be the first sign of a policy change.
Despite the strong recovery in China, there remain doubts as to whether the world economy in general, and China’s in particular, can return to the path of economic growth and financial prosperity we have experienced for the last thirty years. Sceptics argue that the western consumer is a long term de-leveraging process which will force a significant reduction in consumption and that China’s old growth model, heavily dependent on western consumption, is now broken. We believe this argument is flawed and that China’s growth story is built on three key issues: Firstly, China’s economic model has evolved significantly and net exports now account for only 10% of Chinese Gross Domestic Product, with government spending, consumer spending and capital formation accounting for 14%, 36% and 40% respectively. It is interesting to note that the growth in Chinese personal consumption is greater than that of the US, Europe and India added together. Capital formation is being driven by the unleashing of Chinese entrepreneurship leading to significant increases in labour productivity growth which has averaged 12% per annum since 1980. What would western industrialists give for 12% productivity growth?
The second issue is the urbanisation of China’s economy – the transformation from an agricultural society to an industrial one, and this has only just begun. Back in 1960, only 20% of China’s population was based in cities and this has now grown to c.45%. A huge level of change, but still a long way behind the urbanised western nations and also behind other Asian countries such as Korea, which also had a 20% urban population in 1960, but now has over 80% of its citizens living in cities.
The final issue is globalisation, which has significantly benefited China by allowing its exports to grab a significant share of the global export market. Indeed, China now has the largest share of the world’s export market, having recently overtaken Germany. When coupled with huge levels of foreign investment into China, we can see why China has what is probably the world’s most efficient manufacturing base.
The western world’s recovery process is behind China but that does not mean we should completely discount any chance of a sharp ‘V’ shaped recovery in the developed world. It is not impossible that Bernanke, King and Trichet are beginning to contemplate their ‘exit strategies’ from the global stimulus program, and investors need to consider the impact this will have on asset prices.
To go back to our opening paragraph, where we commented on investors’ worries that perhaps the recent drop in Chinese stocks has signalled the start of a slowdown in China’s economic recovery and particularly, whether the decline indicates trouble for global equities; perhaps the recent fall back in Chinese A-shares is a response to the shrinkage of the Chinese stimulus package, rather than fears that the Chinese economy is broken.
Our view is that none of the three drivers of Chinese growth seem likely to vanish over the next five to ten years and that China and the developing world will continue to take economic leadership roles.
We are reflecting these views in our clients’ investment portfolios and have made increased allocations to Asia and emerging markets, as well as taking direct exposure to locally listed medium sized Chinese companies that are set to benefit from the continued urbanisation of China’s economy (for higher risk clients only).
Please take professional advice before acting on the topics discussed. For more information please contact Adrian Gough, or your usual Vantis contact. Alternatively, please complete and submit the online form below.