By Andy Rothman, Matthews Asia
"The most important thing to recognize is that Chinese equity markets do not reflect the health of the Chinese economy."
Christine Lagarde, Managing Director of the International Monetary Fund was once quoted as saying, "Markets love volatility." She may be correct in the abstract. But right now, investors in Chinese equities would certainly love a bit less volatility.
2016 is likely to be a year of volatility in China. With the government apparently keen to continue intervening in its A-share market, we can expect continued volatility there. And with the manufacturing and construction part of the economy set to grow more slowly, there will be macroeconomic volatility. As privately owned firms take more market share from state-owned companies that too will contribute to volatility. In addition, as the government presses ahead with structural reform in the state sector, capacity reduction will add to volatility.
We can, however, point to two areas where volatility is less likely: China's booming consumer and services sector; and U.S. - China relations as China prepares to host its first G-20 summit.
This volatility can, however, create opportunities for investors, especially when dire headlines incorrectly assume that weak performance by outdated market indexes signal an economic hard landing. And keep in mind that volatility due to execution of necessary reforms, such as reducing the role of state-owned enterprises (SOEs), is good for the long run.
In this year's first issue of Asia Insight, we ask Matthews Asia Investment Strategist Andy Rothman to discuss the ups and downs he anticipates for China in 2016.
Wow, what a start to the year in the A-share market! Many observers claim this signaled serious problems in the Chinese economy. Do you agree?
No, I don't think the start-of-the-year sell-off in the A-share market had anything to do with China's economy. This was about continued volatility in the A-share market, due in large part to the very high share of market turnover (more than 80%) from small, retail investors. A-shares have always been very volatile, with 30 bear markets in the past 20 years!
It is always a challenge to understand what drives day-to-day movement in the market, but the early January sell-off was probably driven by the impending expiration of a six-month ban on selling by major shareholders, which was imposed by China's securities regulator. Another factor was that a new "circuit breaker" for the market was poorly designed, fueling investor anxiety about liquidity as the index declined. Regulators later suspended the use of this new measure, which was contributing to, rather than reducing, volatility, and the "temporary" selling ban was extended. The next round of selling was probably triggered by concerns about the exchange rate.
Keep in mind that just a few days earlier, the Shanghai Composite Index ended the year 2015 down 31% from its June 12 peak but up 9% for the full year, making it one of the world's best-performing markets for 2015. Within a few days, the index was down 2% year-over-year (after falling almost 7% on January 4). Because the index is heavily weighted toward state-owned firms (rather than the privately owned companies that employ more than 80% of the workforce and create all of the new jobs and wealth), and because the index is focused on the old economy, rather than on services and consumption-the biggest part of the economy -dramatic fluctuations in the index do not reflect what is happening in the broader Chinese economy. This is why very few Chinese invest in the A-share market, and foreigners hold less than 2% of the market capitalization. Most foreign exposure to China comes via mainland companies listed in Hong Kong, a market which is less volatile, with a higher share of institutional investors, as well as less expensive. (About 6% of Matthews Asia's China holdings were in A-shares at the end of 2015.)
How about macro-economic volatility? Will GDP growth in 2016 be the slowest pace since the Tang Dynasty?
Possibly, but as we don't have GDP data going back to the year 907, I'd prefer to say that 2016 is likely to deliver the slowest GDP growth rate in about 25 years. But that isn't really important.
My view is that it is inevitable that most economic statistics, including GDP, will grow at gradually slower year-over-year (YoY) rates for many years to come. This is due in part to structural changes, including a shrinking workforce, and because after three decades of 10% growth, the base has become too big to sustain double-digit expansion.
On the other hand, because of the bigger base, the incremental increase in the size of China's economy this year (at what I expect to be a 6% - 6.5% growth rate) will be significantly larger than the increase a decade ago at a much faster rate. This means that 2016 will provide, at the slower anticipated growth rate, a larger opportunity for firms selling goods and services in China, as well as a better opportunity for us to invest in those firms.
Moreover, GDP growth may be the least important statistic in China. After all, we don't make investment decisions in the U.S. or Europe based on GDP growth rates. As in other markets, the important stats in China concern employment, income, inflation and consumer spending. All of these data points should be healthy in 2016.
In response to this slower growth, will the Chinese government launch an economic stimulus?
Some pundits are predicting a dramatic stimulus this year, but I disagree.
I expect unemployment to remain manageable and wage growth to be strong, leading to a very healthy consumer and services sector, which is now the largest part of the economy.
If growth were to weaken below my expectations, I think the government would roll out a stimulus, but as in 2015, these measures would be designed to put a floor under growth, rather than to push growth back up toward 7%. The government appears comfortable with the fact that growth is decelerating, and, in my view, will only intervene to ensure that the slowdown is gradual.
Two stimulative policies from last year that will probably be maintained are cutting interest rates and taxes. The central bank cut its benchmark rate for one-year loans five times in 2015 for a total of 125 basis points. But, at 4.35%, that rate is still relatively high, and I expect the central bank to continue moving in the opposite direction of the U.S. Federal Reserve this year.
This will be great for Chinese homeowners, and will reduce financing costs for the largest group of corporate borrowers: the small, privately owned firms that generate all of the country's new jobs and wealth.
I also expect more corporate tax cuts as the government tries to reduce a very high burden, especially for smaller firms. (A very low share of individuals pay personal income tax.)
What are the risks of a hard landing?
2016 will undoubtedly deliver another round of headlines proclaiming the imminent collapse of the Chinese economy. In my view, a hard landing is very unlikely, and the doom-and-gloom reports may offer an opportunity for investors who have a deeper understanding of what is happening on the ground in China.
Think about it this way: the global media continues to write about the June 2015 "crash" of China's A-share market, even though the Shanghai Composite Index finished the year up 9%.
China's old economy will remain weak this year. Manufacturing, especially heavy industries such as steel and cement, will be sluggish, as China has passed its peak in the growth rate of construction of infrastructure and new homes. But manufacturing has not collapsed, with a private survey revealing that factory wages were up 5% to 6% last year, reflecting a fairly tight labor market, and more than 10 million new homes were sold.
More importantly, few investors recognize that 2016 is likely to be the fifth consecutive year in which the manufacturing and construction part of the economy will be smaller than the consumption and services part. China has rebalanced away from a dependence on exports, heavy industry and investment, and has in my opinion become the world's best consumption story.
In the past, you've written that China is the world's best consumer story. Will that still be the case this year?
Yes, and the consumer sector will continue to be a focus for our portfolio managers.
I expect the consumer story to remain strong for several reasons. Income, while decelerating along with the rest of the economy, should grow by about 7% in real (inflation-adjusted) terms. This follows a decade of more than 130% real income growth, compared to about 8% growth in real per capita disposable personal income in the U.S. over the same period. I expect another year of moderate consumer price inflation, at about 1.5%. Household debt is very low, and the savings rate very high.
All of this should contribute to an increase in the growth rate of real retail sales of roughly 10%. A bit slower than last year's pace, but still very fast. And consumption is also likely to drive the majority of China's GDP growth this year.
One source of volatility has been the currency, and some are predicting China will initiate a "currency war." Is that likely in 2016?
The risk of China initiating a currency war is very low, and this is another topic where media coverage has been sensationalized and shallow. This year, I expect the renminbi (RMB) to devalue a bit against the U.S. dollar, while remaining stable against a trade-weighted basket of currencies. There is, in my view, little chance of the dramatic (double-digit) devaluation that some are predicting.
Last year, the RMB devalued by 5.8% against the dollar, but this should be kept in context. In my view, this devaluation was largely a Chinese response to a very strong dollar-which rose by about 9% in 2015-rather than an effort to boost Chinese exports. China's exports were weak last year, but still outperformed global exports, signaling that the problem was soft global demand rather than a lack of competitiveness. In fact, the Chinese share of total U.S. imports continued to rise, reaching 21.5% during the first 11 months of last year, up from 19.9% in 2014, 16.1% in 2008 and 13.4% in 2004. This gain in market share came despite strong appreciation: since the hard peg to the dollar was broken a decade ago, the RMB has appreciated by 47% in nominal terms and by 57% in real effective terms.
Assuming continued dollar strength, this year is likely to deliver more of the same: modest devaluation against the dollar, but stability against a trade-weighted basket of major currencies. We estimate that last year, the RMB appreciated by about 1% against the basket established by the Chinese government. The Bank for International Settlements calculates that by the end of last year, the RMB appreciated by 3.9% in real effective terms, after having gained 6.1% in 2014.
The problem really is the terrible job the Chinese central bank has done in communicating their strategy. It appears that they are trying to let the RMB depreciate in response to a strengthening dollar, while at the same time trying to keep the RMB stable against a trade-weighted basket of currencies (the CFETS basket). They've largely accomplished this: as of January 21, we estimate that the RMB depreciated by only about 0.09% against this basket year-to-date.
In my view, the biggest risk right now is that the Chinese government continues to fail to adequately communicate its intentions regarding the exchange rate, leading Chinese investors to lose confidence in their country's policy-makers and head for the borders. (With limited RMB convertibility, I'm far less worried about what foreign speculators think.) But I want to emphasize that I don't see this happening now, and I think this risk is very low.
Will China's debt problem worsen this year?
China suffers from a serious case of "debt disease," but the treatment and side effects may not be as severe as some expect, and dramatic credit tightening is very unlikely. Debt is concentrated among state-owned firms, while the private firms that generate most of China's new jobs and investment have already deleveraged.
As I explained in a May 2015 issue of Sinology ("Diagnosing China's Debt Disease"), the medicine for this problem will be another round of significant SOE reform-including closing the least efficient, dirtiest and most indebted state firms in sectors such as steel and cement-rather than broad deleveraging, leaving healthier, private firms with room to grow. At the end of last year, the government indicated that it was finally prepared to begin reducing capacity in construction-related heavy industry. In contrast to the experience in the West after the Global Financial Crisis, cleaning up China's debt problem should actually improve access to capital for the privately owned companies that drive growth in jobs and wealth.
Let's turn to politics. Will U.S.-China relations become more volatile in 2016?
U.S.-China relations will remain complicated and noisy this year, but the two countries will continue to engage productively on the most important issues.
Territorial disputes in the South and East China Seas will again dominate the headlines, but two points are worth keeping in mind. The U.S. does not claim any of the disputed territory, and China seems resigned to the fact that the U.S. Navy will continue to exercise its right to patrol the region. The risk of accidents remains, but none of the players appear to be looking for an excuse to engage in a military conflict.
Finally, with China preparing for its first time as host of a summit of G-20 leaders in September, it is likely to behave more conservatively during the first three quarters of this year.
Finally, how can investors deal with all of this volatility?
The most important thing to recognize is that the Chinese equity markets do not reflect the health of the Chinese economy, and to expect some market volatility. Second, to recognize that the market indexes underrepresent the strongest parts of the economy: privately owned companies, and the consumer and services sector. This is why we believe in an active approach to investing in China, rather than an index-based strategy.
Matthews Asia Investment Team Perspectives on Managing Volatility
We asked three of our portfolio manager to share their thoughts on Chinese volatility. Here are their comments:
Yu Zhang, CFA, Portfolio Manager:
From the standpoint of the Matthews Asia China Dividend strategy, we focus on companies that:
- Either enjoy certain structural growth tailwinds or have defensive, "sticky" business models
- Have clean balance sheets and the ability to generate strong free cash flow
- Are willing to share profit with minority shareholders via dividend payments.
To us, dividends are really the optical lens through which we can better evaluate the underlying quality of a business. During times of market volatility, dividends themselves may also act as safety nets, providing certain downside protection to a share price. In managing a single-country strategy, we cannot completely escape macro-driven market volatility. But we can try to dampen that volatility by keeping our focus on companies with these attributes.
Andrew Mattock, CFA, Portfolio Manager:
We are not short-term in our investment horizon and so we see periods of downside volatility as a good chance to buy attractive stocks.
Our core philosophy is growth at a reasonable price (GARP) and it's the "reasonable price part" that should protect a portfolio on the downside, especially at recent valuation levels. Obviously we can't control market levels of volatility but we have seen a structural decline in volatility in the Hong Kong market. This has been interrupted with periods of volatility that have not lasted long. Again, these are the times when we see the opportunity to add stocks that we like.
Tiffany Hsiao, CFA, Portfolio Manager:
Investors often believe small-cap companies to be more volatile so we attempt to counter this perception by investing in companies that have a better chance of defying the odds from the standpoint of macro and market volatility. We believe the key to doing this is maintaining a fundamental perspective. We focus on:
- Structural growth sectors with competitive moats
- Quality cash flows and strong returns on invested capital.
- In the small-cap universe, we also spend a good deal of time trying to understand potential corporate governance conflicts. We are also chiefly concerned with the alignment between management and shareholder interests.