“China’s Rubik’s Cube: Rethinking Risk”

18th June 2015


Douglas Turnbull, head of Chinese equities and manager of the Neptune China and Greater China Income funds takes a look at the current investing environment in the world’s second largest economy…

There is now a weight of evidence that the Chinese government is willing and able to successfully support their economy, lending credence to our belief that Beijing is capable of balancing near-term economic management with the necessary ongoing reforms – a contention that the market has long doubted.

China faces a “Rubik’s Cube” policy trilemma, whereby it needs to sustain a minimum acceptable level of growth, deal with issues such as overcapacity and also reform the financial system to make it a far more efficient allocator of capital. Given the contradictory nature of these objectives, there are no ‘big-bang’ policy solutions open to Beijing. However, what can be seen is a multiplicity of small steps being taken which do address these objectives complementary.

Whilst the tone of the slowdown remains unmistakable, the government is playing it safe, comfortable to err on the side of too little stimulus rather than too much, which would only exacerbate the aforementioned longer-term challenges, largely due to the still encouraging employment picture in China.

Whereas in a democracy one gets a campaign full of bold promises to stir a market into justifiable excitement, one also runs the risk of a period of disappointment when the time comes to execute and implement policy. On the other hand, China had no such campaign or even election; rather a new leadership team were appointed in November 2012, about whom the market knew little definite about in terms of either its policy inclinations or political capability. What has now become apparent is that the current leadership is both relatively market friendly given its pro-reform stance and is also well able to implement and execute its policies. In addition, despite a limited change in the near-term earnings outlook, corporate sentiment is certainly improved compared to 2014.

We expect growth to be in the region of 6-7% in 2015. Whilst as a qualitative story this was fairly well known, sentiment has shifted towards a belief that this will not equate to an economic disaster. This shift, allied to robust liquidity provision and pro-market commentary from official voices, has caused a significant upward move in the A-Share market and – although at risk of a healthy consolidation – the government is incentivised to keep a steady upward market trend. The government needs a decent market in part to equitise some of China’s corporate debts over time and also to facilitate the spin-offs and listings that will form an important component of state-owned-enterprise (SOE) reform.

A move towards increased domestic consumption is a key part of the government’s reforms. In this space, long-term investment themes such as the growth of discretionary spending (as well as wage growth) and middle class Chinese consumers upgrading goods purchased continue unabated. Indeed, domestic firms are increasingly winning in categories such as smartphones and fast moving consumer goods. This is because products are much more tailored for the local consumer and domestic companies are more responsive to the detail and timing of promotions and the ability to upgrade purchases, which remain very important to the average Chinese shopper.

We believe that balancing near-term economic growth and long-term economic health remains a major focus for the government, with supportive policy being utilised to ensure that continues. However, we also believe that any further moves will be gradual as the government still has much room for manoeuvre. A lot of reform progress has been made to date, and there is good visibility of more to come. Therefore, we believe that risk is being managed effectively and that the Chinese market deserves to be on a lower risk premium – and higher multiple – hence the rally that we have seen so far in 2015.

A strong equity market provides a positive wealth effect and is good for domestic consumption, further Renminbi internationalisation and the equitisation of SOE debt. However, the government wants to see a steady, sustained bull market. Thus they might want to rein back the recent surge at some point. For example, a clamp down on margin-lending should be well anticipated, which may well lead to a market pull-back. We believe this correction will offer an excellent buying opportunity for long-term investors in China

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