Is China truly uninvestable?

This article is an education piece about investment outlook in China. For informational purposes only.

Given the recent interventions by the China policy makers, some people are wondering whether China is becoming an uninvestable market.  But is it true? While it may be extremely volatile, I believe China remains a market which still presents immense long-term opportunities. A view which is echoed by Howard Marks, co-founder of distressed asset manager Oaktree Capital Management, who said “compared with the US, Europe and Japan, I think of China as an economic adolescent … tempestuous and volatile but its best decades are ahead¹”. I could not agree more. Investing in China is not for the short-term, and one needs to have a longer-term view and investment horizon to participate in its continued evolution of its economy.

It is easy to forget that while China is now the world’s second largest economy after recording immense growth over the past decades, it is still in the development process and remains an emerging market with all its associated risks and volatility. And China’s financial markets and business operating environment will remain volatile as China continues to restructure its economic model for the next stage of development, one where the old growth model based on resource intensive and low labour costs manufacturing will be replaced with a shift towards higher-end manufacturing and higher quality services, with stronger focus on consumption rather than investments. Given that current model has been in place over a few decades, obviously there will be pain associated the change. As the proverb says, “no pain, no gain”, this transition will lead China towards a developed nation status with more sustainable growth.

“Common Prosperity”

To accelerate this shift, China aggressively embarked on its “common prosperity” agenda for its 14^th Five-Year Plan with heavy regulatory action on multiple sectors, which has unsettled many foreign investors and prompted many to flee the market. This exodus by foreign investors led to sharp declines in China’s capital markets, leading to some to call China as uninvestable. Now “common prosperity” is not new. It was first coined in the 1950s by Mao Zedong and reiterated in the 1980s by Deng Xiaoping, as communist China sought to build a stronger economy. To achieve this, Deng Xiaoping believed that by allowing some people and regions to get rich first would accelerate economic growth and eventually achieve the goal of common prosperity². This approach to incorporate elements of capitalism worked well since, but China has now reached a stage where the widening income and wealth gap is leading to deepening inequality, a threat to the future growth and stability of both the economy and society.

While the trillions lost in capital markets may appear to be resulting in “common poverty”, one needs to understand it is necessary to maintain key long-term structural growth trends such as the emerging middle-class which in a country with a massive population size of 1.4 billion, presents tremendous potential and opportunity. To “unlock” this huge consumption potential, China needs to raise the living standards of its people and reduce income inequality. No surprise that early policy actions targeted areas which are important to the middle-income – education, healthcare, and housing.

More equality drives more growth

“Common prosperity” is highly important to China as its economy moves from a period of high growth to slower but more high quality and sustainable growth. To achieve the latter, China needs to address its rising-income inequality as many studies show that it damages long-term economic growth. An empirical study of 31 OECD (Organisation for Economic Co-operation and Development) countries from 1970-2010 found that rise in income inequality over 1985-2005 cut 4.7 percentage point of cumulative growth over the 1990-2010 period³, while a decline in income inequality by 1 Gini coefficient point (measure of income or wealth inequality) contributes to a 0.88 percentage point rise in cumulative growth in the following five years⁴. From a global perspective, China’s income inequality is higher than that of most developed or developing Asian economies (Refer to Figure 1), and its own estimate of their income Gini coefficient was even higher at 0.47 in 2019. For a US$18.1 trillion economy⁵, every percentage point counts as it can amount in the billions.

Figure 1: Disposable-Income Gini Coefficient by Country

Long-term growth with cheap valuations

If one can look past the short-term pain, there is immense long-term growth potential in China’s evolving economy. Not only is China addressing income inequality to continue growing its middle-class and bolster consumption, focus and resources are also being channeled into new growth areas such as renewable energy, green manufacturing, healthcare, software, semiconductors, artificial intelligence, and new energy vehicles. Even the technology sector which bore the brunt of regulatory crackdowns, remains a key focus area in China’s 14^th Five Year Plan⁶ as government plans to raise the proportion of the added value of the “digital economy” in its GDP to 10% in 2025, up from 7.8% in 2020. That 2.2% difference on a GDP which is US$18.1 trillion in size equates to an additional US$400 billion!

Following the extremely sharp declines over the past year, MSCI China is now trading at historically cheap levels at between 8-10x 12M forward PE multiples (Refer to Figure 2), despite Peoples Bank of China embarking on an easier monetary policy, and ⁷IMF forecasting +4.8% growth in GDP for 2022. This compares against 19x for S&P, with the US Federal Reserve committed to and initiating an aggressive tightening policy, and ⁷IMF forecasting +4% growth in GDP for 2022.

Figure 2: Forward P/E of MSCI China vs S&P 500

Source: Bloomberg

Cost of missing out could be substantial

If history is of any guide, the worst for China could soon be behind us as it enters a period of consolidation before the next stage higher (Refer to Figure 3). This may be a generational opportunity for investors with a longer-term view, and the cost of missing out could possibly be substantial. Highlighted by our venerable former founder and Prime Minister Lee Kuan Yew in his timeless wisdom – “If you do not know history, you think short-term. If you know history, you think medium and long-term” (see “Lee Kuan Yew: The Grand Master’s Insights on China, the United States, and the World”). Growing pains is an inevitable process of progress, one should look forward towards the future. Remember, it is always darkest before dawn.

Figure 3: MSCI China entering consolidation phase

Source: Bloomberg

About the writer

Prior to venturing into wealth advisory, Jamie was an equity sales trader for two decades covering global financial markets and servicing both institutional and retail clients. Having seen many market cycles, booms and busts, a key lesson that Jamie learnt is to never underestimate human ingenuity and its ability to adapt, improvise and overcome. Jamie hopes he can help to free the mind of others on the complexities and inter-connectedness of the financial markets, just like Morpheus in the “Matrix” movies.

References

1: www.ft.com/content/eb7dce16-fc1c-45dc-bc6e-5f521623bd3e

2: www.scmp.com%2Feconomy%2Fchina-economy%2Farticle%2F3146271%2Fwhat-chinas-common-prosperity-strategy-calls-even

3: www.oecd.org%2Fsocial%2Fin-it-together-why-less-inequality-benefits-all-9789264235120-en.htm

4: www.oecd.org%2Fels%2Fsoc%2Ftrends-in-income-inequality-and-its-impact-on-economic-growth-sem-wp163.pdf

5: https://news.cgtn.com/news/2022-02-28/China-s-2021-GDP-surpasses-110-trillion-yuan-NBS-180VnNx50Ry/index.html

6: www.xinhuanet.com%2Fenglish%2F20220112%2F4a0801b5429144a7b390e868ee6c23fb%2Fc.html

7: www.reuters.com/markets/us/imf-cuts-growth-forecasts-us-china-world-omicron-spreads-2022-01-25/