China: New year, new direction?
Craig Farley, Investment Manager at Ashburton Investments.
As we enter the Chinese Year of the Fire Rooster, investors are busy postulating over prospective returns, associated risks and what 2017 may hold in store.
We are fond of the observation that one of the few consistencies in China’s equity market is the perpetual absence of a Goldilocks scenario; the porridge is invariably too hot or too cold, but rarely just right. As it stands, Beijing remains engaged in a delicate balancing act between tolerating a slower growth profile and initiating structural reform, while a tweeting Trump administration brings with it considerable potential for geopolitical surprise. It would appear 2017 is unlikely to signal a change in trend.
Market update
Twelve months ago, currency and related devaluation fears were primary concerns, with widespread fears prevailing of perceived out-of-control capital flight and a predicted hard landing in the mainland economy. Beijing quickly found itself in an all too familiar position, bound to dislocating capital markets and facing uncomfortable choices; maintain the status quo at a potential cost of immediate and significant financial contagion, or respond with accommodative measures and delay China’s own ‘Minsky moment’* for another day. Stabilisation prevailed over transition and the trusted prescription of liquidity injections and monetary and fiscal stimulus were applied. Fast forward to the current day, and we observe an economy that, on the surface at least, is enjoying a welcome period of resilience.
The fourth quarter 2016 GDP of +6.8% year on year (YOY) follows a recent trend of improving headline statistics in aggregate, with a consumption recovery, commodity price rally and easier baseline comparisons underpinning the data. The average consumer’s penchant for discretionary spending remains buoyant despite slowing wage growth, evidenced by consumption’s 65% contribution to overall China growth in 2016. Online shopping phenomenon Double 11 (Singles Day) boosted full year e-commerce sales (+26.2% YOY), while luxury goods are enjoying a recovery following a modest relaxation of anti-corruption efforts. Auto sales were also strong (+14.4% YOY) with demand being pulled forward on account of a beneficial tax rebate for vehicles with small-sized engines.
A second ‘surprise’ has been the government elicited turnaround in the PPI (producer price index), as supply constraints in key industrial materials, namely coal and steel, have positively impacted demand. The quantity-of-purchases PMI (producer manufacturing index) expanded during the fourth quarter of 2016, reflecting increased procurement of raw materials and intermediate goods by manufacturers, who also raised aggregate capital expenditure amid a higher commodity price environment and improving profits. The GDP deflator reading improved to 2.4% versus 1% in the third quarter of 2016, indicating the presence of modest inflationary pressures. A continued moderate expansion should bode well for consumption trends and manufacturing profitability.
Politics
Stepping away from the economy to the political arena, the Central Economic Work Conference concluded in late December, with President Xi pledging stability for the currency, lower financial risk, continued supply side reform and efforts to curb the property bubble. The key takeaway is the statement that it is not necessary for China to meet the 2017 GDP growth target if the result is elevated risk down the road. This change in stance has likely been motivated by two factors. Firstly, growing recognition that the country’s debt profile is unsustainable as total debt as a percentage of GDP climbed to 261% in 2016 and secondly, concerns over America’s trade policy going forward following President Trump’s inauguration. From an investment standpoint, the shift in rhetoric is a welcome development and suggests that firm annual growth targets may be discarded altogether.
On the subject of debt, it remains difficult to envisage a watershed deleveraging scenario via the growth channel in the foreseeable future. According to estimates by Bank of America Merrill Lynch, China added some RMB 26 trillion of new debt in 2016 to produce a nominal GDP growth expansion of RMB 5 trillion at a ratio of more than 5:1. Assuming the same level of debt is added this year, the economy will need to expand by approximately 15% in nominal terms to prevent the ratio from rising further. A sudden, sharp devaluation could make this a plausible scenario, but it is certainly not our base case given the well-flagged economic interests of the People’s Republic of China (PRC).
Without a new and powerful growth lever, the alternative is for Beijing to address the debt mountain. A plethora of initiatives including, but not limited to, bad debt write-offs, non-performing loan disposals, the removal of implicit guarantees from debts underwritten by major financial institutions and debt-to-equity swaps have been suggested and/or introduced but ultimately, Beijing has either refrained from adopting the initiative given the prospect of rising systemic risk, or the impact relative to the size of overall debt is insignificant. To date, the measures to deleverage have been modest and lacking in urgency and ambition, whilst failing to address the root cause of the problem.
International relations
And then there is “The Donald”, whose views on US trade policy have remained remarkably steadfast in the context of a colourful public life to date. As far back as 1987, Trump’s full page ads in the New York Times, Washington Post and Boston Globe vociferously attacked US foreign policy as weak, particularly in the area of trade. Similar tirades followed in the 1990s, with verbal attacks on Japan, Germany, France, Saudi Arabia and OPEC. By 2011, he was consistently calling for across-the-board tariffs on Chinese products and made getting tough on China a cornerstone of his presidential bid from the outset. When he announced his formal candidacy in June 2015, Trump promised that one of his goals was to ‘beat China’.
It is clear that the current global economic landscape, when viewed through the lens of Trump, puts the US at a considerable, and unfair, disadvantage. The US trade deficit is served up as ‘proof’ of unbalanced trade deals that have given trading partners unencumbered access to the world’s biggest consumer market and not been reciprocated. Up to now, the PRC has adopted a wait-and-see approach towards Trump, but there is growing acknowledgement that the new administration ‘represents a discontinuity in American politics’ (TS Lombard). In addition, China could be concerned that acquiescing to Trump could lead to a perception of weakness by the public, which may harm the top leadership politically.
What can we expect going forward? As it stands, the most likely outcome is posturing on both sides followed by a long renegotiation of existing trade deals, in which selective, high-profile inputs in the industrial and consumer sectors are subject to modest tariffs, while the volume on the Chinese practice of dumping low-value added goods onto international markets is ratcheted up. Ultimately, the two sides may cooperate more on trade in the long term, but this may be preceded by some tough rounds of negotiation and/or confrontation. The chance of a full blown trade war still appears remote, but is probably higher than most investors perceive. We will continue to monitor events with interest.
Later this year, the 19th Communist Party of China congress takes place, a twice a decade event that involves a reshuffling of China’s top leadership. A major focus will be the seven member Politburo Standing Committee, the country’s most powerful decision making structure, with five members expected to retire. It is highly likely that the government will adopt a whatever-it-takes approach to ensure stability through this transition, including a fresh injection of fiscal stimulus should signs of growth weakness re-emerge. Against this backdrop, the spectre of financial instability continues to loom large. What is clear is that the road for China’s equity markets in 2017 is unlikely to be a smooth one.
*Minsky moment - when a market fails or falls into crisis after an extended period of market speculation or unsustainable growth. A Minsky moment is based on the idea that periods of speculation, if they last long enough, will eventually lead to crises; the longer speculation occurs the worse the crisis will be.
