Following the change in leadership in March there has been a significant shift in the Chinese Government’s economic approach. The focus is now more on quality of growth, rather than quantity. It seems there’s no more ‘growth at all costs’ agenda and this is having a huge impact around the world.
A core problem in China is that manufacturing has become unprofitable. Overcapacity and local debts are taking their toll and China’s economy is struggling. Industrial production is on the slide and projected export growth is lower than before the financial crisis in 2008.
New Premier, Li Keqiang, in the first year of a 10-year term, has signalled his intent to use supply-side reforms as supposed to demand-side investment used in the past to drive the economy. The Government is expected to announce a reform package in the autumn. The idea is to allow greater private sector investment, give tax cuts to service sectors, create interest rate liberalisation and clamp down on shadow banking (financing outside of state banks). If effective, this could lead to greater efficiency and, coupled with private sector investment, generate stronger long-term growth.
However, the reforms are likely to be gradual and could take time to have an impact. Investors may worry the reforms could be bad for growth in the short term.
So far this year, emerging markets have under-performed compared to developed markets. At time of writing, the China Shanghai Composite Index is down over 8% (source: Bloomberg) compared to a rise of over 15% for the US S&P 500 Index. And economic surprises have rebounded in developed markets this year but continue to fall in China and emerging markets.
While we don’t forecast a hard-landing in China, we feel the lack of a strong stimulus programme similar to previous years will lead to GDP levels below the current consensus forecasts of 7.65% for 2013 and 7.60% for 2014. And we’re not expecting the reform announcements to produce a sharp rally. It’s likely that many investors will wait for evidence that the reforms are working.
A recent rise in the Chinese interbank lending market has shaken the confidence of many investors as it appears that Beijing are not in control of the economy.
What’s more, house prices in the big cities have increased dramatically. According to the IMF, Beijing has the highest imbalance between house prices and incomes in the world at a ratio of 22.3. That makes it more than three times as expensive as London in relative terms, which has a ratio of 6.9. The positive is that China has one of the highest savings rates in the world so there is not a lot of consumer debt in the housing market.
We believe the Chinese equity market is likely to remain choppy for a while. Valuations are at very attractive levels but the market could drift lower in the short term, amid policy uncertainties. Emerging markets have been suffering from the headwinds of rising borrowing rates (following US Federal Reserve comments on tapering quantitative easing), declining commodity prices (high exposure to resource related sectors) and strong dependence on China growth. We recently sold all emerging markets stocks and have no exposure there, though we’d review this should the emerging markets situation improve and, in particular, if there’s more concrete evidence that the China reforms will prove a success.
Sources for charts: Macrobond and Bloomberg
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