China beyond the trade war

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There is more to investing in China than the fortunes of the Sino-US trade negotiations, as we report in this edition of The Intelligence Report [1].

  • The effect of the trade war on Chinese growth should remain limited
  • Expect support for domestic demand, but no aggressive measures
  • Further out, economic transformations should benefit Chinese equities

What about the economic situation in China?

Since early 2018, it has become difficult to talk about the Chinese economy without mentioning the trade dispute with the US and the slew of tariffs imposed on billions of dollars of Chinese products imported into the US and vice versa.

Growth in the Chinese economy slowed to 6% year-on-year in the third quarter, marking the lowest rate in 27 years. However, we cannot attribute the entire slowdown to protectionist US policy.

  • First, growth has slackened structurally because of the shift from an investment-oriented economy to one that is more consumption-driven.
  • Second, from a more cyclical point of view, tighter credit conditions (in particular, to curb shadow banking and to control debt and the housing bubble) have weighed on growth.

Measures by the central bank in recent months have brought monetary policy back into neutral territory. Further easing may be decided, in particular to stimulate small business credit still with the aim of fuelling domestic demand. Such measures, and a possible use of fiscal stimulus, should help GDP growth stabilise at 6% in 2020.

Exhibit 1: Chinese GDP growth and credit impulse (YoY change)*

China GDP growth and credit impulse (YoY change)*

* The credit impulse reflects the year-on-year change in the growth rate of outstanding loans as a percentage of GDP. Source: Bloomberg, BNPP AM; November 2019

Clearly, the trade war has added an unknown to the equation and has certainly limited investment, but specific factors explain the downturn in the economy. Rising pork prices linked to swine fever have led to higher inflation, which is weighing on household purchasing power. Lower new car registrations have severely hurt manufacturing activity, but there are signs of recovery.

The practical consequences of the trade war: exports

Chinese exports to the US, which account for 19% of total exports, have fallen, narrowing the Sino-US trade deficit. At the same time, the US trade deficit with the rest of the world has risen, particularly as imports from Asian countries including Japan, South Korea, Taiwan and Vietnam increased. This may reflect the relocation of production sites from China to other Asian countries.

While there may be a substitution effect here, with the US importing more goods from outside China, it should also be noted that Chinese companies already began to reorganise production chains a few years ago as (labour and environmental) costs in parts of China rose relative to those in countries such as Vietnam. This shift tallies with China’s move towards the production of higher value-added products and away from economic growth based primarily on low labour costs.

Moreover, Chinese exports to countries participating in the Belt and Road Initiative have grown steadily since 2016. Overall then, total Chinese exports have not crumbled (see Exhibit 2).

Exhibit 2: From a broader perspective, Chinese exports have not collapsed (YoY change)

From a broader perspective, China exports have not collapsed (YoY change)Source: Datastream, BNPP AM; November 2019

The practical consequences of the trade war: continued ‘noise’

It seems highly unlikely to us that US companies can decouple from their Chinese partners. Reorganising production would be a lengthy process and, in many cases, impossible. In addition, China sales account for large chunks of US company revenues. While the US and the Soviet Union were able to ignore each other during the Cold War, this looks unfeasible today: economic considerations are taking prominence over geopolitics.

We believe that the trade war will remain a topic for the markets and that the possible signing of a ‘phase 1‘ agreement in the near term will not mark the end of the story for investors. We regard the enthusiasm over progress in Sino-US talks in October as excessive.

This theme looks set to create further ‘noise’ and market fluctuations. Given the mitigating factors listed above, the fact that China’s exports to the US account for only 3% of global trade, and the Chinese trade war tactics, we believe it is important not to give it too much weight in investment decisions. The effects of the trade war for China look manageable to us.

Our approach to investing in Chinese equities

Drawing on six experienced portfolio managers and research analysts in Hong Kong and Shanghai, our investment approach involves bottom-up stock-picking. The team benefits from the top-down analyses by our Hong Kong-based senior economist for China. We believe this is particularly important to take advantage of all the opportunities resulting from the structural transformation of the Chinese economy and its sources of growth.

As for the environmental, social and governance aspects, data and company input are still inadequate despite rapid progress since 2018, so we attach great importance to active engagement and dialogue. Companies that are listed on the onshore market, and that often search for more stable share ownership than Chinese consumers, are particularly sensitive to this approach and open to dialogue. We believe this ESG approach can help limit risk and identify investment opportunities.

Additionally, we believe the integration of material ESG factors can help enhance risk-adjusted returns. This is particularly true in the Chinese equity universe, where the limited availability of information can result in mispriced ESG risks and opportunities. By working with our Sustainability Centre on not only ESG research, but also engagement with companies, we believe we can bridge both the ESG information gap and encourage more sustainable corporate practices and generate valuable insights for our investment decisions.

Three growth stories to build a portfolio

We aim to invest in companies that fall into three distinct groups:

  1. Companies with a dominant position linked to strong competitive advantages (a ‘moat’) and clear visibility on the results over several years.
  2. Companies likely to benefit from the transformation of the economy. We expect their earnings growth to accelerate due to new technologies or the rapid adaptation to new market conditions.
  3. Quality companies that have been neglected by investors, but that we expect to return to growth after a turnaround in strategy or management.

We believe our approach is aligned with the Chinese economy’s new realities. As the middle class rises, business development models will need to adapt to a world of services, including travel, education and healthcare. Our approach should allow us to pick the winners in this transformation.


[1] Written by Nathalie Benatia; based on a recent presentation by Caroline Yu Maurer, Head of Greater China Equities, Lead Portfolio Manager


This article appeared in The Intelligence Report – 26 November 2019


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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

 

Nathalie Benatia

Macroeconomic Content Manager

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