Medium to longer term fundamentals for China are strong in our view, driven by a combination of sustainable consumption-driven growth, innovation and ongoing reform. Private consumption will increasingly drive the Chinese economy as it shifts away from its reliance on exports. This structural shift is moderating growth in the near term, but is expected to drive more self-sustaining long-term growth. Favorable demographic drivers should continue to support consumption growth and technological innovation. The upper middle class continues to grow at an accelerating rate, and is expected to comprise 59% of the Chinese population by 20201. China also boasts the largest millennial population in the world, with the 415 million-large cohort exceeding total population in the US. Their evolving consumption patterns will continue to effect profound wealth creation and economic impact. For example, Millennials have driven the proliferation of online retail consumption. Roughly 42% of global e-commerce transactions took place in China last year, larger than the total in US, UK, France, Germany and Japan. China’s large talent pool has also been crucial in the drive for technological innovation, which aims to establish the country as a major global player in advanced manufacturing. China is on track to spend more money on R&D than the US by next year and hopes to become the world’s leader in technology and in life sciences. Finally, accelerating reforms have been instrumental in improving economic fundamentals and market efficiency. Supply side reform has reduced heavy industry productions, regulatory reform has also further encouraged innovation, and reform of the large and inefficient state-owned enterprise (SOE) segment remains a key focus. In addition, financial reform and deleveraging have been reducing China’s heavy debt reliance and non-bank lending. In recent years, China has increased efforts to lower local government leverage and reduce funding from non-bank lending in order to mitigate systemic financial risk and improve debt dynamics, while shifting to a more sustainable economic expansion.
Ongoing trade tensions and tariffs remain a concern for investors. Uncertainty persists around the outcome, but headwinds to China may be smaller than investors fear. Exports to the US comprise only 4% of China’s GDP (Exhibit)2, while listed Chinese corporates have only roughly 2% direct sales exposure to the US3. Furthermore, we believe balanced government stimulus could help cushion a potential slowdown, in contrast to the outsized 2009 stimulus which created economic imbalances. A mix of loose monetary policy, regulated credit policy and active fiscal policy channel credit into real sectors instead of real estate and finance. Tax cuts for corporates and households could help support private sector animal spirits and household consumption, while leverage stabilization is likely to continue.
Source: China Customs, IMF WEO via Haver and GSAM as of June 2018.
We see a sanguine medium term outlook and a commensurate investment opportunity set. Potential catalysts that could create an interesting entry point include a resolution on trade frictions, a positive growth surprise from the government steering of reform and stimulus, or tailwinds from US dollar weakness. Consensus earnings forecasts remain in the double digits for Chinese equities for both 2018 and 2019.4 Meanwhile price-to-earning (P/E) valuations are trading at a ~15% discount to its 20-year historical average, and a ~33% discount to US equities4 Relative to its share of global population, economy and trade, China is currently significantly underrepresented in the global equity benchmark. China’s weight in the MSCI EM Index is poised to increase from the roughly 30% currently to roughly 42% following the inclusion of “onshore” A-shares.5 From our observation, many clients are currently under-allocated to China, as well as broader Emerging Markets, and should consider increasing their allocation. We are one of the first and most experienced A-shares managers in the industry with a 14-year track record.6 Our team’s local experience investing in both A-share and H-share equites and our fluency in Chinese have provided us with deep expertise and insight, especially since the majority of China A-share companies do not report their financial statements in English. We are constructive on “New China” opportunities created by online and offline integration; technological innovation, higher-value manufacturing and import substitution; reform and regulation; as well as winners of consolidation in the “Old China” segment of the market.