In our “Themes for 2018” we postulated that, at some point around the middle of the year, concerns about China growth would re-emerge. We have not been disappointed.
The concerns are partly China-specific. Assets have come under pressure recently reflecting a renewed slowdown in growth amid continued deleveraging and rising default risk. The trade war with the US has also contributed to the general uncertainty and negativity.
At the same time, the broad emerging markets complex has suffered a general malaise as the US dollar and interest rates have risen, putting pressure particularly on emerging economies with structural weaknesses such as Argentina and Turkey. Trade wars have added another layer of uncertainty.
Since the peak at the end of January this year, emerging markets equities are down 18%, while China is down 21%. Valuations indicate emerging markets are cheap again. However, with earnings forecasts being downgraded for many developing market corporates, and their debt costs rising, it seems likely that emerging assets could get even cheaper in the near-term.
Beyond likely further near-term weakness, whether we continue to hold to two long-held assumptions will be critical to when we look to take advantage of that value. The first is that emerging economies are, on average, in better shape than they were in the 2013-2015 period. We have written on that extensively in the last few weeks in the context of recent developments in Argentina and Turkey.
This post looks at the second assumption, which is that while we expect China growth to continue to slow, the risks around a sharper disruptive downturn in growth and increased stress in the finance sector are manageable.
To say that China is complex is an understatement. Depending on what data you look at and how you interpret it, it’s equally easy to be a ‘China bull’ or a ‘China bear’.
We tend to think about China within a framework of long-term economic rebalancing and the ‘three-Ds’ of debt, deleveraging and defaults. More recently, the trade war with the US has added an extra layer complexity to the outlook.
The rebalancing of the economy is well underway. Growth in the ‘new economy’ (consumption and services) has been outpacing growth in the ‘old economy’ (heavy industry, exports, investment) since the beginning of 2014.
Another sign of the rebalancing is the gradual elimination of China’s large current account surplus, which peaked at 10% of GDP in 2007 but now stands at 0.5% of GDP. The goods balance has deteriorated as import growth has consistently outstripped exports since late 2016. Service imports have also risen as middle-class incomes have risen. This is the China side of our own strong service exports into New Zealand, particularly in tourism and education.
Labour market outcomes will be critical to the pace of the rebalancing. So long as the new economy is able to absorb the supply of labour being freed up from the old economy and the unemployment rate remains low, the authorities will press ahead. Right now, the unemployment rate sits at 3.83% and is on a downward trajectory. But we have no doubt they will step in as they did in 2015 to steady the ship should that be required. They have shown they have the will and the means to do this.
Tighter financing conditions as the authorities have sought to rein in strong credit growth has been a key part of the recent slowdown in growth, particularly fixed asset investment (FAI). Annual FAI growth is running at 5.5%, the lowest rate in 20 years. That said, investment is weakest amongst the State Owned Enterprises (SOEs) with private sector debt holding up reasonably well.
Since the GFC China’s non-financial debt to GDP ratio has increased from around 150% to 260% of GDP. Much of this growth has been in corporate debt which now stands at around 160% of GDP.
Our concern about the sharp rise in corporate debt is ameliorated to some extent that this includes the debt of SOEs. There is no official breakdown between SOE and non-SOE debt but estimates centre on around 60% of corporate debt belonging to SOEs. We think of this as quasi Government debt with the not insubstantial support of the Chinese government behind it.
Also, China’s debt is a function of a high domestic savings rate within an environment of limited opportunities for equity investment. A longer-term challenge for China as it rebalances is to transform its savings from debt to equity.
Quality of the debt is an important consideration too, especially given the rapid build-up and the fact that a lot of the growth in debt has been outside the more regulated banking sector in the so-called ‘shadow banking’ sector. It has been regulations to contain shadow banking activities that have led to tighter monetary conditions and slower growth in both credit and GDP growth more generally.
That concern is reflected in a rising level of bond defaults. So far this year, China has seen 14 onshore bond defaults. The record is 18 in 2016 and it appears likely that will be surpassed this year. While bigger companies are now defaulting, this needs to be kept in some perspective – total defaults this year currently stand at 0.4% of all corporate bonds outstanding.
We are not seeing this as a systemic problem. Indeed, a modest level of default can be a good thing as they allow for debt restructuring and remove risk from the financial system. But we will be alert to any deterioration, if defaults on loans trigger unexpected write-downs surfacing elsewhere in the markets.
The new risk is the impact of the trade war with the US. At issue is China’s US$375 billion trade surplus with the United States, and how this will play out remains highly uncertain. We had expected an uplift in the protectionist rhetoric prior to the US mid-term elections in November, but much will depend on how things play out after the elections. A key consideration for the US administration will be reaction to the domestic impact of rising tariffs – rising prices.
On balance, we remain comfortable with our forecasts of 6.5% GDP growth in China this year. The economy is clearly slowing again but we believe the risks of a hard landing are manageable, as are finance sector risks.
The Chinese authorities remain willing and able to support growth when needed. Indeed, since the April Politburo meeting there has been an easing of both fiscal and monetary policy, including cuts to the required reserve ratio to release liquidity into the banking sector.
Given the growth outlook and the manageable risks, China shares represent attractive value. But the trade war with the US remains the wildcard. Until there is some clarity on this issue, we are reluctant to take advantage of the opportunity. We will keep you posted.
This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.