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Will Year of the Rat lift China’s low rating?

Graham Smith

Graham Smith - Market Commentator

This weekend marks the beginning of a two-week-long celebration of the Chinese New Year. A whole host of customs and traditions will be observed in China and other countries throughout Asia and around the world, all with the aim of attracting good luck in the year ahead.

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Some luck is needed too. 2020 began with news China’s economy grew at its slowest rate last year since 1990 as the country’s long running desire to rein in risky credit and a trade spat with Donald Trump’s America continued to bite1. This week brought news of a deadly coronavirus which has already spread to other parts of Asia.

This inauspicious start to the year comes at a time when investors in China will be lamenting the ground lost to soaring stock markets in the US as well as China’s more local rival – India – over the past couple of years.

It’s true that 2019 was a strongly positive year for Chinese stocks, but the gains seen then have only brought the stock market back to roughly where it was at the beginning of 20182.

That leaves Chinese markets looking reticent about the future; prepared for a further period of sub-par growth and cautious about the ability of the authorities to engineer an improved environment for businesses.

Based on the earnings of companies over the past year, stocks are cheaper in China than in the UK3. That’s surprising if we consider China’s economy probably grew about five times as fast as Britain’s last year4.

Moreover, China has already delivered the year’s first significant economic surprise. Data out this week showed industrial production grew at a surprisingly strong 6.9% annual rate in December, after dipping to 4.4% and 4.7% last August and October5. That’s consistent with the worst period for the economy having passed and perhaps at least a suggestion of future good fortune.

It’s also perhaps a sign of just how important China’s domestic economy has become. While exports are subject to the vagaries of international tariffs and overseas economic slowdowns, China’s consumer has remained resilient. Retail sales increased by 8% last year. Online sales rose more than twice as fast6.

China’s recent economic slowdown has been self-inflicted from a position of strength. Decades of fast growth have given the government the space needed to realign the economy away from past growth drivers like infrastructure investment and exports.

The current focus is on building a wider and deeper consumer economy that will benefit individuals and be a more sustainable source of economic growth over the longer term. Certainly consumerism is where the growth is at. Standouts in 2019 were sizable increases in spending on beverages, cosmetics, phones and medicines7.

As Chinese companies become better at meeting the needs of consumers, so the local opportunities multiply. Innovators can build an immense customer base quickly. The incredible growth of China’s Internet kings Alibaba, Baidu and Tencent illustrate the potential.

There are opportunities for other service sector companies too. For example, as a growing band of middle class individuals prepare to retire or pass new found wealth to the next generation, the demand for life insurance and financial services is likely to continue to grow. An aging population spells opportunities for healthcare providers.

There are risks though. Whether China and the US can build upon the phase-one trade deal they signed earlier this month remains to be seen. Whatever the outcome to talks this year, the battles for supremacy in technology and political influence in the Pacific region are multi-decade affairs. That means depending on the US as the consumer of last resort no longer quite cuts the mustard.

Whether the government can continue to manage economic growth at a sustainable level is another risk. So far China has managed to keep overall growth stable in the 6% to 6.5% range through modest means – the tweaking of interest rates and the amounts banks are required to keep in reserve against their loan books, for example.

However, these risks and the possibility of a number of other disadvantageous outcomes appear to have been at least partly discounted in the modest valuation of China’s stock market. Where else in the world can you buy into economic growth of 6% for a price of around 15 times the earnings companies made last year?

Positively, China’s decision so far not to launch a bigger package of economic stimulus measures means there’s still plenty of scope to do so in the event of a further downturn.

Given the risks inherent in investing in what is, after all, still an emerging market, it’s unsurprising to see China-only funds remain absent from Fidelity’s Select 50 list of favourite funds. However, investors can still gain an appreciable exposure to the world’s second largest economy from the list via either a global emerging markets fund or Asia-Pacific focused fund.

The value-biased Artemis Global Emerging Markets Fund is currently overweight China compared with its benchmark and Chinese stocks account for around 38% of the portfolio. Current large holdings include the property developer Country Garden, banking group ICBC and Anhui Conch Cement8.

Anhui Conch Cement also features among the top holdings of the Merian Asia Pacific Fund, but here the online growth theme is in stronger evidence by virtue of large holdings in Alibaba and Tencent. China currently accounts for around 37% of this fund9.

Sources:

BBC News, 17.01.20
Bloomberg, 22.01.20
Bloomberg, 22.01.20
PwC UK, November 2019
5,6,7 National Bureau of Statistics of China, 19.01.20
Artemis Fund Managers, 31.12.19
Merian Global Investors, 31.12.19

Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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