Year of the Dog looks promising for Chinese equities

February 22, 2018 11:26
China's spending on research and development activities is expected to surpass that of the US this year. Photo: Bloomberg

In this Lunar New Year, the stars seem to be aligning for China. President Xi Jinping is providing steady leadership, "One Belt, One Road" is spurring massive regional investments, and China’s R&D spend could soon overtake that of the US. Also, China's A-shares are set to be added to MSCI’s emerging-market index in May.

Under Xi's leadership, Beijing is asserting its regional influence in increasingly strong ways:

• The One Belt, One Road (OBOR) project is facilitating greater infrastructure investment across the region. Not every project will make sense for every nation, and debt-servicing will be an issue for some, but OBOR is delivering a much-needed boost to many countries.
• OBOR is also improving trade links across land and sea, opening new markets to Chinese companies.
• China’s influence on the world stage is waxing while the global role of the US is waning under President Donald Trump.

At home, President Xi has broadcast his intent to follow three clear policy stars, focusing on growth (while considering environmental costs for the first time); on stability (with a stronger connection to China’s Communist Party); and on reform (with a more deliberate industrial policy that focuses on efficiency and profitability).

China is also baring its teeth with an anti-corruption campaign meant to encourage investment and reduce the kind of capital flight that undermined Beijing’s credibility in 2015. Fears of imminent renminbi devaluation have dissipated, replaced by greater international willingness to hold and trade in China’s currency. We expect this to continue evolving during 2018, as China’s regulatory environment and transparency move ever closer to international standards.

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China’s 13th Five Year Plan calls for 6.5 percent GDP growth, which should support Beijing’s attempts to "rebalance" its economy away from exports and manufacturing towards services and consumption. Continued growth should also help China prepare for the ageing of its population.

As China rebalances and as Asia continues to promote intra-regional trade relationships, they could become less dependent on exports to the US. At the same time, both China and Asia are vulnerable to President Trump’s anti-trade policies, even though US consumers rely on foreign-sourced goods.

At the heart of China's new economy are Asia's new disruptors – particularly the BATs (Baidu, Alibaba and Tencent), which are China’s equivalent of the US FANGs (Facebook, Amazon, Netflix and Google). Internet connectivity and smartphone mobility are helping these companies drive the growing emergence of the millennial generation and the middle class, modernizing China’s economy along the way and creating a new ecosystem of investment.

China also spends more on research and development than the entire European Union, according to the OECD, and it's expected to surpass US R&D spending in 2018. Many Chinese companies and the government itself seem to understand the importance of artificial intelligence and next-generation technologies, such as DNA sequencing. Significant efforts to improve education and science skills are boosting the earnings of China’s millennials, who now earn three-quarters of the income of their US counterparts.

By capitalizing upon these new technologies, skills and business models, Asian economies will strive to boost the living standards of its 4.4 billion people, creating new structural growth markets for investors for the next 30 years.

In another tail-wagging moment, a number of China A-shares will be included in the MSCI’s emerging-market index in May 2018. Given that Chinese equities represent 16 percent of the world’s market capitalization, yet currently have little index representation, it’s easy to see why investors could have an "unconscious underweight" to this asset class.

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One of the key concerns around China is its high level of debt, which is more than 250 percent of GDP – an alarmingly high level. Yet Beijing’s politicians and policy makers are fully aware of this serious issue, and they are ready to deal with it.

Chinese banks are being encouraged to "de-risk" many clients through debt-to-equity swaps, and many state-owned enterprises are being forced – through restructuring and mergers – to become more competitive, more profitable and less leveraged. China's consumers still save nearly 25 percent of GDP per annum, so its banks are not likely to run out of deposits. All told, this deleveraging may still take years, and investors are right to be concerned, but fears of China’s bite seem to be diminishing.

For many investors, investing in China has long been like eating Marmite: it’s an acquired taste that one either loves or hates. Yet it is undeniable that China has an enormous effect on the global economy. Factor in improved regulations, connected exchanges, more open markets and low correlations to the US, and investment interest seems sure to grow.

Investment implications in the Year of the Dog

• China's economic rebalancing is being turbo-charged by the vision, investment and innovation of the BATs, which are now peers of their US FANG equivalents.
• A new generation of Chinese consumers – the millennials – are entering the workforce with strong education, good job prospects and strong work ethics.
• Overall, international investors seem seriously underexposed to China's equity and bond markets, which continue to open up attractive diversification opportunities.

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As Global Strategist at Allianz Global Investors, Neil Dwane is responsible for presenting strategic house views and overseeing the Economics and Strategy Research teams.