China: The red hot market

There couldn’t be a better symbol of China’s economic dominance that the bull that stands outside the Shanghai stock exchange.

Strong GDP growth, high urbanization rate and growing disposable incomes have been the key components of China’s meteoric rise to its current status. At a time where correlated global markets are in the doldrums, the Chinese economy, depend largely on domestic drivers for growth, is firing on all cylinders. The Chinese market continues to soar as investors clamour for a slice of the world’s fastest growing economy

So how does the Chinese market remain upbeat in the face of major negative global developments such as the government debt crisis in Europe?

The short answer is sound economic fundamentals and diminishing reliance on European demand, says Eng Hock Ong, managing director of AGF Asset Management Asia Limited and portfolio manager of AGF China Focus Class.

“China continues to show strong GDP growth despite the European crisis, as domestic demand remains buoyant,” he says. “Taking longer time frames like the past five or 10 years, the Chinese stock market has performed significantly better compared to the stock markets in the developed countries reflecting China’s better economic and corporate fundamentals.”

Investors are increasingly recognising that the risks in the world are not in emerging markets such as China, says Phil Langham, head of Emerging Markets Equity, RBC Global Asset Management. “China’s balance sheets,” he says, “are relatively strong and therefore its economy has been outperforming even in a weak global environment.”

In contrast to the developed economies, China has low government debt and a strong fiscal position with healthy budget surpluses. Although exports growth is expected to moderate, due in part to its decision to de-peg the yuan, higher disposable incomes from rising wages will continue to support domestic demand.

“The most attractive sectors are, therefore, domestic demand related, in particular, financials, consumer discretionary and staples and telecoms,” says Langham.

Following the credit crisis in Greece, growth in China is moving from being driven by exports and infrastructure to consumption. There’s plenty riding on the back of domestic consumption.

“Over the medium to long term, we are most positive on consumer, healthcare and internet sectors in China,” says Ong.

To a large extent, these three sectors share the same driver: rising consumption. “These sectors will also provide the Canadian investor some diversification away from the resource dominated Canadian market,” says Ong. “Recent acceleration in wages and the government’s intention to transform the economy from an export driven model to a more domestic-driven economy will enhance growth prospects of the consumer sector in the coming years.”

Further policy measures to raise rural incomes to ensure greater equality in income distribution will also boost consumption in rural provinces and smaller cities.

Faster growth and attractive valuation are the two key factors that make China attractive to Canadian and other foreign investors, says Langham. “China has consistently been able to grow at 8% to10% over the last decade, much higher than any developed market, and this trend looks set to continue given its strong balance sheet and reserves, low wages, high savings and continued urbanization.”

With urbanization of rural areas comes deeper penetration of technology, particularly the spread of the Internet. “We also believe that the underpenetrated internet market and better IT infrastructure will benefit the Internet market as a whole,” says Langham. “China’s economic growth has been and will continue to be strong.”

Other than positive demographics, the opportunity to participate in the structural growth of Chinese companies is the key attraction to foreign investors.

“China presents a very compelling case for foreign investors: faster growth, attractive valuation, wide choice, inefficiencies in the marketplace present opportunities,” says Langham.

Despite the recent pause in the Chinese stock market, which experts say provides a good buying opportunity, the outlook for China remains positive. “(The consumer sector) companies will also benefit from an appreciation of the yuan, especially those consumer staple names which import raw materials and sell their products locally,” says Ong.

Any individual emerging market has potential political or economic risks and China is no exception. Domestically, the two main investor concerns are a potential bubble in the property sector and excessive bank lending over the last two years leading to excess capacity.

Ong assures that these issues are currently being addressed preemptively by the Chinese authorities. “The government has announced several rounds of property tightening measures to deter speculation and prevent sharp increases in property and land prices,” he says. One of those measures is increased restrictions on mortgage lending. “Besides curbing property related loans and loans to local government financing vehicles, the government has also implemented strict quotas on bank lending.”

The policy strategy was aimed at preventing an asset bubble by directing bank lending to the real economy. The policy makers are looking to slow growth from 12% to 13% in the first quarter to a more sustainable 8% to 9%. There are growing fears that tightening may be overdone.

Not really, say those who’ve got the ring side view of the market. These measures, they assure, will inevitably loosen once the desired effect is achieved. “Tightening concerns look set to ease in coming months as inflationary pressures peak and the property market corrects,” says Langham. “And this should act as a boost to the market.”

The subdued performance of the Chinese market, a function largely of the fiscal tightening measures, this year reflects investor concerns over potential property bubbles, unsustainable bank lending growth and over-investment.

Ong, though, stands by his analysis. “All these issues, in our view, have not reached excessive levels, and are recognised and being addressed by the authorities.”

Emerging market experts can’t stress enough how important it is to invest in a broadly diversified portfolio of investments.

As impressive as China’s fact sheet is, it pays to look at the small print. China is still a centrally planned economy, which arguably increases the systemic risk of the market should there be a policy mistake. Relatively weaker corporate governance compared to developed markets and an intense competition arising from over investment may be some of the factors investors would do well to consider.

All things considered, though, authorities on Asian markets assert that this risk profile is not extraordinary and certainly doesn’t make the Chinese dragon the fire-breathing monster of Western lore.

(09/23/10)