How to assess whether China will offer anything to crow about in the year of the Rooster

First of all this column would like to wish all of its regular readers kung hei fat choi, offering good wishes as China’s Year of the Rooster began on Saturday 28 January.

Roosters are reportedly punctual and trustworthy and since this is a Fire year among the Chinese elements, those born in the coming 12 months will supposedly be good at managing money too. That sounds like a decent start, although this column is intrigued on two counts to learn Roosters are also supposedly impatient, critical, eccentric, narrow-minded and selfish.

First, the author is a Rooster (albeit one of 1969 vintage). Second, those characteristics could, according to some, be applied to the President of the USA, Donald Trump, whose words and deeds could have a great influence over China’s economy, its policies and financial market performance for the next four years (and beyond).

Much of Trump’s fiercest invective on the issues of trade and American jobs has been reserved for China. Although the President has yet to follow through on his campaign promise to brand Beijing as a currency manipulator, a move which under US law would permit retaliation after a year if negotiations fail to bring a solution, he has regularly referred to China as a prime cause of American job losses and a target for tariffs.

Although there are grounds for believing Trump is misdiagnosing the cause of a 30% drop in manufacturing jobs since 1987 (an 85% leap in output over the same period suggests the issue is automation not Chinese competition) his threats cannot be ignored, even if a 15% gain in the Shanghai Composite index over the past 12 months suggests advisers and clients with exposure to the country are still fairly sanguine for now.

That said, the Shenzhen Composite is up just 3% on a 12-month view after a 10% pull-back over the last two months so there is no room for complacency, even if the macroeconomic statistics on whole suggest China is on track to meet its 6.5% to 7.0% GDP growth target this year.

China’s stock markets have recovered from 2015’s sharp falls

Source: Thomson Reuters Datastream

Now may therefore be a good time to check out some traditional indicators of Chinese economic and stock market health to help advisers and clients assess whether direct exposure is suitable or not, or indeed whether there are going to be any surprises which have wider, global implications for their portfolios.

Currency conundrum

On the face of it, China’s economy continues to perform as expected. Fourth-quarter GDP numbers released in late January showed a year-on-year growth rate of 6.8%, smack in the middle of the target range laid down by the authorities:

Chinese GDP growth looks to be on track

Source: Thomson Reuters Datastream

However, the country’s currency has endured a tougher run. Even allowing for a rally in January, the renminbi has ground inexorably lower against the dollar over the past 12 months.

The trend is the renminbi still looks to be one of declines against the dollar

Source: Thomson Reuters Datastream

This is the sort of trend which may be shaping trade policy in the White House, although China watchers argue that Beijing is actually doing its best to support the currency and prevent a disorderly decline. This is because China has sold down a big chunk of its foreign exchange reserves, which have dropped from $4 trillion to just over $3 trillion since 2014, to defend the renminbi in the face of determined currency outflows.

China’s foreign reserves continue to decline

Source: FRED, St. Louis Federal Reserve database

The source of the outflows is hard to divine (especially for someone sat in London) but they have accelerated as China has begun to liberalise its capital markets, as part of its plan to open up (little by little), attract foreign capital and reduce its reliance on exports and debt for growth.

According to George Magnus, respected commentator and Senior Economic Adviser at UBS Investment Bank, Chinese policy now finds itself on the horns of a ‘trilemma’ as it tries to keep a strong currency, an independent monetary policy and embrace free movement of capital all at the same time. Magnus argues only two of the three are possible at the same time as liberalisation permits capital to leave the country as well as enter it.

The desire of capital to leave China reflects Chinese citizens’ desire to invest in overseas assets and presumably the relative attractiveness of overseas currency assets relative to ones denominated in renminbi.

Such trends raise questions about the underlying health of the Chinese economy, even if the headline numbers look good and there are good reasons to do some further digging around. China won’t want a mass outflow of currency as this would presumably erode the capital base of its banks in a country where debt continues to rise very quickly and remains a key fuel for economic growth.

Bank of International Settlements estimates put the nation's total-debt-to-GDP figure at 255%, while McKinsey Global Institute analysis suggests China’s debts have quadrupled since 2007.

Quality or quantity

The good news is the Chinese market has rebounded from 2015’s crunching falls for three reasons:

  • Hopes for political, social and economic reform in the wake of a major shift in Communist Party policy, initiated at the Third Plenum held in November 2013
  • Government and central bank action to reinvigorate growth, in the form of the Silk Road infrastructure investment scheme and looser monetary policy respectively, has largely paid off
  • The launch of the Hong Kong-Shanghai Connect and Hong Kong-Shenzhen trading programmes, which continued China’s liberalisation of its financial markets.

In addition, there has been plenty of economic growth over the past decade, as quarterly GDP in absolute local currency terms over the past years soared by 270% between Q1 2007 and Q4 2016.

But for all that the Shanghai Composite languishes some 50% below its October 2007 all-time high of 6,093 because:

  • the rate of GDP growth has slowed
  • the quality of the growth has come into question, thanks to an over-reliance on capital investment
  • the risks associated to this growth have risen as China’s debt pile has mushroomed

Political poser

Debt remains a key problem for China and its currency is a visible sign of the strain it is under as President Xi Jinping and Prime Minister Li Keqiang seek to keep the plates spinning, especially as they prepare for this autumn’s 19th Communist Party Congress, as these twice-in-a-decade meetings are vital staging posts for ambitious members and will be an opportunity for Xi and Li to cement their positions.

As Magnus puts it in one of his ever-informative columns: “The likelihood of any restraint being applied to either monetary of fiscal stimulus before the 19th Congress at the end of 2017 seems slim.”

Any dip in GDP growth or failure to deliver well-defined targets could have political and economic ramifications so it would be unwise to expect the headline numbers to disappoint.

Yet only so much encouragement should be drawn from that fourth-quarter 6.8% growth figure. Such numbers are backward-looking and therefore by their very nature useless when it comes to fathoming potential returns from equity markets, which are forward-looking discounting mechanisms.

Moreover, the Chinese GDP numbers are collated within a month and never revised. The equivalent data from the UK and USA are subject to two revisions and the final figure takes the best part of eight weeks to prepare, across geographic areas which are far smaller.

If this sounds cynical, it is meant to and even the Chinese have their doubts about some of the numbers. The Economist ran a story a few years back which quoted now Prime Minister Li Keqiang as saying he preferred to look at three separate economic indicators rather than the headline GDP growth number as they were more reliable. Those data points were

  • demand for loans
  • rail cargo traffic
  • electricity consumption

It should therefore be worth revisiting them now.

Three-part test

The first test is credit growth and this next graphic looks at loans offered to domestic Chinese customers by the four largest state-owned commercial banks. Demand growth is still running at just over 9% even if this does represent a marked slowdown from prior years.

Chinese loan growth reaccelerated in Q4 …

Source: Thomson Reuters Datastream

Loan growth also accelerated from Q3 to Q4, a picture backed up by the People’s Bank of China’s loan demand index, which rose to 57.5. This will be a relief to some, since that indicator had fallen to a score of just 55.7 in Q3, the lowest reading since the PBOC began to collate the data in 2004.

… but is still coming in below historic trend levels

Source: People’s Bank of China, Thomson Reuters Datastream

The second of Prime Minister Li’s trusted indicators is rail traffic. This seems sensible as for the economy to thrive, goods must be shipped and this in some ways equates with Richard Russell’s Dow Theory and the view that transport stocks must be doing well for the overall equity market to thrive.

This looks much more encouraging, to suggest that the Chinese authorities’ fiscal and monetary pump-priming is paying off. Whether it helps in the goal to rebalance the economy from production and construction toward consumption is another matter and it could only be delaying the inevitable slowdown, according to the sceptics.

Chinese rail cargo volumes are rising sharply again

Source: Thomson Reuters Datastream

Premier Li's final litmus test also shows signs of acceleration in late 2016. Growth in electricity output looks to be regaining some its spark although even December’s (much improved) 4.5% year-on-year increase does not necessarily sit entirely easily with claims of 6.8% GDP growth for the final quarter.

Growth in Chinese electricity output is rising again

Source: Thomson Reuters Datastream

Hard on the steel

It is possible that the Li Keqiang index is past its prime, as China is undeniably seeking to shift its focus from construction and investment to private consumption. But Beijing is still relying heavily on fiscal stimulus and debt to do the heavy lifting so the three-point indicator may still be of great value.

It may be worth advisers and clients keeping an eye on a fourth factor, first suggested in research written back in 2014 by John Clemmow of Barclays Stockbrokers. He made a powerful case for using steel prices as a gauge of Chinese activity, at least in the old command-style.

This perhaps paints a picture that is perhaps brighter than any of the three measures of growth preferred by Prime Minister Li, even if they have started to point in the right direction.

The Chinese steel price index has firmed markedly

Source: Thomson Reuters Datastream, Barclays Research

These four items suggest Chinese growth is back on track for now, but its reliance on fiscal stimulus and debt remain a concern, while much may also depend on how its currency, capital market reforms and Trump interact.

Debt remains the long-term danger, although as Erik Leuth, global emerging market economist at fund manager Legal & General, points out at least the liabilities are almost entirely domestically funded. As a result, Beijing is not exposed to the whims of foreign investors whose tendency to pull the plug and repatriate cash at the worst possible time has been the catalyst for many an emerging market debt crisis, notably Mexico in 1994, Russia in 1997 and Asia in 1997-98. For now, however, some are even suggesting China could overheat in the short term. Widely respected forecaster Song Yu of Goa Hua Securities is arguing interest rates are too low and encouraging corporations to borrow too freely, while ratings agency Fitch is cautioning that the effort to meet short-term targets could lead to longer-term problems. Fitch’s base case is slower trend growth rather than a collapse as the Government can use State Owned Enterprises as a tool to manage the economy and support it.

Given these cross-currents, advisers and clients may wish to tread carefully when it comes to deciding whether portfolio exposure to the Middle Kingdom is desirable or not. If they do feel that the country’s financial markets sit comfortably with their overall investment strategy, target returns, time horizon and appetite for risk there is a good selection of dedicated active and passive funds, while pan-Asian collectives will also potentially own Chinese assets.

The best performing Chinese funds over the past five years

Source: Morningstar, for China Equity category.
(Where more than one class of fund features only the best performer is listed.)

The best performing Chinese investment trusts over the past five years

Source: Morningstar, The Association of Investment Companies, for the Country Specialists: Asia Pacific category
(* Share price. ** Includes performance fee)

The best performing Chinese ETFs over the past five years

Source: ETF.com, Morningstar, for the China Equity category.
(Where more than one class of fund features only the best performer is listed.)

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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