China: The World’s Best Consumer Story

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If the Trump administration goes after Chinese exports, it could create a fantastic buying opportunity, says Matthews Asia Strategist Andy Rothman.

As Earth’s second-largest economy, China accounts for more global growth than the U.S., Europe, and Japan combined. Yet it’s also a source of endless investor apprehension, as economic growth has slowed from double digits to about 6.5% and its communist government works hard to steer China toward capitalistic consumption.

With more than half of its 1.4 billion citizens already living in urban areas, the biggest boost from urbanization is largely behind it. Yet Andy Rothman, Matthews Asia’s strategist, continues to expect big things from China’s consumers.

Rothman, 58, has watched China transform its economy over three decades—first in the U.S. Foreign Service, as head of macroeconomics in the U.S. embassy in Beijing, and then as CLSA’s China strategist. In 2014, he joined Matthews, which manages more than $30 billion invested in Asia. Recently, in a phone interview with Barron’sfrom his San Francisco office, he spoke about China’s economic prospects, Beijing’s coming leadership reshuffle this fall, and its trade tensions with the Trump administration. As a macro strategist, he declined to name stock picks.

Barron’s: The People’s Bank of China has raised benchmark interest rates to a two-year high. What should we expect?

Rothman: Beijing is engaged in what I call de-risking. Right now, the Chinese government sees a period of quite healthy economic growth, and this gives it an opportunity to tackle some of the more serious problems in its financial system.

For example, there are concerns about the proliferation of wealth management products, so the government has progressively tightened the standards for these. The growth rate has come down, and today, only 16% of these are risky, hedge fund–like products, down from 21% in 2014.

You see some determination not to let risks go unchecked and develop into a crisis. For instance, regulators are cracking down on insurers selling instruments that aren’t really insurance products. There are also small banks whose deposit base isn’t growing fast enough for them to keep issuing loans at the speed they wish to, and so they’re trying to manipulate the interbank market, and the government is stepping in to curtail that.

What about the risk of capital flight?

Early last year, the media and fund managers were all worrying that China might run out of foreign-exchange reserves by year end, which could cause the yuan to depreciate dramatically, by 20% or 30%. None of that happened. In fact, China’s forex reserves grew by $70 billion this year and remain above the $3 trillion threshold, so Beijing still has way more reserves than it needs.

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A majority of recent outflows aren’t capital flight; Chinese chief financial officers had issued debt in Hong Kong denominated in U.S. dollars. But since late 2015 and early 2016, when that carry trade no longer made sense, they moved money from the mainland to Hong Kong to repay those offshore loans and reissue debt onshore in yuan.

Another factor is wealth diversification. Chinese people have become increasingly wealthy over the past decade, and their investments have largely been at home, and in real estate. Anyone who went to an advisor would be told they shouldn’t have all their money tied up in Beijing and Shanghai real estate. So more people are moving money offshore to diversify their investments.

What’s your outlook for the yuan, now at $0.15?

Matthews doesn’t issue a house view, so I’ll give you my view. The answer depends on the dollar’s outlook more than what’s happening in China. Last year, the yuan depreciated about 6% against the dollar, and this year, as the dollar weakened, the yuan has appreciated about 4%, still not by nearly as much as some other emerging market currencies.

I believe Beijing accepts that the yuan’s direction will be determined by the dollar’s strength or weakness. But it will intervene to prevent the yuan from moving more than 5% or 6% in either direction against the dollar in any calendar year. So if you think the dollar will weaken further, then you might see the yuan up by 5% or 6% in 2017.

What’s your outlook for China’s gross-domestic-product growth?

In my view, the GDP growth rate is the least important statistic in China. While the number is not wildly inaccurate, the government does smooth it out. Instead, we should focus on cues about Chinese consumer health, because that’s the largest part of their economy, the part that drives growth and, not coincidentally, the focus of our investment strategy. So I look at income growth, consumer spending, inflation, and consumer sentiment, and where investment by privately owned companies is going.

Real income growth is 7% this year, and real retail sales are up 9% in the first half. On top of that, consumer sentiment is positive, household debt is low, and household savings rates are high. That’s why for a long time I’ve been calling China the world’s best consumer story.

Now, all these numbers are slower than a few years ago, and almost every statistic on China is decelerating year over year. We’re never going back to double-digit income or retail-sales growth. But the economic base for all of these has also gotten really big, and those growth rates are still phenomenal.

Has China succeeded in steering its economy from exports toward more domestic consumer spending?

People have been predicting China’s imminent collapse for years, and a central tenet is that an economy based too much on exports and investment isn’t sustainable. China has made tremendous progress in restructuring toward a more consumer-oriented economy.

This may come as a surprise to people who go to Wal-Mart Stores, where it looks like everything in the U.S. is made in China. But net exports—the value of exports minus the value of imported pieces that go into them—accounted for just 2% of China’s GDP last year. This will be the sixth consecutive year in which tertiary industries (like real estate, finance, retail, and services that aren’t part of primary industries like agriculture, or secondary industries like mining and manufacturing) make up the biggest part of China’s economy. In other words, services and consumption will exceed manufacturing and construction for a sixth straight year.

Services and tertiary industries rose from 43% of GDP in 2007 to 54% last year, which shows that China’s rebalancing is well under way, but not yet done. China remains the best consumer story in the world, and the only other thing that comes close is India.

Does rising debt and overexposure to property change that story?

Household debt to GDP was recently about 43% for China, compared with 79% in the U.S. and 88% in the United Kingdom.

Yes, new home prices in the Tier 1 cities of Shanghai, Beijing, Shenzhen, and Guangzhou are up 85% since 2011. But those four cities are about 4% of new-home sales in China, and they’re no more representative of the entire Chinese housing market than New York and San Francisco home prices are of the entire U.S. In Tier 3 cities—most of them have a million or more people—prices are up 10% over the same period. And Tier 3 cities account for 62% of the urban population and 65% of new-home sales by volume.

In some ways, the Chinese housing market is like ours: In a few cities, prices have grown a lot, and there’s a serious social problem if a majority can’t afford to buy or even rent a home. China is dealing with this in Tier 1 cities and spending money on low-income housing.

But bubbles are all about leverage. In 2006, the median cash down payment for a new U.S. home was 2% of the purchase price. But China is more like U.S. home financing in the 1950s and 1960s—the minimum cash down payment is 20%, and most banks require 30%. During the Asian financial crisis, Hong Kong house prices fell by 70%, but the mortgage default rate peaked at only 2%, because Hong Kong buyers, like the Chinese, had to put down more cash. With most Chinese mortgages, the banks that originate the loans hold them to maturity, so they have incentive to do due diligence and there’s little mortgage securitization.

What should we expect from the Communist Party’s twice-a-decade leadership transition this fall?

We know the majority of Chinese leadership below Xi Jinping—China’s president and head of the Communist Party—will be stepping down and be replaced by a new crowd. But it’s not all that material to our investment strategy because there’s no evidence the current leadership has been an obstacle to Xi’s economic policy.

We’ll see more of what we’ve seen this year: gradual deceleration in credit growth, more de-risking, gradual focus on shifting away from heavy industry toward the consumer, away from state-owned toward private enterprises.

How is Donald Trump affecting China and its standing?

President Trump could be really important for investors, and also impossible to predict. He spent much of his campaign arguing that China was the cause of our economic woes. Then in the first six months of his administration, he hasn’t bashed China, although he seems to be losing patience again—he tweeted that China wasn’t helping more on North Korea, and Commerce Secretary Wilbur Ross has argued that China and the European Union are closet protectionists. That makes me wonder if he’s laying the groundwork for trade sanctions on China and the EU.

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I think his administration probably will use the Trade Expansion Act to put limits on U.S. imports of steel from China. A formal study has been under way for months at the Commerce Department, looking at whether Chinese steel imports represent a national security threat.

Could this go beyond steel?

It could be broadened to anything, but what Trump and Ross have been talking about is steel. It’s one of those industries, like coal, whose reinvigoration Trump seems to feel will set the U.S. economy back on the right footing.

For investors, this could be a huge issue in the coming months. If Trump goes after Chinese imports, the initial reaction from the media and analysts probably will focus on the negative impact on the Chinese economy. Investor sentiment toward Chinese equities could take a significant hit, bringing valuations down, and that will be a fantastic buying opportunity.

Let me explain why: A hit to Chinese exports won’t have as big an impact on the overall Chinese economy as most people think. Only 18% of China’s total exports come to the U.S., so there are other big markets. Also, the consumer story will be largely unaffected.

As the largest active Asia-only U.S. investment manager, we own shares in just over 100 Chinese companies, and 87% of our holdings are in consumer and service companies. We’re focused primarily on Chinese companies selling goods and services to Chinese consumers.

It’s not rocket science to say the consumer is the best part of China’s economy, and because the market understands it, these stocks are too expensive. Here’s where it’s important whether you take an active approach versus a passive index approach: Indexes on China are mostly backward looking, focused on big state-owned companies and heavy industries rather than entrepreneurial, privately owned companies. Consumer stocks in these indexes also tend to be really big and popular and maybe expensive, whereas the median forward price-to-earnings valuation for all of our China holdings is only about 15 times.

Name one risk that worries you.

It’s too hard to pick just one, so I’ll tell you three. In the next six to 12 months, what worries me are the risks emanating from Washington—will the Trump administration engage in a trade war with China? The second risk is how Trump will handle North Korea, because both of these things can have a big impact on how investors view China.

The third risk is from Beijing. While the biggest growth is coming from private entrepreneurial firms, the government still plays an outsize economic role, particularly in the financial sector, and it makes mistakes all the time. Beijing usually fixes mistakes pretty quickly, but there’s a risk it makes a policy mistake and doesn’t correct it in a timely fashion.

But overall, Beijing is opening up its capital markets, both equity and fixed income, to foreigners, and over time this will help make them more transparent and better regulated. More foreigners are going to feel comfortable investing in the Chinese economy. Last year, China accounted for 28% of global economic growth, more than the U.S., Europe, and Japan combined, and yet very few investors have direct exposure to that growth.

Thanks, Andy. 

By KOPIN TAN
Barron’s

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