With protectionist policies being mooted by the new US administration and rising levels of debt, fund managers believe there are several challenges facing the Chinese economy in the year of the Rooster.
The Chinese economy grew by an estimated 6.7 per cent in 2016, according to the International Monetary Fund’s World Economic Outlook and is forecast to grow by 6.5 per cent this year. Indeed, investor demand has seen total funds in the IA China/Greater China sector exceed more than £2bn.
However, over the past year the average sector fund has underperformed the MSCI China index, with the sector returning 40.64 per cent compared with a 44.63 per cent gain for the index, highlighting the challenges of investing in the highly complex economy.
Sector vs MSCI China over 1yr
Source: FE Analytics
With economic growth anticipated to far outstrip developed economies once again in 2017, fund managers give their views on the economy and corporate environment in the Chinese year of the Rooster.
Despite cutting exposure to Hong Kong and China more recently, Liontrust head of Asia income Mark Williams remains positive on the outlook for the Chinese economy.
“Much of the equity strength has reflected a confluence of positive factors in the Chinese economy,” he said.
“Rate cuts in 2015 took interest rates to accommodative levels which were maintained throughout 2016, which helped those with high debt burdens and benefitted areas such as property.
“Government spending also continued, much of it in long-term infrastructure projects, which combined with recent cuts in capacity to improve material prices.
“This was further aided by the US promise that whichever party won last year’s election would increase American infrastructure spending.”
“We think that Trump’s infrastructure promises will not deliver too much immediate commodity demand, however, and we also see the Chinese stimulus reducing as property tightening measures are already being implemented.”
While property tightening measures have reduced the number of short-term positive drivers, it has not made Williams negative on the country.
Explaining why the fund has moved to lower exposure, Williams says the high levels of bank lending and sharp reductions in foreign exchange reserves have posed challenges for the economy.
“We do not see either of these as a prelude to disaster, but as we have argued for some time the failure to cut lending and ongoing large reduction in reserves does increase risks for the economy,” he said.
Indeed, concerns over credit growth has forced some managers to become more cautious towards China. Gary Greenberg, head of emerging markets at Hermes Investment Management, says the country is on a “unsustainable track” as debt has risen.
“There had been hope that China would embark upon economic and legislative reforms by now, but so far the evidence is sparse,” he said. “Therefore we believe that China is on an unsustainable track.
“Official credit growth is expected to slow down but in any case, at the current rate we believe that the credit to GDP ratio will be as high as 350 per cent by 2020.
“This is less egregious than Turkey or Brazil because the majority of this debt is held domestically.”
Performance of MSCI China index over 3yrs
Source: FE Analytics
However, Greenberg says growth remains sustainable thanks to continued government spending on infrastructure.
“Also, credit growth and negative real rates keep liquidity high,” he added. “Normally in this environment money would leak overseas but the authorities are working hard to plug any leaks so that they can manage the eventual economic slowdown, putting it off for at least another year.”
Greenberg believes excess domestic liquidity and a slower property market will see retail money find its way into the Chinese ‘A’ shares.
He said: “The market’s valuation has gotten cheaper since last year. We are not expecting the MSCI China to re-rate upwards, despite the fact that A Shares are doing so, and therefore we think 2017 should be a calm year for the benchmark.
“One could make the argument for value stocks in China given they should continue to enjoy policy support, but investing based on government subsidies is a weak and shaky strategy.
“We expect 12 per cent earnings growth this year and some currency depreciation, translating to a high single-digit return for the MSCI China, but a better return from A shares.
Jade Fu, investment manager at Heartwood Investment Management, agrees that there are some risks in the near term but is positive over the longer run.
“Chinese equities (both onshore and offshore) are likely to be vulnerable to swings in short-term sentiment, but we continue to hold a constructive view in the longer term,” he added.
“Economic rebalancing is expected to create new investment opportunities in consumer and services sectors.
“Moreover, despite the significant size of China’s economy, this market’s actual weight in major benchmarks remains low relative to other economies. It is still under-owned by overseas investors, which we believe further supports the longer term investment case.”
However, headwinds remain in the shape of new US president Donald Trump who has signalled a greater shift towards protectionism, which could hinder Chinese growth.
She said: “It is difficult to predict what will happen as president Trump attempts to assert US interests in any trade negotiations with China.
“This uncertainty and a moderating growth backdrop could lead to volatility for Chinese equities in the near term.
“China has a much larger share of exports destined to the US than the US has exports destined to China. While this implies that the economic impact of US protectionism is more significant for China, it is less than clear cut.
“Tariffs would be harmful to the profitability of US-listed companies, which generate a larger share of their revenues from China than China-listed companies generate from the US.”