Investors have cooled on the concerns over China that dominated the headlines a year ago but a bubble still remains possible in the future, according to Baillie Gifford fund manager Ewan Markson Brown.
At the beginning of 2016, investors were particularly worried about a potential slowdown for the Chinese economy, with the devaluation of renminbi at the end of 2015 causing widespread speculation that the economy could be on the brink of a bubble set to burst.
However, since the start of last year the MSCI China index has risen 33.02 per cent as the economy grew quicker than anticipated and investors returned to the market.
Performance of index since January 2016
Source: FE Analytics
The Chinese market has also been boosted by a rise in uncertainty in the developed world caused by Brexit, the US presidential election and the fear of a rise of populist movements in Europe.
However, concerns still remain that potential trade sanctions from the US due to Trump’s protectionist rhetoric, instability surrounding North Korea and a large debt burden could cause China’s bubble to burst this year.
Indeed, earlier this month Capital Economics wrote: “Evidence of a sharp turnaround in growth and policymakers’ success in preventing a destabilising slide in the renminbi have underpinned a dramatic shift in sentiment towards China.
“But there are good reasons to expect growth to slow again soon and for the renminbi to come back under pressure.
“Most important, there is no sign that the leadership is using this respite to push through needed structural reform. Prospects for the medium term therefore continue to worsen.”
Ewan Markson Brown, investment manager within Baillie Gifford’s emerging markets team, agrees. 
“Ever since I started looking at China in 2002, every year someone has told me the whole thing is a bubble about to collapse and periodically you get scares and it all goes down and then it recovers,” he said.
“Yes, the overall debt numbers are high and they’ve been growing fast. Yes, there’s lots of bad assets in property, there’s lots of dead zombie companies and there [are] a lot of bad SOEs [state-owned enterprises].”
This, he says, is reducing the growth rate, which is now around 4-5 per cent rather than the 6-8 it has been in previous years.
“The growth rate is rebounding this year because last year it was much lower than forecast and is probably much more in-line with what the government is telling you the growth rate actually is,” he said.
As well as the growth rate, there is capital flight from Chinese residents, he added: “If I talk to rich Chinese people they want to get their money out but it’s difficult, it’s not broad-based and there’s no fear as such it is more a way of thinking to get some money out.”
Markson Brown says slower growth and the risk of capital flight from the Chinese economy could mean “at some point there will be a crisis in China”.
He says: “How devastating it is going to be is the open question; I think the [bigger] problem for the world is that China has been worth 60-70 per cent of the international credit market and world growth over the last five years.”
Yet, China will remain a major part of the international credit market and a key driver of global growth for the next few years, says the manager, making the short-term prospects for the Chinese market generally positive.
“There are no signals that they’ve lost control of the system and they are focusing on important areas such as innovation and that is effectively providing growth, jobs and productivity and paying for the bad assets,” he explains.
However, he concedes there are areas of the Chinese market that need to be avoided with a large number of failed companies still afloat thanks to government backing.
“It is a risk – we don’t own the banking system, we don’t own property companies and we don’t own heavy industrials – we have nothing where we see excess capacity,” the manager said.
“In the same way I look at South Korea and they have three ship-building companies, one is in receivership and the other is going to be. Do they need three?
“My guess is they don’t need any because world freights are going to be much lower and not growing because of localisation.”
These kind of industries will all eventually hinder the banking system, he says, as defaults become more likely from failed enterprises, but he asks whether this really matters for investors in the growth areas of China.
“This comes back to the fact that broken banking systems have historically destroyed economic growth but the [innovative] companies I am talking about, especially online, they’re all asset-light businesses. There are few people and they don’t need the banking system,” he said.
“That’s why global interest rates are low and there is excess capital because the old businesses have too much debt and are dying and new businesses don’t need capital and I don’t think that is going to change.
“So focus on growth and avoid that belief in cheap valuations or mean reversion because it is just not going to happen.”
Markson Brown has co-managed the Baillie Gifford Pacific fund with Roderick Snell since 2014, during which time the fund has beaten the IA Asia Pacific ex Japan index but is behind the MSCI AC Asia ex Japan.
Performance of fund versus sector and benchmark since manager start
Source: FE Analytics
However, it has been a top quartile performer over five years and has returned more than both the sector and benchmark over the last decade.
The fund, which has a clean ongoing charges figure of 0.74 per cent, is currently 30.9 per cent weighted to China, with Tencent, Alibaba and JD.com its top three holdings.