Negative headlines and a lack of in-depth research has led to many investors worrying about the health of the Chinese economy and that it could plunge global markets into turmoil, according to Andy Rothman.
The investment strategist at Matthews Asia says the economy has changed drastically for the better over the 30 years he has lived and worked in China due to an increase in smaller entrepreneurial companies, higher levels of growth and greater wealth creation.
China became a hot topic of debate last year when the Shanghai Composite index made a total return of 53.15 per cent during the first six months of 2015 alone, sparking fears that the market was rising too sharply.
Then the combination of a growth slowdown, the collapse in commodity prices and a yuan devaluation led the Shanghai Composite index to plummet, causing a mass global sell-off in August which has since been dubbed ‘Black Monday’.
Performance of index in 2015
Source: FE Analytics
Year-to-date, the index is down 16.74 per cent while the MSCI AC World index has returned 4.99 per cent.
Rothman, however, believes that too much emphasis is placed on the behaviour of the index, as it only focuses on the region’s large corporations that are often exposed to oil & gas and commodity sectors.
“I would encourage people not to pay very much attention to the market in China and this is why we take an active approach as opposed to an index-based approach – the index is dominated by state-owned companies whereas most people are now employed by private companies – those are the much more dynamic ones,” he pointed out.
“The index is also dominated by the capital-intensive sectors such as steel, aluminium, oil & gas as well as the state-owned banks.”
“But the consumer part, which is the fastest-growing and most entrepreneurial, is grossly underrepresented in the index. It is going to be a problem for a long time until those indices can be restructured to better reflect what’s happening in the economy.”
The investment strategist says China has become a hugely entrepreneurial region over the years, with more than 80 per cent of the population employed at start-up companies or smaller firms.
As such, he points out that China has become a wealthier region on average – it now accounts for one third of global luxury sales and is responsible for one third of global economic growth in general, which he says is a greater percentage than Europe, the US and Japan combined.
“Even if the investor doesn’t want to invest directly in China, it’s really important they understand what’s happening in China because it obviously has a big impact on everything, from performance of UK-listed companies to what decisions the Fed or the Bank of England are making about interest rates,” Rothman explained.
“My focus now is to try and explain how, over 30 years of looking at China, I’ve developed a framework talking about what’s going on in China and to share the framework so people can build better understand what’s happening.”
“Otherwise, you’re buffeted every day with the news that’s coming through about China, whether it’s car sales or home sales or inflation rates and if you don’t really have a framework to put that in, then your ability to analyse just depends on what the latest headline is. Often the headlines are just about an impending crisis.”
The investment analyst admits that China’s economy is facing a number of problems at the moment, such as high levels of corporate debt and high levels of inventory in the housing market.
However, he says these issues are unlikely to lead to a hard landing in the region and will instead lead to gradually lower levels of growth and slightly heightened volatility, given that it is the world’s fastest-growing economy and has a broad economic base.
“A key part of the framework is understanding how much things have changed in China over the last decade, I think a lot of people who are really pessimistic don’t know that its economy is now driven by small private firms,” Rothman said.
“They think that China is all large state companies, and it’s kind of the trap we all fall into in our own countries. If we read the Financial Times or the Wall Street Journal, all they ever talk about are giant listed corporations so you get the impression that everybody works for BP or Walmart, when in fact most people in our countries work for very small private firms.”
“It’s the same in China. Another thing people tend not to understand is that the structure of the Chinese economy has changed a lot – we tend to view China as a giant manufacturing and construction site and this is almost certainly going to be the fifth consecutive year in which the services and consumption part of the economy is bigger than the manufacturing and construction part.”
Rothman says that many of the people he speaks to are concerned that China is too focused on investment, but argues that in the first quarter of this year, 85 per cent of China’s growth came from consumption.
Another headwind that many investors misunderstand, according to the investment strategist, is the country’s debt and how this impacts markets.
He argues that China’s debt issue is very different from many developed regions in that, while private enterprises play a big role in market behaviour, the state is still very much in control of the financial system.
“When we think about debt, we need to recognise that this debt problem is not like debt problems in countries with real market-driven financial systems, so everybody is all excited about the high level of debt to GDP in China,” Rothman continued.
“The real problem in China is corporate debt, which is about 150 per cent of GDP and that’s very high, but we have to recognise that a majority of this debt and most of the problem debt in China is the result of the state instructing a state-controlled bank to lend money to a state-controlled company.”
“This is not like debt problems in market-driven economies that have a market-driven financial system, it’s not like Lehman Brothers. Because this is all debt owed from one state entity to another, the state actually has a lot of ability to control how quickly and when they deal with it. They’re starting to do that now and that’s why I think the risks of a crisis are quite low.”
He says that he is more positive on China than he has been in previous years because the Matthews Asia team is seeing progress in the government’s reforms and its willingness to tackle economic issues.
One of these issues that is on the path to being resolved, according to the investment strategist, is the debt issue surrounding state-owned companies. Another example he gives is that 400,000 jobs were cut from state-owned enterprises to tackle overcapacity issues.
“I have a really long list of thing I’m cautious about: debt, high levels of inventory of housing in smaller cities, I’m worried about how the exchange rate gets challenged by whatever the Fed does, I’m concerned about pollution levels. There’s a long list of things,” Rothman said.
“But the key distinction I’m making is that all of these problems are significant, I think they’re all challenges which means growth each year is going to be a little bit slower, but none of them I think represent a high risk of a hard landing or a crisis.”
“I think a hard landing or a crisis are what most people are expecting and what is priced into the market. If you can understand those risks are not that big, there’s a great opportunity there.”
