China is a market many commentators love to hate – its rapid transition from a heavy industry export machine to the world’s innovation hub has gone unnoticed in parts of the market. 
However, despite widespread concern in 2016 about its rate of indebtedness and the burdensome state-owned enterprises, it was anything but a dog last year.
Many global and emerging markets investors were caught off guard by the renminbi’s strength against the dollar last year, not to mention much stronger than expected earnings growth, resulting in a market gain of 51 per cent, outpacing the vast majority of global markets.
Drilling down, industrial margin growth was stronger than expected. A strong recovery in profit margins in China’s materials sector as a consequence of the 2016 recovery in commodity prices resulted in a 58 per cent recovery in profits in this group, which in turn had the beneficent effect of bringing zombie manufacturers back to life. According to a recent industrial survey, the proportion of loss-making firms in this sector fell from a high of 23 per cent in 2015 to 15 per cent in 2017. Add this to the established Chinese recipe of growing GDP strongly to dilute the effect of bad loans and one can see why non-performing loans have peaked. Thus, in addition to a healthy e-commerce sector, the financial sector is also looking strong.
This year the fundamentals still look pretty good, despite the market trading at a modest premium to its long-term price-to-earnings prior to the turbulence seen earlier this month. Thus, the market valuation is still sensible and the 2 per cent yield provides solid support.
New China
Right now, China represents a tremendous opportunity, both in terms of its ongoing GDP growth rate, but also in terms of its growing claims to developing its own intellectual property. The direction of policy and industry in China suggests that it is likely to settle into a more sustainable and modest growth rate over the next few years.
Several indicators reflect a fundamental shift in the Chinese approach to economic policy, including realistic near-term growth projections from companies, calm pride in the surge of Chinese patents, a dramatic outpacing of the US in educational terms and the recognition of technological innovation, by both the private and the public sector, as the best way to move the economy forward. Coupled with supportive external factors, this attitudinal shift is paying dividends in the Chinese economy and creating a deep, rich market that is a great place to look for stocks.
Learning new tricks
Longer term, China’s prospects are defined by the digital. According to CB Insights, in 2017, 22 Chinese technology businesses achieved unicorn status – valued at $1bn or more - meaning that almost 10 per cent of the world’s unicorns were created in China last year alone.
The surge of innovation cannot be overstated, and it is these companies that will benefit the most from China’s ongoing economic strength. In a country where cashless culture is several steps ahead of the West, technology can directly tap into the increasing influence (and dollars) of the Chinese consumer, benefitting in turn from urbanisation and improving education.
Meanwhile, the Chinese government has made technology an explicit policy focus - in July 2017, the government published an ambitious roadmap for the use and development of AI in China, with clear targets up to 2030. This kind of endorsement is encouraging Chinese technology businesses to challenge their western rivals. For example, ride-sharing start-up Didi effectively drove Uber out of the Chinese market. Similarly, western technology firms are sourcing ideas from their Chinese peers, such as California start-up Limebike, which has adapted the dockless bike models of Chinese firms like Ofo for the US market.
Cat among the pigeons
The big concern among investors, prompting many to keep China at arm’s length, is its high level of indebtedness. Investment-led growth in China has been fuelled by debt; further rises in debt will exacerbate the misallocations of capital already made and could precipitate an eventual crash. While authorities appear to be managing a gradual slowdown in the growth rate, this debt level remains a key risk for the Chinese economy.
Meanwhile, the US-China economic rivalry is about to heat up. President Trump is changing his tone, denouncing China as a rival in his state of the union address on January 30th and he is likely to place tariffs and other sanctions on Chinese products.
In addition, he is likely to curb investments in the US by Chinese companies – he has already blocked some deals - impose limits on student work visas for Chinese citizens in tech and place tighter restrictions on US technology exports and the ability of US citizens to work for Chinese companies. US officials mistakenly believe that China depends so much on foreign trade and investment, and has such a fragile financial system that unilateral pressure from America will cause it to collapse; however, the US no longer has the ability to single-handedly compel other countries to do its bidding.
Staying loyal to China
Dogs may have their day, but China has had several good decades. While both emerging markets and global investors remain substantially underweight, the market and short sellers decry the fragility of China’s model, 2018 should be yet another year when the dog of financial collapse doesn’t bark and the market makes further progress.
Gary Greenberg is head of emerging markets at Hermes Investment Management. The views expressed above are his own and should not be taken as investment advice.