We recently took the recommendation of our favorite China analyst, Jonathan Anderson of Emerging Market Advisors, and devoted an afternoon to reading The 1 Hour China Book by Jonathan Woetzel and Jeffrey Towson. It was a worthwhile read -- not breaking new ground, but bringing some large, essential themes into clear focus.
As we noted in this letter a few weeks ago, for two decades, China has been a deep frustration for western investors. The complaint is the same as that heard for emerging markets in general -- “stock market returns bear no relation to economic growth.” In short, secular growth outstripping developed markets characterizes EM as a whole, but that growth doesn’t translate into profitable investing.
Emerging markets as a whole become more comprehensible when investors realize that what really matters is not GDP growth in local currency, but GDP growth in U.S. Dollar terms. And further, the best indicator for GDP growth in U.S. Dollar terms is simply the rate of export growth. So EM is not as impenetrable as many investors think -- it is still largely a boring story of export growth. The time to buy EM is when export growth is low but accelerating.
China, though, is different. Since 2000, even when we take this kind of analysis into account, the behavior of the index has not been correlated with growth trends. With brief exceptions, and looking at a six-month moving average, GDP growth accelerated steadily from 2000 to 2014. Earnings, while not having quite the same steady upward trajectory throughout the period, also accelerated. And yet the indices showed no correlation -- neither the MSCI China that tracks large Hong-Kong listed companies, nor the Shanghai Composite that tracks mainland A-shares.
|As you can see in the chart below, before the recent rally in Chinese stocks…..the disconnect between strong economic growth and earnings fundamentals vis a vis stock values… had gotten very wide.|
|Source: Emerging Advisors Group|
In short, during the past years of epochal growth, investors haven’t been rewarded for that growth. The Chinese market has traded almost entirely on psychology and momentum, even though that psychology has been at least partially shaped by government policy. To a large extent this remains the case today.
However, even though the current rally is being fuelled primarily by the public’s perception of government policy, that policy has a visible goal which will eventually begin to make things different. One primary reason that mainland Chinese stock markets in particular have been so volatile and so psychologically driven is that they have been relatively small and insulated from the rest of the global financial markets. That’s changing as a result of policy shifts.
China’s determination to see the Yuan as a part of the SDR basket of the International Monetary Fund, as well as its multilateral efforts to build global financial institutions outside the control of the United States and its allies, show that the government sees that its longer-term geopolitical ambitions will now be served better by financial integration than by isolation. Our perspective is that by encouraging stock ownership among Chinese, opening markets more deeply to global investors, encouraging the use of the Yuan in global trade settlement, cracking down on corruption, and rationalizing the big state companies, China is laying the groundwork for a stock market that functions much more like stock markets elsewhere in the world -- that is, a stock market that will trade more on fundamentals going forward, and where stock market returns will more closely track GDP growth. The day will come when investors in Chinese equities will be able to reap rewards not simply by following momentum and the psychological exuberance of the market, and not simply by close monitoring of government policy, but by fundamental analysis similar to the fundamental analysis they deploy in other markets.
We are excited at this prospect, because we believe that the growth story of the middle class Chinese consumer is probably the best global growth story of the next generation, and the likelihood is becoming greater that global equity investors will be able to take advantage of it. We are bullish on China.
The case for this bullish view of China’s current transformation is laid out in The 1 Hour China Book in six themes. With each theme, the authors emphasize how the huge scale of the process dwarfs what we can observe elsewhere, even in a high-growth economy like India. And further, the epochal transformation of China depicted by these themes is far from complete -- they have a lot of room to run.
Urbanization. In the past generation, 300 million Chinese have moved to urban areas -- and there are 350 million left to go before China begins to approach the urbanization rate of the developed world. There are now 160 Chinese cities over a million people. Unlike 19th century European urbanization, which in the short term often resulted in impoverishment for rural migrants, urbanization in China has resulted in wealth, with both GDP per capita and disposable income per capita tripling in the past generation. This trend will continue. Water and pollution are huge problems as urbanization continues, and the commercial, residential, and infrastructure construction involved will keep being bigger than anything ever seen before in human history. As far as Chinese urbanization goes, this time really is different.
Manufacturing. Urbanization has fueled manufacturing scale in China that’s also unlike anything ever seen, and in the past 30 years the advantages of that scale -- and of China’s low labor costs -- have transformed global trade. China’s labor costs have grown, but China will continue to challenge other global manufacturers -- with the baton now passing from low-value-added to higher-value-added industries. Chinese companies making higher-value-added products will start moving more strongly into the global marketplace to challenge developed-market incumbents. This is the same process that happened in post-war Japan, but on a much bigger scale.
|Shanghai -- Bigger Than You Can Really Imagine|
Consumers. Chinese middle-class consumers are the future for global markets -- this is the simple truth. The growth of this cohort in income and influence will dwarf the growth of every other cohort on the planet. Until now, Chinese consumers have been very value-focused, but they are beginning to become more like consumers in developed markets, where consumption has become a form of personal expression and fulfillment. As they become more affluent, this trend will accelerate.
Money. The vast expansion in urbanization, manufacturing power, and consumption have been facilitated by a vast expansion in the scale and complexity of Chinese finance -- driven largely by state-owned banks, but by necessity including the spectacular flourishing of an undergrowth of unofficial, shadow-sector finance. Although the power of China’s growth story will shape global markets for decades, the financial system is showing distortions and excesses that will almost certainly result in mid-term crises, and investors must be alert for signs that such a crisis is getting closer.
- Brainpower. The usual trope is that the Chinese aren’t creative -- “designed in California, made in China,” as Apple (AAPL) says. This is a false generalization, and one that westerners make at their peril. As China moves into its next growth phase, it will also become a source of creativity and innovation; research and development expenditures are rising and now outpace much of the developed world. Coupled with the power of its manufacturing scale and its deep culture of education, we believe this trend will bring Chinese companies into the forefront of creative innovation in global markets.
|The Biggest Global Consumer Cohort|
The internet. The rise of China’s consumer has happened at the same time as the arrival of the internet -- they’re growing up together. Chinese are intensely active online, and view the peer-to-peer exchange of information as critical for their consumption decisions. We all know it, but we’ll say it again: if the Chinese consumer is the dominant story in global growth for the next generation, Chinese e-commerce is the air the Chinese consumer will be breathing.
Investment implications: The growth and wealth of the population of middle-class Chinese consumers will be the top global growth story for decades. Just as this story is moving into high gear, the Chinese government is seeing that its geopolitical ascendency will require greater transparency and a deeper integration into global financial markets. Foreign investors will gradually be able to apply fundamental analysis to Chinese markets -- and Chinese markets will begin to reward that analysis with returns commensurate to economic growth. There will be opponents and naysayers to this story. Some vested interests within China will work to undermine the success of the story, but we doubt that they will be successful.