As China returns to a policy of monetary and fiscal stimulus, growth should pick up in the second half of the year.
One of the reasons 2018 turned out to be such a disappointment for equity investors was the underwhelming performance of the Chinese economy, the ramifications of which were felt as far afield as Germany.
While most equity markets had a rough year, the performance of emerging markets and eurozone stocks were among the worst. So for 2019, some of the most important questions facing investors are what caused the slowdown in China last year and when the economy is likely to bounce back.
At face value, one might blame Washington and its hostile approach to trade for Chinese woes. But this was not the primary reason why the Chinese economy stumbled in 2018. Chinese activity started to slow long before concerns about respective tariffs were raised. In fact, the slowdown in China was largely self-induced. Worried about rising leverage, Chinese policymakers moved to a much tighter policy stance through the course of 2017. This was a strategic shift, described as a focus on ‘quality of growth over quantity’.
China’s overdone tightening
With the benefit of hindsight the tightening turned out to be too effective. As in the West, it is extremely hard for central banks to merely moderate growth, since commercial banks have a tendency to swing from exuberant to overly tight lending standards. As a result, through the course of last year China underwent a fairly significant credit crunch, the effects of which were felt long before US trade concerns surfaced.
The downturn in Chinese business sentiment was compounded as the trade skirmish escalated through the summer months. Chinese export orders were falling rapidly into year-end, according to the business surveys. Industrial production in November grew at its slowest pace since 2016.
The roots of the trade war run deep and lie well beyond the matter of whether relative tariffs are fair. The US Administration also wants to see a change in China’s approach to intellectual property (specifically so that a US business no longer has to partner with a Chinese entity and in turn transfer intellectual capital in order to establish a footprint in China). In addition, the US believes that the state-level subsidies China provides to its fast-growing tech industry give them an unfair advantage over US tech companies.
Chinese policymakers are making considerable efforts to placate the US administration on the issue of tariffs and intellectual property, and with some success. So far, the US Administration has postponed raising tariffs from 10% to 25% on $200 billion of goods while negotiations continue. The trade tensions are not boiling over but they remain on simmer.
Meanwhile Beijing’s authorities are once again focused on stimulating the economy. The ‘quality over quantity’ agenda has been put on the backburner. The central bank controls lending in the economy by changing the reserve ratio requirement which increases the banks’ capacity to lend. This rate has been reduced by 3.5 percentage points in the last year. Beijing is also issuing local government bonds to fund a multitude of infrastructure projects. VAT is being cut in a bid to support consumer spending.
The market has reacted to this new stimulus with nervous optimism. The trepidation comes from the fact that with each effort to increase lending and sustain rapid growth, debt levels in China climb. Aggregate debt in China has increased notably in the past decade. Total debt outside of the banking sector – that of households, corporates and the government – has increased to 250% of GDP from 140% in 2007.
This rise in debt provides ample fuel for Chinese doomsayers. Indeed, it is often argued that China is merely the latest Asian tiger capturing market attention. And like Japan in the 1980s and Korea in the 1990s, it is only a matter of time before the Chinese debt bubble bursts.
However, there are three differences between the situation in China and the experiences of the Asian tigers.
First, Chinese investment has been funded by Chinese savings, and the Chinese financial system is still to a large degree closed from global markets. With the debt held domestically, Chinese borrowers are not vulnerable to the whim of international capital flows that proved so disruptive in the Asian crisis. Back then, concerns about the ability of the Thai authorities to repay its debt spread rapidly to neighbouring countries whether they deserved it or not.
Second, China remains at a relatively early stage of development despite 20 years of rapid expansion. In the 1970s and 1980s Korea and Japan experienced high levels of growth as they adapted to the new technologies widely available in the West. The structure of their economies moved from being primarily agricultural to manufacturing and then to services. This process involved considerable urbanisation. And as the economies became more sophisticated average per capita incomes rose. By the mid-1990s both economies had essentially caught up with the level of income per capita in the US. With the process of catch-up complete, growth slowed.
No Asian tiger-style bust for China
In China, the process of catch-up with the West is far from complete. Around 16% of the population still work in agriculture, compared to 2% in the US, while 60% of the population lives in urban areas compared to 80% in the US. The average income per capita at just 15% of the average of a US citizen is another demonstration that the catch-up process is ongoing. China’s middle class is expanding rapidly but has a long way to go.
Finally, stock prices do not suggest that equity investors are overly optimistic about the future of the Chinese economy in the way we saw with the early Asian tigers. In 1989 the Japanese stockmarket reached a price-to-book ratio of 4.3 times. By contrast the Shanghai stock index currently has a price-to-book ratio of 1.5 times.
That is not to say everything is rosy in the Chinese economy. The large state-owned enterprises are often unproductive and need winding down to deploy resources better elsewhere. But overall I think the long-term prognosis for the Chinese economy is good. Now that Beijing has taken its foot off the policy brake, an improvement in growth momentum seems likely in the second half of the year.
This could set the stage for a strong year for emerging market equities, particularly if the rebound in China occurs alongside a modest slowdown in US growth. Slowing US growth would suggest the Federal Reserve would be under less pressure to raise interest rates this year. This could put downward pressure on the dollar, which would help the emerging markets who remain dependent on dollar funding.
Nonetheless, while the backdrop for emerging market stocks looks more favourable, taking a position on a purely tactical basis is unlikely to be well-advised. This asset class is volatile – the MSCI emerging market index rose more than 25% in 2017 but gave back almost 10% last year.
Emerging market stocks are perhaps not for the faint-hearted. Those who have a strong preference for assets whose prices slowly and steadily grind higher may not appreciate the additional volatility that emerging markets bring to a portfolio. If, however, investors have a long time horizon and can stomach the volatility, then emerging markets should pay returns well in excess of developed market equities in the coming decades.
As poor demographics and weak productivity growth hinder Western economies, the emerging markets will account for a larger share of global growth and increasing investment opportunities. Total annual returns in emerging market equities are expected to be close to 8% on average in the coming decade, according to our Long Term Capital Market assumptions. This compares to 5% in developed market equities.
Emerging market stocks are the type of asset to hold for the long term. For those able to lock up funds and stomach volatility, emerging market stocks – and Asia in particular – may well be a strong addition to a portfolio at this point, before the Chinese stimulus really kicks in.
Karen Ward is chief market strategist for EMEA, JPMorgan Asset Management.