“The Year of the Dog is likely to usher in a period of major change in China: policymakers are seeking to strike a balance between the need for major economic reforms and the need to sustain growth,” says Charles Sunnucks, Assistant Fund Manager, Emerging Markets at Jupiter AM. “With change comes volatility, and it will be more important than ever to distinguish between companies that are benefiting from a positive change in fundamentals and those that are simply riding a favourable trend that may then run out of steam.”
Since 2006, the last Year of the Dog, it would be easy to think that the economic and political change we have seen in China has been small beside the epoch-making changes experienced in Europe after the 2007-08 financial crisis, after Brexit and following the election of Donald Trump in the US, to name just a few examples. Digging deeper, however, it is clear that the Chinese economy has undergone a profound restructuring, achieving one of the most radical transformations of any global market. And there is still a great deal more to do.
Supply-side reform: eliminating excess production capacity
Let us begin with the thorny issue of excess production capacity. For many years some Chinese manufacturing sectors have suffered from production far in excess of demand, undermining domestic efficiency but also causing friction internationally, as Chinese producers have dumped their surplus output on global markets, depressing prices across the board. Domestic reforms have not brought about major changes because local leaders have been reluctant to give up growth or to be held responsible for rising unemployment. Yet we have begun to see transformations, as some provinces have taken advantage of a favourable macroeconomic environment to accelerate the process of capacity reduction or to encourage M&A transactions.
Taking the steel sector, China has set a target of cutting production capacity by 150 million tonnes by 2020[1]. The initiative has been a success and the target should be reached by the end of the year. Ultimately, the objective is to consolidate the sector and make it more efficient by reducing the number of smaller operators and moving from 40% to 60% of market share concentrated in the top ten producers: a significant change for the sector[2]. For Chinese companies deemed inefficient, there is clearly a substantial risk, but at the same time for those that survive there is an improved outlook.
Financial reform: a lot of work has been done, but there is still more to do
Chinese banks, too, have in the past built a reputation for inefficiency and slowness to adapt. Many of them have nevertheless proved highly innovative. Innovation, however, has its risks. A high level of state control over Chinese financial markets has given the most experienced bankers in China an incentive to circumvent credit regulation, moving traditional lending towards the perimeter of “investment products”, an area with more limited supervision that requires no capital adjustments.
As a result, many banks have a greater exposure to “investments” than to their loan portfolio, an effect that has supported asset growth but has created a considerable systemic risk not fully reflected in the official data. Last year we saw the Chinese financial regulator begin to propose more incisive measures to limit the growth of so-called “shadow banking”, and this has already had a positive impact on financing practices. However, although recent growth in bank assets has slowed, the system’s debt levels are still high and this will require continued reforms over the medium term.
Changes at company level: a rapidly evolving landscape
In China, the pace of change has always been faster in the retail sector. The rise of online transactions has hit businesses globally, but few countries have been affected by this revolution as much as China. With around 15% of all retail sales taking place online[3], the share of e-commerce in China is almost double that of the United States, and market leader Alibaba is already aiming to “redefine the experience” of the remaining 85% of sales made offline through a “new retail model”. In addition, Chinese Internet companies have expanded their services in the financial field well beyond their Western equivalents.
This has made China the world’s largest eFinance market, with around 500 million ePayment users, 400 million investors buying financial products online and around 160 million online loan subscribers[4]. As economic activity has moved online, a long list of casualties has been produced among those businesses that were slow or unable to adapt. At the same time, we are concerned that the share prices of some Chinese Internet companies may be distorted by excessive optimism about their prospects. Going forward, the revolution brought about by online innovation will continue to be profound, with consequences that will go well beyond the Internet sector. For us it is essential to look at past short-term profit projections and to monitor our holdings in Internet companies for any signs of risk that they may go from predator to prey as the sector evolves.
Divergent returns
Given that both Mother Teresa and Donald Trump were born in the Year of the Dog, it is perhaps unsurprising that the performance of Chinese companies is likely to be highly varied. Radical changes have created great opportunities, but also considerable risks. So far, the positive macroeconomic backdrop has supported Chinese businesses that would otherwise have been struggling. In 2018, a change in this environment could see that support withdrawn, a situation that could be a heavy blow for those investors who are careless about the challenges awaiting the country from here on. In 2018, being “beware of the Dog” will mean a much more selective approach since, despite the challenges, China retains some of the most interesting bottom-up opportunities of any global equity market.
http://www.wallstreetitalia.com/opinioni/mercati-attenti-allanno-del-cane-2018/
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