Fund managers give mixed reviews on China's short-term prospects but say problems are surmountable.
It's amazing how much things have changed. To be sure, the days of believing that China's robust economic growth and rock-solid fiscal position could bail out the economies in the West are clearly over. Morningstar equity analyst Daniel Rohr tackled the big picture of the problems associated with China's economic imbalances. Runaway inflation, a looming real estate and credit bubble, the shadow banking system, and rapidly declining exports are just some of the problems we think might plague the Chinese economy.
Scarier terms have rarely been associated with a single country:
Inflation for August remained stubbornly higher than the targeted 4% for the year, coming in at 6.1%. The inflation rate has been on an upward trajectory since 2010. In particular, there is a fear that a vicious cycle of wages chasing prices and prices chasing wages will push prices ever higher.
Driven by the rapidly growing middle class and population urbanization, Chinese property prices have risen by more than 140% since 2007 and as much as 800% in some major cities. Affordability, as measured by price to income, is five times the international average.
Shadow Banking System
In an effort to curb inflation and rein in credit, the People's Bank of China has raised reserve requirements seven times since January 2010 and imposed a quota on new lending by the banks (CNY 7.5 trillion; $1.18 trillion). These policies have limited regulated lending to all but the largest and most creditworthy companies. They've also created a host of unregulated lenders reportedly charging exorbitant rates up to 5% per month to smaller companies looking for credit. Some estimate the size of the shadow banking industry to be CNY 15 trillion ($2.4 trillion).
The most obvious threat to the Chinese economy are declining exports fueled by the poor economic climate in Europe and the United States, wage inflation in China, and the upward pressure on the yuan (albeit only slightly because of strict government currency and capital controls).
What Fund Managers Are Saying
On the other hand, if you talk to business owners, residents and even the majority of investors in the region, you will find that for the most part optimism still prevails. Are we missing something or is this wishful thinking on their parts?
As a global organization, Morningstar has more than 100 fund analysts on the ground in North America, Europe, Australia, and Asia. They speak to thousands of investment managers about their strategies and views on the global economy. In many cases, the conversations turn to China. Although there is little consensus on China's prospects in the short term, on the whole, managers are still relatively bullish about China's long-term prospects. Here is a sampling of what the world's fund managers are saying about China.
Philip Ehrmann, manager of Jupiter China and
Jupiter China Sustainable Growth
Ehrmann says that many of these threats are exaggerated and that markets have priced in "the bleakest economic conditions." He says that current inflation is high but that China will likely see the rate fall back toward the 3% to 4% range over the balance of the year. Food prices will fall in response to good harvests, while industrial inputs and energy prices will also trail off as overall global demand drops. As for the shadow banking system, Ehrmann admits that its size is unknown, but he says that the situation is starkly different than the credit bubble in the United States and Europe.
"What is not understood is there is not the same systemic risk involved, as the funds being lent out are not on geared banking balance sheets. If a group of individuals or an SOE (state-owned enterprise) wish to lend their cash balances there are no new funds being created. If the money is lost, it will, of course, affect the 'lender' and impact their own liquidity, but wee will not see soaring nonperforming loans and the need for capital infusions to protect solvency ratios."
Raymond Ma, manager of Fidelity Funds
Although Ma's outlook for the next 12 months is slightly bearish, he says that China is in a good position to be able to withstand a global economic downturn. He says that China is now less dependent on exports because of a shift toward domestic demand and the fact that half of the country's exports go to the Asian region or other emerging markets. Second, he says that despite aggressive monetary tightening over the past year, data through July showed that China's economic growth momentum remained healthy. "Even with the current sequential slowness in manufacturing, China's output is 50% above the pre-2008 crisis level, and industrial production has remained at healthy midteen levels. Retail sales growth and wage growth have remained resilient as well."
Chris Davis, manager of Davis NY Venture NYVTX
Although he is uncertain about the prospects of the Chinese economy in the short term, Davis says that he is fairly confident that over the long term it will have a larger share of global GDP and continue to gain on the United States and Europe. He cautions, however, that "anybody would be crazy to think that there would not be wicked corrections from time to time."
His focus is to take advantage of the inevitable chaos to pick up high-quality Chinese franchises that could one day emerge to be global leaders, if they aren't well on their way already. Most of his current Chinese holdings are in Hong Kong-listed firms with long operating histories and owner/managers. He thinks that these companies are more in his analytical wheelhouse.
Christina Chung, manager of Allianz RCM
China and Hong Kong
The risk of a hard landing is not high in China, Chung says, because China is not burdened with external debt and has large foreign exchange reserves, a high domestic savings rate, a controlled currency, and a largely closed capital account. All of these attributes indicate to her that there will be no forced currency devaluation by hedge funds or capital flight by domestic citizens, which typically drives a downward spiral during times of crisis.
Chung says that the media has exaggerated the the shadow banking system problem. She points out that it has always existed, and, given that there are no reliable statistics on this market, it is difficult to conclude that it is a problem that the central government cannot handle given the country's current financial strength.
About valuations and slowing global growth, she says that "for corporate earnings, we expect there will be some deterioration given the slowdown in China's economy and, more importantly, a sharp decline in the global economy. However, the market has discounted ahead of this earnings uncertainty. In terms of P/B, the Morgan Stanley Capital International China Index and H-shares are already well below the 2008–09 crisis level."
Vincent Strauss, manager of Comgest
Strauss maintains his long-term view on China: It's a market where it is difficult to make money. He says that the region favors workers over shareholders, and although manufacturing volumes are definitely much higher, prices are more controlled, which puts pressure on margins. But Strauss says that everything has a price and that some valuations have gone too low; he is adding to some of his long-term consumer plays. One area in which he remains negative is the banking sector, where he says that there is excessive debt.
Agnes Deng, manager of the Baring Hong
Kong China Fund
Deng continues to see China as a country with great growth prospects given its strong balance sheet and rising domestic demand. While she acknowledges there are some short-term issues, she says that "the Chinese authorities have sufficient monetary and fiscal tools at their disposal to encourage growth and prevent a so-called 'hard landing.' She is confident that inflation will tail off given that much of it has been driven by a sharp rise in food prices because of a poor summer harvest. In her view, the recent weakness in Chinese equities represents a compelling opportunity for investors to participate in the secular growth of the region at a low-price entry point.
Martin Lau, director of Greater China Equities
at First State Investments
Lau says that in the near term, problems such as a possible rise in nonperforming loans to local governments and continued price pressures mean that caution is warranted. Nonetheless, he remains "optimistic about the longer-term domestic-demand story in China, thanks to structural drivers such as the growing middle class and continued urbanization." In terms of companies, he says that "while the risk/reward of some cyclical stocks is looking more attractive, our preference remains for companies with more defensive characteristics such as strong cash flows and growing dividend yields."
Desmond Tjiang, managing director and
portfolio manager for Great China and Hong
Kong Equity at Pine Bridge Investments
Tjiang is "cautiously optimistic" for 2012. Although he sees many risks and uncertainties ahead, he says that many of the concerns have already been discounted by the market.
"Current market valuation at 8 times forward earnings and 1.3 times forward book value certainly looks appealing on the longer-term investment horizon. Going forward, easing inflationary pressure as well as softening economic activities would prompt the central government in fine-tuning its policies and make necessary adjustments by various degree to maintain reasonable growth for China."
Grant Yun Cheng, head of emerging markets,
Union Investment Privatfonds GmbH
Cheng believes that although the recent economic data in China indicates that the economy is cooling off, he does not foresee a "hard landing." He notes that both domestic consumption and industrial production is proving to be very resilient. On the issue of inflation, he does not believe that the policymakers will relax their tightening stance so quickly, even though headline inflation has likely peaked because of base effect. As for the property market, he does not see the bubble to bursting in China.
"The underlying demand in China is still very strong for the secular urbanization trend. Overall, we believe that the Chinese economy is still on a good growth path with this year's expected GDP at 9% and next year at 8.5%. The transition to a more consumption driven economy is underway. However, this will take time."
Jan Ehrhardt, managing director, DJE Kapital
AG, Pullach/Munich, and fund manager, DJE
Asian High Dividend
Ehrhardt thinks that although restrictive monetary policy is hindering the economic development of China, he is optimistic about the country's growth prospects. He worries that many small property developers are taking very high interest loans from the shadow banking system, and they could be forced to liquidate their properties at lower prices if the property market slows down--although he admits that the situation is not the same as in the United States, because of the much lower mortgage loan/value ratios.
"In general, China's growth in the last few years stemmed from financial investments. This will shift towards more domestic consumption in the future. This already is evidenced by the growth in the retail sector in China of 17.7% in September. All in all, I do not see any signs of stagflation down the road. Chinese stocks and shares from Hong Kong, in my opinion, offer medium and long term the greatest opportunities in Asia."
He further postulates that if the inflation rate falls below 5% in 2012, monetary policy should become expansionary again.