China: consumption is the way forward

Volatility in 2017 could cause short-term pain but long-term gain if it forces Beijing to accelerate economic transition away from exports in the face of anti-globalization.

Internal and external factors look set to drive volatility in Chinese stocks this year. This can create market distortions and mispriced companies. At some point, the government may renew fiscal stimulus to prop up gross domestic product (GDP) growth.

Such boom-bust cycles have become common as policymakers transition the economy away from exports to domestic consumption.

We expect the yuan to weaken further despite dilution of the U.S. dollar’s weighting in the basket of currencies used to determine its value. Beijing is already tightening capital controls as pressure on renminbi (RMB) outflows increases. Companies that have borrowed overseas may be hit hardest.

Moreover, China’s economy has yet to feel the effects of curbs to cool the property market. These measures will catch up with developers and the chain of businesses behind them. Banks could then feel the strain amid a tightening of financial conditions, raising the risk of blow-ups in wealth management products (WMPs) with developers as underlying investments.

As to external shocks, these are most likely to come in the form of trade barriers imposed on Chinese goods by U.S. President Donald Trump. Faced with that, we can expect Beijing to stimulate its economy. Infrastructure spending is an option, with underground rail systems being approved in various cities.

Trying to maintain current growth levels without over-stimulating on the one hand or causing a hard landing on the one other is the balancing act that policymakers are trying to perform. Still, we believe they have the resources and policy tools at their disposal to keep GDP growth within their mid 6% target range.

Stability will be the priority in the run-up to the Communist Party’s 19th National Congress this November. There we can anticipate a leadership transition, with five of the seven members of the Politburo Standing Committee* having reached customary retirement age.

We suspect Beijing’s hand will remain visible in the economy to ward off systemic risks in areas such as shadow banking** and wealth management products (WMPs). Determination to keep GDP growth on track will likely see structural reforms and financial liberalization slip down the agenda.

But instead of responding to each twist and turn, we take a long-term view. Policymakers are committed to transition the economy away from the old engine of growth – heavy industry. Consumption accounted for 64.6% of China’s GDP in 2016, according to its statistics bureau’s January 2017 data. Regardless of what Trump does, we believe  China’s consumption story will likely remain intact.

Although protectionist trade policies may hurt companies’ performance in the short term, at least they might encourage Beijing to refocus on the structural reforms necessary to effect this transition: revamping inefficient state-owned sectors. If its worst anti-globalization fears are realized, Beijing may need to accelerate its reform efforts.

We expect this long-term policy direction, in combination with China’s growing middle-income population, to drive demand for consumer goods. That is where we have concentrated our search for companies. Consumer areas, be these discretionary or durables, are among the least controlled. Hence that is where pricing signals will likely work well.

Recently, we have seen a pick-up in the purchase of luxury goods, which had earlier been hit by the anti-corruption clampdown. As people’s incomes rise, their aspirations to consume premium products should also grow accordingly.

 

*Politburo Standing Committee consists of the top leadership of the Communist Party of China.

**Shadow banking system refers to the financial intermediaries involved in facilitating the creation of credit across the global financial system but whose members are not subject to regulatory oversight.

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