China, once touted as the next frontier for investors, now stands at a crossroads.
From geopolitical tensions to deflationary pressures, the world's second-largest economy is navigating turbulent waters. Yet, amid these headwinds, there are glimpses of potential that warrant investor attention. In this article, we delve into the Chinese investment conundrum.
The cons: Headwinds and hurdles
Rising political tensions loom large on the investment horizon. Fears of a potential Chinese invasion of Taiwan triggering an exclusion from the global financial system, akin to Russia's experience, have deterred many potential investors.
China has also reportedly banned government workers from using iPhones, escalating trade tensions with the US. Apple has long relied on China for its manufacturing needs, with about 90% of its products being made in the country. Foxconn, a Taiwanese-founded supplier for Apple, operates significant factories in China, employing over 1.2 million people.
However, several factors, including political instability and pandemic disruptions, have led Apple to expedite plans to diversify its manufacturing operations. Vietnam and India have emerged as alternate manufacturing hubs, with the production of the iPhone 14 having already moved to India.
In July, China grabbed headlines as it entered deflation for the first time since 2021, with consumer prices falling by 0.3% year-on-year. However, August’s data showed a marginal uptick in the Consumer Price Index - a rise of 0.1% - bringing China barely out of deflation territory. Core inflation, which excludes volatile food and energy costs, only inched up by 0.8%. While some might interpret this as the worst deflationary pressures being over for the country, others may argue that August’s numbers were far from convincing signals of a healthy economy.
Despite the lifting of COVID-19 restrictions, pent-up consumer demand has not materialised as expected. Consumers remain cautious, postponing significant expenditures like homes, automobiles, and travel. Housing activity has fallen due to Chinese homebuyers losing confidence in the ability of builders to complete their homes on time, while consumer confidence has fallen more broadly as the economy absorbs the effects of borderline deflation.
Property market woes
China's property market has hit turbulence, with the sector's issues epitomised by the turmoil surrounding Evergrande, one of China's prominent property developers. The company’s shares plummeted dramatically after the stock began trading again for the first time in almost a year and a half. This comes amid concerns over a wider property slowdown which has hung over China for almost two years, as a growing number of Evergrande’s peers have also defaulted on their debts. The company's financial troubles have raised concerns about a potential spillover effect on the broader financial system.
China's demographic challenge was placed in stark relief earlier this year when India took up the mantle as the world's most populous nation. China's population is now in a state of decline, and this downward trend is expected to accelerate in the coming decades. Chinese citizens are already opting to have significantly fewer children than initially projected when the one-child policy was gradually eased and eventually abolished over the past couple of decades.
To worsen matters, China has a youth employment issue, highlighted by the government's decision in July to halt the publication of youth unemployment data, after it reached a record high of 21%.
US interest rates
The Federal Reserve's decision to raise interest rates in the United States has implications beyond American borders. For China, it limits the ability to use easy monetary policy to stabilise its property market without risking capital flight and currency devaluation.
Estimates from JP Morgan reveal the effect of these combined factors on capital flows for the country. Around half of the approximately $250bn to $300bn that flowed into Chinese bonds (due to their inclusion in various indices since 2019) has flowed out. Foreign ownership of Chinese equities has suffered a similar fate, declining by over $100bn.
But it may not be all doom and gloom for investors.
While the challenges are undeniably great, rays of optimism do shine through.
The pros: China's bright spots
Global tech leadership
China's focus on technological advancement remains a key driver of its long-term growth potential. Chinese customs data shows the country’s semiconductor equipment imports in June and July totalled nearly $5bn, up 70% from the same period last year. The surge in imports underscores China's commitment to the tech sector.
According to a study by the Australian Strategic Policy Institute earlier this year, despite Beijing’s crackdown on big tech firms, China still has a lead over the US in 37 of 44 tech fields, from Artificial Intelligence to robotics. Given the surge in AI advances this year, this puts China in a leading position to benefit from further technological innovation.
This year China surpassed Japan as the world’s leading exporter of electric vehicles. In August, China saw a year-on-year increase in passenger vehicle sales, thanks to enhanced consumer sentiment driven by more substantial discounts and tax incentives for eco-friendly and electric vehicles. The ascent provides a beacon of hope in the Chinese stock markets, amidst what has been a challenging second quarter.
Central bank measures
The People's Bank of China, the nation's central bank, has taken proactive measures to shore up growth. An unexpected cut in key policy rates for the second time in three months in mid-August indicates the government's commitment to stimulate lending and economic activity.
The market, being the weighing machine that it is, is well aware of the risks inherent in the region, and has priced the market accordingly. Valuations are therefore at historically low levels, which can be a signal for strong periods of growth. Low starting valuations, while not being a strong indicator of short-term returns, have relatively high correlations with long-term returns, particularly over the following decade. Given China is trading on a forward P/E of under 11 times earnings and a P/B of 1.2, compared to the US which is trading on a P/E of 21 and a P/B of over four, value-oriented investors may be able to find value in “buying when there is blood in the streets”.
A balanced approach
China undoubtedly presents a headache for investors.
On the one hand, the country is suffering from geopolitical uncertainty, is flirting with deflation, is suffering from an unstable property market, and is fighting against a demographic headwind.
On the other hand, it is a market leader in technological innovation, is on the forefront of the EV transition, is bolstered by a highly supportive central bank, and is trading on much lower valuations than other major economies.
Without a crystal ball, there can be no easy answer to which of these opposing forces may win out, nor the timeframe over which it may happen. While the government and central bank seem supportive in pursuit of long-term objectives, the journey to growth seems unlikely to be smooth. China bears have plenty to point at to justify their portfolio underweights, but for those who are happy to take a contrarian approach, there may be value to be had.
Whether positive or negative on the country, we would urge investors to adopt a balanced approach, by not only including any China exposure as part of a broader global allocation but also held alongside other emerging economies.
Holding China as part of a broader EM allocation, especially when accessed through a low-cost ETF, ensures not just any potential upside from the country’s low valuation, but also exposure to the other future economic leaders, including the particularly interesting case of India, whose more favourable headlines contrast markedly to China’s. Remaining diversified is crucially important given volatility in these regions is likely to remain elevated for some time to come.
Andrew Prosser is head of investments at InvestEngine