Challenge for China
Faith Glasgow asks what Chinese deflation means for investors
China’s economy has been attracting much media commentary recently, and very little is positive. How should investors view the current situation?
When the Chinese economy was opened up after draconian Covid restrictions at the end of last year, expectations were that it would enjoy a decent rebound. Not only has that faltered, but on top of existing problems – an ageing, shrinking population, weak consumer demand, declining exports and serious housing market debt – the Chinese economy is now grappling with deflation (falling prices).
A lower cost of living sounds as though it ought to be a good thing for consumers. Over time, though, falling prices tend to dampen spending, depress companies’ profits, discourage investment and dent confidence in a vicious circle that reinforces economic slowdown.
That’s exactly what is happening right now in China. The consumer price index fell 0.3% in July, driven in part by declining demand for Chinese exports (down 15% year on year) in the face of weak global growth, pushing exporters to cut their prices, and partly by an oversupply of goods in the domestic economy.
“An ageing, shrinking population, weak consumer demand, declining exports and serious housing market debt – the Chinese economy is now grappling with deflation (falling prices).”
According to Chris Tennant, co-portfolio manager of the Fidelity Emerging Markets trust: “So far all the government’s post-lockdown stimulus has been aimed at boosting supply rather than demand, but at a time when western economies are also starting to slow down.”
Elizabeth Kwik, investment manager at abrdn China Investment Company, believes that although the post-Covid recovery is happening, it’s occuring “at a gradual pace – slower than the market had anticipated – and that has pushed companies to slash prices, to try and sell existing inventories to a consumer base whose confidence in the economy is currently low.”
“Property is a major source of wealth for Chinese consumers and many home buyers, for example, have postponed their home purchase plans until after the sector stabilises,”
The weak property market is compounding the problem, particularly as real estate is estimated to account for around a quarter of Chinese GDP. “Property is a major source of wealth for Chinese consumers and many home buyers, for example, have postponed their home purchase plans until after the sector stabilises,” Kwik adds.
This lack of activity, fuelled by rising unemployment, is causing serious structural problems in the property sector, exacerbating oversupply and excessive debt, says Jason Hollands, managing director of Bestinvest. “According to Standard & Poor’s, more than 50 Chinese property developers have defaulted on debt payments over the last three years.”
However, some experts take the view that these are early days for China in the aftermath of the Covid lockdowns, and that the state has the resources to fire up the economy in due course.
“It seems far too early to panic about deflation, and the odds still weigh heavily in favour of further growth to come,” comments Andrew McHattie, publisher of the Investment Trust Newsletter. “If it does provide to be systemic and persistent, it will likely drag down growth rates for all global economies, but we’re not at that stage yet.”
“It seems far too early to panic about deflation, and the odds still weigh heavily in favour of further growth to come.”
Kwik argues that the market has been expecting too much, too fast, in terms of a recovery in domestic demand, and expects a gradual upturn in consumer confidence on the back of existing and further government measures.
“Though the central government has not deployed any of the ‘big bang’ stimulus seen in other large economies during their reopening, it has consistently disbursed support in a targeted and calibrated manner since last year,” she points out.
Importantly, in late July the China Communist Party politburo announced measures to gradually stimulate the struggling property market, including rate cuts and the reduction of downpayments. “It’s been a long time since that last happened,” comments Tennant.
It also issued policy guidelines covering much of the economy, with an emphasis on private sector companies – particularly small and medium enterprises – as key to boosting employment and investment.
“We believe the latest guidelines by the State Council are in the right direction, while more substantiative measures, such as tax cuts, are required from various government agencies,” comments a recent JPMorgan note from the China team.
Where does this complex situation leave investors?
Kwik thinks this year’s sell-off has been excessive. Not only is domestic consumption recovery in evidence, albeit slower than expected, but liquidity is improving, the central government’s relatively low leverage means it is in a position to be able to support local authorities, and earnings expectations are still in positive territory.
“This is a ripe opportunity to find quality assets at attractive prices that have the potential to generate superior returns once the market re-rates,”
“This is a ripe opportunity to find quality assets at attractive prices that have the potential to generate superior returns once the market re-rates,” she asserts.
Tennant sees both positives and negatives looking ahead. Interest rate cuts will clearly help rate-sensitive sectors, including property companies, but undermine the margins of others, notably financials. “Over the next one or two years, the banks are likely to be the most negatively impacted sector in China,” he believes.
There’s also the potential for Chinese disinflation to be ‘exported’ – in other words, falling prices of Chinese exports lowering prices for all of us. This would be very helpful for developed economies such as the UK that are battling persistent inflation, but lacklustre demand and falling prices in China make life difficult for both western and other emerging market exporters.
“It could be a big concern if you’re a luxury goods manufacturer, or making excavators for the Chinese construction industry, for instance,” says Tennant.
“It could be a big concern if you’re a luxury goods manufacturer, or making excavators for the Chinese construction industry, for instance."
Meanwhile, he continues to reduce his underweight exposure to China. He sees compelling opportunities to buy good Chinese companies with strong balance sheets and pricing power, including household names harmed by domestic deflation. “They’re trading at multiples we’ve not seen for a decade or more,” he adds.
Against that, McHattie points out that the four China specialist trusts have had a difficult year so far; they’re up against a weak economy and deflation merely “increases the risks another notch”.
Moreover, he says, despite current economic challenges, they are hardly offering compelling value that might tempt contrarian investors; the average China trust discount, at around 11%, is currently narrower than the 15% average for investment trusts as a whole.
“There are wider discounts and better value on offer across a whole range of other sectors,” McHattie observes. “Investors looking for single-country trusts may find there are better growth prospects now in countries like India and Vietnam.”
Hollands agrees, arguing that India in particular, with its youthful population and thriving domestic economy, stands to benefit as China struggles. He points to “global companies gradually diversifying their manufacturing supply chain exposure away from China [towards India], as well as increased foreign direct investment as it’s seen as a more stable destination.”
“India in particular, with its youthful population and thriving domestic economy, stands to benefit as China struggles.”
Overall, China’s best way forward out of deflation and towards the anticipated post-lockdown recovery is likely to be driven by further policy catalysts. Meanwhile, contrarians with a strong stomach are not short of opportunities.
