China: Will they have the last laugh?

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Two of the world’s largest economies are going head-to-head and investors are fretting. Will the United States and China make a deal? Will tensions ensue and tariffs be raised? What will happen to markets? The stakes are high and with the G20 only a day away, it seems we are at an inflection point. To shed light on the topic, we reached out to Robert Mann, Senior Portfolio Manager and expert in Asian Equities at Nikko Asset Management, to give us his view from the inside.

Mann explains that to understand China, you need to understand their history. He says: “China was a great civilisation, then in 1800 were attacked by foreigners who forced open the Chinese market on trade. Weak at the time, they missed the industrial revolution giving into the foreigners on trade. They then had the century of humiliation. Today, they’ve been able to get rid of foreigners under the Communist Party, and have come back to their rightful spot in the world. Given their history, it’s very hard for President Xi to look weak to foreigners on trade.”

In the transcript below, Mann provides a compelling perspective on the China story, and what this means ahead of the G20 summit.

If you don't have time to read the entire piece, you can read the parts in bold for a summary. 

In 2030, what does China's role look like? 

James: So Jim Rogers, who is the co-founder of Soros Funds Management said, "If you were smart in 1807, you moved to London. If you were smart in 1907, you moved to New York. And if you were smart in 2007, you moved to Asia." And over the last 10 years, US GDP has grown by 34%. China's GDP, on the other hand, has grown by 228%. So imagine it's 2030, what does China's role in the world look like? And how would that be different from today?

Robert: China is in the middle of a big transition. To date, China has followed the traditional Asian growth model. Export-driven growth to pull people out of the countryside and into the cities. However, it has been clear to them for a couple of years  that the model was past the peak of that. They realised they had to go to the next stage, which was getting people working in offices, not in factories, where you're not relying on exports, and the economy is much more domestically driven around the consumption of services. So that is the transition China has been making. As part of that move, they recognised that they had too much debt, they were relying on credit for growth and they clearly slowed that down over the past couple of years, which is why the economy is weaker this year. Nothing to do with trade, at all.

“They recognised that they had too much debt, they were relying on credit for growth, and they clearly slowed that down over the past couple of years and that is why the economy is weaker this year. Nothing to do with trade, at all”

They are going to continue that transition so they can move away from low-end manufacturing and move towards high-end manufacturing. That takes a number of years. So by 2030, you'd expect China to be the largest economy in the world.

“So by 2030, you'd expect China to be the largest economy in the world”

The most difficult part of the question is the US interaction with China. The Chinese point of view is that the US is trying to knock them off the growth trajectory. They believe they are going to be the biggest economy in the world, that they should be impacting the world, and that the US is just sour grapes about being a weaker power. Needless to say, I think they are clearly concerned at the moment. They’re going through a tricky transition of slowing down credit growth, so their economy is weaker, and they are dealing with the challenges of the trade war. 

 “And the Chinese point of view is that the US is trying to knock them off the growth trajectory”

The uncertainty is what exactly the US wants from them. Do they just want China to reduce the bilateral trade deficit? Because they have already agreed to that six months ago. The US sort of hand shook the deal and walked away from it. Or is the US trying to move lots of industry back to the US? And if that's what the US is trying to do, from China's point of view, why would you want to make a deal with someone who's trying to do that? And that's what I think they're going through at the moment. Given that, we have seen the U.S warn big multinationals that having a supply chain just in China is more dangerous than you thought. So there will be some manufacturing that returns back to the US, and I think the more high-tech, the more it is part of the defence supply chain, then the more it will have to be in the U.S.

This will make it more difficult for China to move upmarket because they’ve got to spend more money to get there. Having said all that, I still think they’re going to be the largest economy in the world, probably a bit later than they would have beforehand, and the other thing is, unlike the past, China has thrown its weight around in terms of what the global situation looks like. We saw a little bit of that at APEC. China has the second largest economy. It wants more influence on how things work and so the rules of the game are more influenced by China than they were.

The other thing about 2030 is that India comes into it. The big growth in the global working-age population is actually India, not China, and will those people finish up in useful jobs or will they finish up back on the countrysides growing vegetables? This is an important question for the world. But by 2030, if things work out in India, India will matter. 

"But by 2030, if things work out in India, India will matter" 

The 2 big risks for China

James: There seems to be a sense of inevitability around China's rise to number one. What do you think are the biggest hurdles facing China's path to number one?

Robert: So nothing's inevitable, the future is uncertain. What you're basically asking is what are the risks to that view? I think there are two big risks to that view.

  1. The biggest risk would be they panic in response to the combination of pressure the U.S is putting on them, the weakness in their share market, and the subsequent confidence effects that may have (on people spending less and businesses investing less). Under pressure, they may go back to tried-and-true methods they’ve used to boost the economy. Get government spending up, invest a lot more in infrastructure, and substantially increase credit. Inevitably, because the best projects have all been done, there’s a bigger chance of getting into a situation like Japan or just a low return economy where you can’t get out.
  2. The second risk, which is related but I think unlikely, is that they almost give up on the private sector, and that capital just goes to the big state-owned enterprises, becoming an almost centrally planned type of economy. Clearly that’s already part of the DNA, but they’re moving away from it. But if things start going wrong, could they go back towards it? I don't think that's likely, but they are the two risks if what I am saying is not right.

However, while China may be going through a tricky transition, they’re focused on what’s good for their overall economy. As opposed to Western politicians who might disagree on say, bailing out the banks, the Chinese are probably less ideological. They’re less ideological about the methods to get to the outcome at times than we are in the West. The classic example was TARP in the U.S, which got voted down. If China was in the same problem and it needed TARP, it would happen. It wouldn’t even be discussed. 

How is the Trade War being perceived in China? 

James: From the outside world, we obviously read the headlines around trade wars and there's a lot of friction between the US and China. How is that being presented and perceived in China by the Chinese? Is it to the same extent that we see from out here?

Robert: It’s changing over time. To understand their views, you need to understand their history. Really simplistically, China was a great civilisation, then in 1800 were attacked by foreigners who wanted to force open the Chinese market on trade. Weak at the time, they missed the industrial revolution and gave into foreigners on trade. They then had the century of humiliation. Today, they’ve been able to get rid of foreigners under the Communist Party, and have come back to their rightful spot in the world.

So given their history, the Chinese perceive they are being attacked by foreigners on trade, but their response is, “We've got to keep calm, buckle down, and focus on the long term. Don't get distracted from where we want to go.” So it's been a pretty measured reaction. They are trying to keep the people focused on what is good for China in the long-term.

Interestingly, the Chinese members of our investment team who run our A share strategies based in Shenzhen perceive the direction of domestic policy, such as deleveraging and monetary policy, as much more important market drivers than the trade war. It seems the non-Chinese maybe excessively focused only on trade. 

“They are being attacked by foreigners on trade, but their response is, “We've got to keep calm, buckle down, and focus on the long term. Don't get distracted from where we want to go”
 


The G20 Summit 

James: The G20 Meeting is coming up. Do you think this is an important one and, if so why? What are some of the outcomes you are expecting?

Robert: Clearly everyone is focused on the Xi Trump meeting. I have no special insight obviously with what the US will go into the meeting with. It would appear from reading the press that there are two groups of advisors behind Trump that have very different views and there's almost public fighting about who wins.

On the day what side he goes with I have no idea. Though, I think China is prepared to buy more from the US. If you want to just stay on the trade stuff, that’s easy. China has already agreed to buy more from the U.S. If the U.S wants China to move off its path of moving up-market in technology, then I think China won’t agree to that. So the question is, will the U.S just focus on the trade deficit or is it more about the technology? Even if a deal is done, I think China will assume this is probably temporary, and that they will continue going in the same direction. But you can’t put probabilities on these things.

“The question is, will the U.S just focus on the trade deficit or is it more about the technology?”

I hope that I’m wrong and that really it’s all about trade and we get an agreement. From here, the Chinese are worried about the confidence effect, and I think that the US is now worried that if they go up an extra 25% (in tariffs), a lot more consumer goods will be impacted which will impact the U.S economy. The stakes are clearly rising. 

And what about Australia's role? 

James: And so from an Australian perspective, what are some of the risks for Australia and as these two superpowers engage with each other, in this combative sort of way, can we remain diplomatic and have a good relationship with them both?

Robert: It will be more difficult than in the past. I think we clearly have to try to do that, but you've got to be very careful. The closer you are to China, the harder it’s going to be to do that. And China will put pressure on Australia to choose a side, and the U.S. will be putting pressure on in the same way.

A lot of what Australia provides to China is probably hard to replace easily. So tourism, coal, iron ore, clean food, education and so forth. Education, especially if Chinese students don’t go to the US, which is a big chunk of the English speaking education market. China’s prepared to put the pressure on to see if Australia will give in or not.

James: Well picking up on some of those comments you made about the Chinese liking to make money and being momentum investors, one place where momentum in China has been bad is in equity markets.

Robert: The Chinese market swings aggressively in both directions, and we saw that with last year’s stellar returns. Obviously we’re swinging in the other direction at the moment, and that’s part of what China is already worried about.

The Chinese government has been trying to break the cycle of negative psychology, and they’ve have been doing it through lots of different levers. It seems to have stabilised it, though what happens at the G20 can change it all again. But you have a government now that has indicated it is very worried by the equity market spiralling down and is prepared to come in and support it.

“The Chinese government has been trying to break the cycle of negative psychology, and they’ve have been doing it through lots of different levers. It seems to have stabilised it, though what happens at the G20 can change it all again”

But now you've got much better valuations. Last year, the biggest movers in the index (Tencent, Alibaba and so forth), grew earnings unbelievably strongly and valuations went up even more. And so last year what happened is that the brokers' forecasts had started too low, and went too high. So there’s still earnings growth this year, but a lot less than what people forecasted at the start of this year. As a result, valuations are cheap. So now you get really well-managed companies that are part of the new world you want to be in with strong growth. Tencent, for example, is on 23 times 2020 earnings, and that seems reasonable.  Ultimately, a lot of the mood this year was correcting overvaluation after a really good year in 2017. If markets keep going lower because of momentum, the government will try to stop that. Whether that's successful or not is a judgement you'll need to make. 

Ultimately, a lot of the mood this year was correcting overvaluation after a really good year in 2017. If markets keep going lower because of momentum, the government will try to stop that. Whether that's successful or not is a judgement you'll need to make. 

Is China stable?

James: If you were to give a sense of how stable the footing of the Chinese economy is right now, the time that you've been looking at, just on your observations, how stable do you think it is right now?

Robert: So politically, it's very stable. Clearly Xi has a lot of support from the average person, and so you have a strong leader with strong solid support, and a long-term vision.

He's put in place very sensible people underneath him who believe in the markets. You have an unbelievably entrepreneurial, aggressive business sector that sees all the opportunities and that is prepared to take risks, but if they make a mistake, it is move on and we'll just find the best way of doing things.

However, it does have a lot of debt. But that debt has been used for a lot of good assets. The infrastructure is good, they’ve built some amazing companies, but the worry is that the really good projects have already been done. And that if you keep building infrastructure now, it could become a case of those Japanese bridges to nowhere.

While there is a lot of debt, they have a very well educated workforce, they're very focused on the long-term, and if they make a mistake, which on occasion they will, they're not ideological, they'll change and they'll do something else until they get it right. Usually when you get crises it's when people lose trust in the banking system, but the banking system is the government and the chance of losing trust in that is virtually zero or is zero. China has a really robust base because of that. So I'm not worried about a short-term crisis. As I said earlier, the risk would come from panic and them just adding more debt. And that's still not a crisis it just means lower growth, just the growth slows much quicker and you get a long period of slower growth. But that's definitely not our central case.

“If they make a mistake, which on occasion they will, they're not ideological, they'll change and they'll do something else until they get it right. Usually when you get crises it's when people lose trust in the banking system, but the banking system is the government, the chance of losing trust in that is virtually zero or is zero. So it's got a really robust base because of that”

Further Insights

If you'd like to read more cutting-edge insights from the team at Nikko, please click here

 

 


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