Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here, Dale Nicholls, Portfolio Manager of the Fidelity China Special Situations Fund urges investors to look beyond the headlines.
When looking at China, overseas equity investors are bombarded by headline grabbing negative stories. News about slowing GDP, rising debt and falling property prices has driven negative sentiment towards China. Yet in 2014 the Shanghai Exchange was the world’s best performing market. So is this negative sentiment justified and what have investors been missing?
To answer the first question, yes, some of the negativity towards China’s markets is justified – China clearly has its challenges but if you scratch below the surface there is much more to the headlines than meets the eye.
First, GDP is slowing, but China is a $10 trillion economy and it is unrealistic to expect consistent high single digit growth rates over the long-term. It is generally accepted that 2015 growth will slow to around 7%, but in US dollar terms that is still around $700 billion of growth, or roughly 25% of the entire UK economy. In conjunction with this, the economy is shifting towards a consumption-led model, which lends itself to lower, yet more sustainable growth rates. This is still a ripe environment for the strongest companies to grow.
Second, debt levels have risen significantly, and history teaches us that this should lead to non-performing loan (NPL) issues down the road. But I do not think this will lead to a credit crisis of the likes witnessed in the West in 2008. A key characteristic of a credit crisis is the drying up of liquidity, but strict rules means China’s banks have among the lowest loan-to-deposit ratios in the world, while their largest shareholder is the government who can direct liquidity to where it is needed. Also, one of the big differences is the level of consumer credit.
Debt has risen in China but mostly at the corporate level, including State Owned Enterprises, rather than the consumer level. Mortgage penetration is very low, and the deposit requirements for mortgages are relatively high versus Western standards. I do think NPLs will become a greater issue for banks going forward – and this is key reasons I do not own Chinese banks in the portfolio. My hope for the benefit of banks and the broader economy is that these are dealt with rapidly and decisively.
Third, after years of gains, falling property prices have been perceived by some as the beginnings of the bursting of a bubble. To me, a key aspect of a bubble is rapidly declining affordability. Property prices have moved up strongly in the past decade, but so have incomes. In fact in many cities we argue that affordability has actually improved in the last decade. We should also note that the largest gains in property prices have been in the first tier cities while gains in the lower tier cities have been much more muted.
Ultimately it will come down to supply and demand. Supply has increased significantly, but has already begun to adjust since last year. I believe there is also still a reasonable case to be made on the demand side. We must keep in the mind that the debt increases have been mostly at the corporate level and the consumer balance sheet remains in very good shape. Finally, many of the structural drivers of demand, such as urbanisation and general upgrading, remain in place. I think the pick-up in market volumes that we have seen in recent months reflects these underlying demand trends.
I am not saying there are no pockets in China with serious overbuild issues – the country is large and there will always be failed projects – but it’s not as bad as often made out. For example, so called “ghost towns” dominate the media. I have visited many of these, and while there are some areas with problems on the whole I can say that the problem is generally overstated.
So where are the opportunities for investors? I continue to believe the course is set for an unprecedented reform programme that will open up the Chinese economy and its markets, but we must monitor progress in terms of implementation.
There are many ongoing economic and social reforms that address issues such as reducing government intervention, allowing markets to determine prices and improved welfare. These changes tend to take baby steps forward, so can often slip under the radar, but in aggregate they are really changing the investment landscape in China to one where private entrepreneurs and companies can further thrive.
Overall, I acknowledge there are macro challenges, but find these are often overstated for the sake of a juicy headline. The economic model in China is changing and slower growth is the “new norm”, but it is still growing nonetheless and a good environment for innovative companies to thrive.
Reform is a broad concept, but it is a key driver to progress in China and it will present investment opportunities across an array of industries. From a stock picking perspective, the opening up of the A-share market is really exciting and I look forward to continue searching this market for the many opportunities it offers. At the end of the day I still believe stocks follow earnings and cash flows - and I see strong opportunities for growth in both.
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