Key points
Andy Rothman, Investment Strategist, Matthews Asia
Christine Lagarde, Managing Director of the International Monetary Fund was once quoted as saying, "Markets love volatility." She may be correct in the abstract. But right now, investors in Chinese equities would certainly love a bit less volatility.
2016 is likely to be a year of volatility in China. With the government apparently keen to continue intervening in its A-share market, we can expect continued volatility there. And with the manufacturing and construction part of the economy set to grow more slowly, there will be macroeconomic volatility. As privately owned firms take more market share from state-owned companies that too will contribute to volatility. In addition, as the government presses ahead with structural reform in the state sector, capacity reduction will add to volatility.
We can, however, point to two areas where volatility is less likely: China's booming consumer and services sector; and U.S. - China relations as China prepares to host its first G-20 summit. This volatility can, however, create opportunities for investors, especially when dire headlines incorrectly assume that weak performance by outdated market indexes signal an economic hard landing. And keep in mind that volatility due to execution of necessary reforms, such as reducing the role of state-owned enterprises (SOEs), is good for the long run
2016 will undoubtedly deliver another round of headlines proclaiming the imminent collapse of the Chinese economy. In my view, a hard landing is very unlikely, and the doom-and-gloom reports may offer an opportunity for investors who have a deeper understanding of what is happening on the ground in China.
China suffers from a serious case of "debt disease," but the treatment and side effects may not be as severe as some expect, and dramatic credit tightening is very unlikely. Debt is concentrated among state-owned firms, while the private firms that generate most of China's new jobs and investment have already deleveraged.
As I explained in a May 2015 issue of Sinology ("Diagnosing China's Debt Disease"), the medicine for this problem will be another round of significant SOE reform-including closing the least efficient, dirtiest and most indebted state firms in sectors such as steel and cement-rather than broad deleveraging, leaving healthier, private firms with room to grow. At the end of last year, the government indicated that it was finally prepared to begin reducing capacity in construction-related heavy industry. In contrast to the experience in the West after the Global Financial Crisis, cleaning up China's debt problem should actually improve access to capital for the privately owned companies that drive growth in jobs and wealth.
China's old economy will remain weak this year. Manufacturing, especially heavy industries such as steel and cement, will be sluggish, as China has passed its peak in the growth rate of construction of infrastructure and new homes. But manufacturing has not collapsed, with a private survey revealing that factory wages were up 5% to 6% last year, reflecting a fairly tight labour market, and more than 10 million new homes were sold.
More importantly, few investors recognize that 2016 is likely to be the fifth consecutive year in which the manufacturing and construction part of the economy will be smaller than the consumption and services part. China has rebalanced away from a dependence on exports, heavy industry and investment, and has in my opinion become the world's best consumption story.
The most important thing to recognize is that the Chinese equity markets do not reflect the health of the Chinese economy, and to expect some market volatility. Second, to recognize that the market indexes underrepresent the strongest parts of the economy: privately owned companies, and the consumer and services sector. This is why we believe in an active approach to investing in China, rather than an index-based strategy.
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The views and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writers' current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Matthews International Capital Management, LLC ("Matthews Asia") does not accept any liability for losses either direct or consequential caused by the use of this information.
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