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US trade deal key to lifting gloom over Beijing – and Asia

By Chris Hall April 2, 2019

What should US investors make of the torrent of bad news pouring out of China throughout the first quarter of 2019? As the world’s second-largest economy – and its dominant growth engine – stutters, should retirees and savers cut their exposure to China, and the wider Asia-Pacific region? What too should we make of calls to increase investment in China?

“This could be an interesting tactical entry point for US investors,” says Tai Hui, Hong Kong-based chief market strategist for Asia at J.P. Morgan Asset Management.

No one’s denying that China’s had a bad run. Unemployment jumped to 5.3% in February. Industrial output is at its weakest since 2009. China’s 2019 GDP growth target is 6.0-6.5%, down from last year’s 6.6% and a far cry from the near-10% rate achieved 1979-2010. In response, capex by Asian firms is forecast to fall 4% this year.

The downbeat headlines and disappointing data have two key triggers, both of which relate to China’s transition from a manufacturing to a service-based economy. First, China prioritized tackling its debt problems in 2018, at the expense of growth. Whilst getting the bad debts of state-owned banks and enterprises under control, China also curtailed shadow banking, which hit privately-owned SMEs, the most productive part of the economy.

It’s no surprise Chinese equities ended the year of the dog in the dog house as one of the worst performing markets globally. But the year of the pig could still see canny investors bring home the bacon.
“The credit transmission channel was reliant on shadow banking,” explains Charles Su, managing director of CIB Research. According to San Francisco-based Matthews Asia, the services sector has been the biggest element of the Chinese economy for the last seven years. Shutting off credit to SMEs slammed on the brakes.

Second, the tariff war and subsequent prolonged China-US trade talks have weakened confidence and investment, in China, Asia-Pacific and beyond. “It has hurt US firms. But it has hurt China more,” notes Anthony Saglimbene, global market strategist at Ameriprise.

It’s no surprise Chinese equities ended the year of the dog in the dog house as one of the worst performing markets globally. But the year of the pig could still see canny investors bring home the bacon.

The Shanghai Composite Index has gained more than 20% already in 2019, topping major equity markets. The notoriously momentum-driven nature of China’s retail investors – which account for at least 60% of A-share trading volumes – plays a part. As do expected inflows as equities benchmarks increase Chinese weightings. But many cite longer-term reasons to bet on Chinese growth.

China’s leadership set the tone at the National People’s Conference, underlining that every necessary step would be taken to deliver growth and seal a deal with the US. This includes 11 million new jobs in 2019, two trillion yuan of tax cuts and a bonfire of bureaucracy.

Steen Jakobsen, chief economist at Saxo Bank, notes China’s commitment to grow by unleashing the vitality of its private sector, not fiscal stimulus. “China’s choice is to energize market players,” premier Li Keqiang told the NPC. “For historic reasons, 2019 cannot go wrong,” says Jakobsen, referring to the government’s need to ensure social cohesion.

A US trade deal will also support this growth agenda, says Andy Rothman, investment strategist at Matthews Asia. Entrepreneurs in China’s most innovative sectors – including healthcare, education, robotics – need the foreign investment beginning to flow into its capital markets. Saxo estimates this will exceed US$1 trillion over three-to-five years, as bond and equity indices increase their exposure.

Competing for these inflows will increase efficiency and dividends, but improvements in governance and protection for intellectual property must also be implemented to attract investors. Says Rothman, a “lack of IP protection explains China’s under-developed software and pharmaceuticals sectors. The changes demanded by the US are in China’s self-interest.”

As China reorients toward services, consumption is a better indicator of performance than exports, says Rothman. Veteran ex-Templeton emerging markets guru Mark Mobius agrees and is targeting the discretionary consumer sector at his new venture, Mobius Capital Partners.

Mobius cites “unnoticed” SME opportunities in China and across Asia: “Investors need to ask: where is the innovation taking place?” But he also sees returns being generated by the relocation of manufacturing. Vietnam, Indonesia, Bangladesh, Thailand and Sri Lanka all now have much lower labour costs than China and, perhaps critically, offer firms – Chinese and international – a way to avoid future tariff rows.

Both the firms that pivot their factories quickly away from China and those that help to build new supply chains across Asia could offer value to investors, says Hui at J.P. Morgan Asset Management. But he warns the region as a whole is in the late stages of its current economic cycle.

Even if China comes good in the second half of the year, investors should remember “all cycles end.” Despite his current pro-risk ‘tilt,’ Hui advises flexibility. “Investors have got to be nimble on asset allocation, ready to take a more balanced or even defensive approach.”