The View from the Ground - Baird Capital on China

Anxiety over China's recent investment and economic troubles sent shockwaves through the global investment markets in August. Given the headlines – from the slowing of the economy to the stock market crash to the devaluation of their currency – it's easy to understand why more casual western investors might have assumed the worst.

At Baird Capital we believe that, like most market angst, this latest round of headline-grabbing volatility was more rooted in uncertainty that a true understanding of the fundamental dynamics at work. We've had investment and operational professionals on the ground in China for more than a decade, and the perspective they provide paints a significantly less dire picture of the country's longer-term investment and economic potential.

The China You May Not See
Given the flurry of news coverage spotlighting China's newly minted millionaires in recent years, and the number of westerners whose experience of China might consist only of a visit to Shanghai or Beijing, one could easily come to the false conclusion that rapid wealth accumulation has already transformed China into a first-world economy. And if that were true, it would be easier to believe their impressive 20-year economic growth story might be coming to its natural end. But the reality is that China is still a very poor country and at a relatively early stage in its economic evolution.

According to the International Monetary Fund, 2015 Gross Domestic Product (GDP) per capita in China is estimated at $13,801 per person per year – slightly more than The Dominican Republic at $13,553. By contrast, U.S. GDP per capita is about $56,421 per person per year – more than four times the estimated per person wealth of China. Ratios are similar when comparing China to Hong Kong or Saudi Arabia.

Also worth noting in an assessment of China's current stage of economic development is the ratio of rural to urban population rates. China's urban population exceeded its rural population for the first time in 2012, when the country's National Bureau of Statistics reported the former at just over 680 million or slightly more than 51%. That ratio is similar to U.S. census data from the 1920s.

These facts inform Baird Capital's assessment of China as a still-emerging market with significant economic running room ahead.

China's Market and Economy Tell Different Stories
It's a fairly common misconception that a country's economic and stock market performance will always reflect each other. But a look at the pair of charts below shows the Chinese stock market has not moved in lockstep with economic growth over the past 10 years.

China's Stock Market – 2005-2015


(Click to view larger image)

China's GDP 2005-2015


(Click to view larger image)

One prominent economic fear cited in relation to a declining stock market is the so-called "wealth effect," whereby it's assumed that people who see decline in their stock portfolios will feel less wealthy and stop spending, thus hurting the economy. But those who raise this concern regarding China may be overestimating the amount of money the average Chinese consumer has in the stock market.

Only 12-15% of Chinese household assets are invested in the stock market – a small percentage compared to the more than 30% of U.S. household assets reported by the Federal Reserve in June of 2015. And while margin lending in China rose sharply in tandem with stock valuations this year (see below), in June the Chinese government began to restrict margin financing in an effort to control what it rightly viewed as a speculative bubble. This measure may actually have contributed to the crash by forcing levered investors to sell in order to cover their margins. Regardless, the average Chinese citizen market losses in China will scare the Chinese people into spending significantly less.


(Click to View Larger Image)
Source: WIND Info and the Wall Street Journal

It is also worth noting that bull market corrections are a common phenomenon for emerging economies. Based on data from Goldman Sachs Global Investment Research, out of 36 bull-market episodes that occurred in emerging markets since 1970, 61% experienced a correction greater than 20%. In that light, and in looking at the aggressive run up in Chinese stock valuations since the beginning of 2015, Baird Capital views recent market losses as not only normal but also healthy.

So why is China's Economy Slowing Down?
Baird Capital doesn't want to diminish the significance of recent market losses (more than $3.2 trillion was wiped out in less than a month). Nor do we deny that the Chinese economy is slowing down. But as we've pointed out, the crash was somewhat expected by those paying close attention. And – as many appear to have forgotten or just never realized – the latter is intentional.

The Chinese government has been purposely trying to slow major sectors of its economy for years. The official state controlled China Daily newspaper, often used to communicate the communist party's plans and intentions, has run headlines such as "China gears down for economic health" and Premier Li stresses quality growth, innovation." This stream of information indicates China has been aware of the need for a "new normal" and that its impressive double-digit GDP growth over the past decade was not sustainable. That remarkable growth, which put China on so many casual western investors' minds, was characterized as low quality growth. It was driven largely by low-margin exports from China to fill the shelves of Target and Wal Marts across the United States, as well as real estate and infrastructure-linked spending on commodities like steel, cement and copper as demand for Chinese-manufactured products soared.

As the cost of manufacturing in China began to creep up with demand, the Chinese government recognized that the future of their economy was in the hands of the consumer, who is alive and well in China. China's middle class has grown with its economy and is currently larger than the entire U.S. population. Under such circumstances, one can understand why the government is intentionally shifting its focus from investment-led growth to consumer-led growth. And lower GDP growth has been engineered with the long-term sustainability of that model in mind.

The Government has the Will to Act
Another important factor when assessing the potential implications of China's current situation is the government's ability to respond. It has powerful levers to pull in attempting to control the trajectory of the economy, and has already demonstrated its willingness to use them.

On Tuesday, August 11, the People's Bank of China (PBoC) surprised markets by raising the daily fixing price of the renminbi (or yuan) by 1.8%. This represented an effective 1.9% depreciation in the value of the renminbi versus the dollar and the biggest one day move in the currency since 2005. It was followed by additional 1.6% and 1.1% depreciation over the next two days.

This move was well received by the IMF but was less popular in the United States, where critics characterized it as, at best, a desperate attempt by the government to stabilize the Chinese markets and economy or, at worst, the start of a currency war with the west.

While the devaluation may have improved China's near-term competitive position in exports, Baird Capital believes the government's actual motives were longer-term and larger scale. The PBoC has announced its intention to set future fixings in the renminbi based on the previous day's closing spot price. This could help to create flexibility in China's exchange rate at a time when the government has shown interest in positioning its currency as an alternative to the dollar among the world's reserve currencies.

Baird Capital does not see these as the actions or ambitions of a nation that is uncertain about its economic future. And as long as the Chinese government remains committed to cultivating sustainable growth, we expect to see investment opportunities continue to arise in this still-emerging market.

 

Past performance is no guarantee of future results. All investments carry some level of risk including loss of principal. Indices are unmanaged and direct investment is not possible. Investments in international and emerging markets securities include exposure to risks including currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political stability.