The Chinese economy has slowed significantly, and investment strategies are risky if they don’t protect against lower Chinese growth in future. We argue that caution is warranted for the near term. But Chi-nese equities are less highly valued than US equities and are attractive on a long-term basis.
A slowdown in China is depressing the world business cycle
Fourth quarter Chinese GDP statistics indicate a decline in year on year growth. While the 6.6% reported may look attractive on an international comparison, it is the lowest reading for this metric since 1990. Probably the “true” figure for growth was far lower. We note the decline in the investment growth rate – to 5.9%, the lowest reading in 22 years.
The temporary calming of the US-China trade war will not do much to boost the world economy
The US-China trade war has encouraged both sides to bring forward import purchases to avoid higher tariffs in future. Thus, it is still very hard to assess the full impact of the tariffs that have already been imposed or threatened. Nevertheless, we believe the trade war – even were it to end rapidly and tariffs cut back down again – will prove to have been highly damaging to growth. Corporate investment is very sensitive to changes in the trading environment. Just imagine a CEO contemplating an investment in China, with a 20 year pay-back under “normal” circumstances but possibly worthless in a high-tariff environment. Who can guarantee our CEO that a trade war will not reoccur even if dramatic peace moves mean a truce is agreed in the next few months?
The basic conflict behind the US-China trade war remains unresolved
The basic conflict between the current Number 1 superpower, the US; and its would-be usurper, China, will not be resolved for many years. This does not mean that investments in China cannot be highly profitable. But the hurdles for investment are now higher. A larger margin of safety is called for as the ongoing fight for supremacy implies further trade conflicts and a long-term deterioration in the trading environment.
But the problem for investors is that many investment propositions only make sense if China’s growth rate stays very high over the long term.
It’s unfortunate that many business models assume an environment in which China’s growth rate stays more or less permanently above 6%. This assumption underpins many forecasts for economic and corporate earnings growth. It is critical for a wide variety of businesses across the globe, including (for example) Qualcomm, 65% of whose revenues emanate from China, and the Brazilian soybean producers.
On valuation grounds, Chinese stocks look attractive relative to US ones
The cyclically-adjusted price to earnings ratio (the “Shiller PE”) for Chinese stocks is currently 13.9, while the comparable figure for US stocks is 26.8. This suggests that Chinese stocks are more attractive than US stocks on a long-term basis. But in the short-term, we advise caution when it comes to investing in China.
Structural factors suggest China’s long-term growth rate is set to decline substantially
1. Labor supply set to turn negative
The effects of a future decline in labor supply due to the one-child policy of past decades cannot be offset by the very best policies of demand stimulus. In fact, the government has since 2016 allowed couples in selected cities to have two children again (thus partially repealing the one-child policy in force since 1979). But the latest figures show this policy change has had little or no impact. In 2018, the birth rate in China dropped to 10.9 babies per 1,000 population, the lowest level since 1949!
2. China’s labor productivity advantage relative to the West is no longer as big
The labor productivity gap between China and the US is no longer enormous. In the past, China could grow by copying Western production processes in which its labor could be just as productive as labor elsewhere. But 80% of the potential efficiency gains to be achieved by copying have now been realized. In the future, China must rely far more on its own technological development if it wishes to boost its labor productivity.
Chinese growth will soon fall below 6% pa.
For the reasons outlined here – declining labor supply with productivity gains harder to come by – the Chinese growth rate will soon fall well below 6% pa. While official Chinese statistics will likely indicate faster growth in order to comply with official targets, this artificial window dressing will not make business models that rely on strong Chinese growth any more profitable.
China in 2050: Chronic current account deficits with the yuan an important reserve currency
China wants to attack the dollar’s position as the dominant currency in the global economic system and wishes the yuan to be an important reserve currency. In order to achieve this, China must continue to open its economy to the rest of the world and accept deficits on its current account. In fact, China had an overall current account deficit in the first quarter of 2018, although the bilateral trade balance with the US was positive.
Over the next few years, Chinese current account deficits are likely to become the rule rather than the exception. As this happens (and especially if the bilateral balance with the US turns negative), China’s trading relations should become more relaxed.
China will then shift from being a capital provider to the rest of the world to becoming a capital importer. In this context, Peking’s efforts to increase the weighting of the heavily under-represented Chinese bond markets in international bond indices are all too understandable.
The debt driven nature of China’s growth process is disturbing
Finding buyers for Chinese debt may well become increasingly difficult given the supply outlook. The Chinese growth process is already very debt-intensive and looks set to become even more so.
China will soon be a leader in many IT sectors
China invests at least as much as the US and Europe in artificial intelligence (AI), robotics, Big Data and space technology.
Chinese schools already have introductory courses in AI. (Is this happening in Europe?) According to studies by the Japanese engineering company Astamuse, China already possesses the world’s second-largest stock of AI patents. Many Chinese students not only study at top US universities but are among the best students there. The Chinese government has the goal of being Number 1 in AI by 2025. The sheer number of Chinese engineers and doctoral students almost ensures the achievement of this goal. Due largely to the lack of legal privacy protection in China, China’s government and its companies have unrivalled access to Big Data.
And Chinese Big Data is arguably worth more than Big Data elsewhere because of the size of China’s population. This means Chinese AI investment might well be more profitable than AI investments elsewhere. All in all, China will soon become the global leader in AI.
China’s concern for intellectual property protection is set to increase over the medium term
As China develops as a technological superpower its interest in intellectual property protection should increase sharply. China will have to accept that a global system of strong patent protection requires international reciprocity.
Contact: Thomas Härter, CIO, Investment Office
Telephone: +41 58 680 60 44
Disclaimer: Produced by Investment Center Aquila Ltd. Information and opinions contained in this document are gathered and derived from sources which we believe to be reliable. However, we can offer no under-taking, representation or guarantee, either expressly or implicitly, as to the reliability, completeness or correctness of these sources and the information pro-vided. All information is provided without any guarantees and without any explicit or tacit warranties. Information and opinions contained in this document are for information purposes only and shall not be construed as an offer, recommendation or solicitation to acquire or dispose of any investment instrument or to engage in any other trans action. Interested investors are strongly advised to consult with their Investment Adviser prior to taking any investment decision on the basis of this document in order to discuss and take into account their investment goals, financial situation, individual needs and constraints, risk profile and other information. We accept no liability for the accuracy, correctness and completeness of the information and opinions provided. To the extent permitted by law, we exclude all liability for direct, indirect or consequential damages, including loss of profit, arising from the published information.
In the latest Aquila Focus, Nicolas Peter, Head of Banking & Investments, discusses the continuing rally in US tech stocks and the lack of an interest rate cut in the USA for the time being.
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In 2023, numerous geopolitical risks came to the fore, supplemented by interest rate hikes by central banks in the fight against inflation. The conflict in Ukraine will soon last two years. In addition, the situation in the Middle East has worsened, particularly between Israel and Hamas. An escalation of the conflict to neighboring Arab countries has been prevented so far. Economic weaknesses are also evident in two of Switzerland's key trading partners: China and Germany. These developments are leading to a lack of important impetus from foreign trade. Geopolitical issues will continue to play an important role in the coming year. However, the past has shown that the impact of such events on the global financial markets is often short-lived.
Fewer sustainability investments, but more investments in pharmaceutical companies and the healthcare sector. Artificial intelligence en masse, but shares instead of gold. These are some of the resolutions of independent asset managers in Switzerland for the first quarter of 2024, according to the latest AVI Index.
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