China Growth Trumps Trade War

It’s an odd time to talk up Chinese stocks. China is locked in a bitter trade war with the U.S. and it was the world’s worst-performing major market last year.

This is an inefficient market. Retail mom-and-pop investors account for 80% of trading turnover on the country’s stock exchanges, which, until recently, were closed to overseas investment. They tend to be swayed by breaking news rather than cool-headed analysis of company prospects. The result is a volatile, sentiment-driven market.

But this creates opportunities for investors to pick up good companies trading below fair value. Sentiment can change quickly. Two drivers that could inspire a turnaround are a U.S.-China trade deal and China’s inclusion in global indices.

A prolonged trade conflict would hurt corporate profitability. Tariffs dent the earnings of companies that benefit from global supply chains, many of which are listed on U.S. exchanges. This may have been a factor behind last December’s S&P 500 Index slump.

It’s in the interest of both sides to resolve this dispute. The catalyst could be another market rout. President Trump is already risking backlash from rural Republicans impacted by Chinese duties.

While we expect talks to continue, we’re confident a deal will be struck — especially with a U.S. presidential election on the horizon. Any deal would likely be received positively by markets, giving companies greater clarity on their revenue prospects and spending plans.

At the same time, global index provider MSCI is doubling the number of Chinese stocks — or A-shares — in its emerging-markets index. Within five years, it’s estimated they could account for 20%. This would draw in capital from foreign institutions that track the index passively.

This is long-term money, stickier than today’s sentiment-driven flows. It will expose Chinese company managements to global standards of accountability and best practice. Improving governance tends to enhance corporate performance and helps to realize value for shareholders. We believe it’s better for investors to get ahead of this curve.

Back to the future

So why invest in China? The answer is growth. Despite frequent bulletins on China’s slowing GDP growth, it is still above 6% a year — faster than advanced economies. At the start of this year, consensus 2019 earnings forecasts for A-share stood at 15%. Investors will struggle to find many markets offering double-digit growth.

Perspective is important. China and India used to account for half of global GDP growth, before the industrial revolution gripped the U.S. and Western Europe in the 18th century and reduced both to a statistical irrelevance.

It was only in 1978 that Communist Party reformists set in motion a process of industrialization and urbanization on an unprecedented scale. China is now the world’s second-largest economy in nominal terms.

Within 30 years, China and India are again forecasted to account for 50% of global GDP growth. It points to the mother of all mean reversions.

Today 60% of China’s population lives in urban areas — and this figure is rising. People gravitate toward cities to find better jobs, health care and education services. It means they get wealthier, too. In 1960, China’s GDP per capita was $100. Today it’s $7,500, and in Shanghai it’s $20,000.

Some 39% of the population is classified as middle class now — from 2% in 1999. That’s half a billion consumers. Life expectancy has also more than doubled since 1960, to 76 years.

Rising wealth and living standards mean China is moving to higher-value goods and services. Investors can buy into listed companies poised to benefit from this structural growth. We have found quality stocks in areas including travel, food and beverages, luxury goods and Chinese medicine.

China’s exchanges also have low correlation to global markets. Chinese policymakers are steering the economy away from manufacturing and exports to reliance on domestic consumption and services. The latter make up more than half of China’s GDP growth today.

Domestically focused firms are less tied to global-economic and interest-rate cycles. They are also more insulated from the worst effects of the trade war. In this way, A-shares can bring valuable diversification benefits to a portfolio.

So investors prepared to look beyond today’s trade war and focus on the long-term opportunity will be well placed to ride on China’s future consumption growth.

A version of this article was first published by Wealth Management on June 11, 2019.

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