Game on for Asia's strongman

Heather Connon from Money Observer

28.07.08

via interactive investor

It was not supposed to happen until after the Olympics. China experts thought the authorities would do all they could to keep the country's stockmarket roaring ahead as a fitting backdrop to the Beijing games, but they reckoned without soaring oil prices and a rapid global slowdown.

Shares on China's stockmarkets have been practising their own version of the high dive: from its peak late last year the Shanghai index effectively halved, devastating the new generation of Chinese capitalists who have made - and now lost - fortunes trading in the latest hot stocks. International investors, who trade mainly in Hong Kong-listed A shares, have suffered, too, as their values have plunged, albeit less precipitously.

Market correction

The key question is whether this is a signal that the Chinese economic miracle will follow the stockmarket into deep water, or whether there is enough momentum to keep it afloat. The consensus, for the moment, is the latter. While the timing may have been unfortunate, a stockmarket correction was inevitable after the raging bull market that saw the Shanghai composite index rise fivefold in just two years.

Douglas Turnbull, China expert at Neptune fund managers, says: "While we have seen a severe correction, on a long-term view, that is not a particular worry. It is a sign that the market is becoming a bit more rational - at the end of 2007, expectations were overly rampant and it was running ahead of reality. Now, values are attractive on a long-term view."

Philip Ehrmann, manager of Jupiter's China fund, agrees: "I am a growth manager and I am looking for companies that can grow by at least 25% a year. Now, the average price/earnings ratio [for those kind of companies] in my portfolio is 11 times; in October 2007 that would have been 14 or 15 times.

"There is still strong retail sales growth, the economy is robust and the policy of wealth redistribution is working fine. I commend the Chinese authorities for engineering a gentle deflation of the bubble."

Economic growth forecasts are being cut back, but with growth still at 8% plus, this is the kind of slowdown that most Western economies would love to have. The trends that lie behind China's gradual emergence as one of the largest and most dynamic global economies remain intact: huge spending on infrastructure, migration of the population from the agriculture-dominated countryside to the cities and the emergence of a sizeable middle class with substantial disposable income.

Investors' main concern, in China as elsewhere, is inflation. The soaring oil price has been exacerbated in China by a rapid rise in food prices. And with food accounting for 40% of the inflation basket, this has had a severe impact: inflation peaked at 8.5% in April and while it fell back a bit in May (to 7.7%) and June (to 7.1%), it is still a worrying sign that the economy could be overheating.

Michael Konstantinov, manager of Allianz RCM's Brazil, Russia, India and China (BRIC) fund, is relatively sanguine. He points out that inflation has been driven by a 60% rise in the all-important price of pork, as disease and supply shortages have hit supplies. That is being corrected, he says, and prices should start to fall in the second half of the year, bringing inflation under control. He adds that core inflation remains low, at around 2.5%.

The Chinese authorities have been taking steps to deal with inflation. Interest rates were increased six times last year, although they have not risen so far this year, and banks have been told to increase their reserves and curb their lending growth.

Gentle stimulus needed

But Quanqiang Xian, a Chinese fund manager at First State, says: "If you look at past experience in the Chinese economy, hyper-inflation was usually associated with social unrest. This time, with the US going into recession, investors are very wary about the impact of government policies to manage growth with inflation. The government needs to stimulate the economy to offset western weakness, but they can't stimulate too much and stoke inflation.

"The economy is in a very challenging situation. Headline growth is robust - 10.1% in quarter one - but we expect aggressive rises in interest rates."

China's vast reserves - its foreign exchange holdings alone are more than $130 billion - mean it has plenty of policy options. While it reduced the subsidy on petrol prices earlier this year - causing storms of protest around the country - the Chinese have still not seen anything like the increases in fuel prices elsewhere in the world.

Moreover, as Konstantinov points out, the country needs to maintain growth at a high enough level to keep the momentum of industrialisation going: "It needs a certain level of growth to keep the transition from an agricultural to a manufacturing economy going without causing too much pain to individuals."

So far, there is little sign inflation or a global slowdown are having much effect on corporate profits. Capital Economics, an economic consultancy, points out that in the first five months of 2008, company profits rose almost 21%, while margins held stable despite rising raw material prices.

Ehrmann points out that the US is a less important trading partner than it was: only 10% of China's exports are destined for the US, compared with around 25% a few years ago. Brazil and Russia, which are also still enjoying robust growth, are increasingly important, while exports to Turkey have more than trebled in three years, from $400 million to $1.4 billion.

These kinds of statistics are behind the 'decoupling' theory, which holds that China and other Asian markets will be relatively unscathed by a global slowdown. China is certainly operating under a different dynamic from the western world. Like the other BRIC economies, it is investing a considerable proportion of its huge reserves on building ports, airports, roads and other infrastructure: almost $900 billion will be spent on transport projects, such as the construction of 42 airports, 2.3 million kilometres of road and 10,000km of rail links, with a further $320 billion allocated to the doubling of its electricity capacity.

The smooth passage for the new Beijing airport, completed well ahead of the Olympics, shows what the state can do. Larger than all Heathrow's terminals put together, it took just four years to build and cost half as much as Terminal 5.

Migration to the cities means the urban population will almost double from 532 million to 970 million by 2012, while spending on everything from housing to mobile phones is soaring. And financial reforms are giving consumers greater freedom about how they save.

Neptune's Turnbull points out that with inflation at around 8% and savings rates at only 4%, it is not possible to get a real return on savings - hence the rush into the stockmarket. There is a trickle-down effect from Beijing investment, he says. "We are seeing wage growth as well as improved rights for workers."

Over the long term, China should remain a great investment story as the pace of reform accelerates, infrastructure spending removes bottlenecks and more of its 1.3 billion population share in its growing wealth.

In the short term, however, there could be more of the turbulence seen this year. Xian is perhaps the most pessimistic about the short-term outlook for corporate profits, although he says oil and gas companies, financial businesses and consumer goods producers should remain relatively robust.

Konstantinov points out that even if forecasts are downgraded, growth should still be healthy. Earnings growth expectations are 30-35%, he says. "If you are conservative and think it will be only 20%, it will still be relatively attractive."

He is now thinking of adding to his China weighting, which had been reduced to a neutral level. Most of the China fund managers are orienting their portfolios towards domestic companies, rather than those that are dependent on exports to western markets. Gigi Chan, manager of the Threadneedle China fund, says: "China has been re-engineering itself as a consumption-based economy, and there has been no slowdown there in the last few months. Consumer staples, especially if they have a brand franchise and purchasing power, should benefit in these inflationary times." She also likes infrastructure companies, which are cashing in on the huge spending programme.

Ehrmann is "very careful" about export-related companies due to worries about appreciation of the renminbi and US demand. But he is finding opportunities among logistics companies and energy producers as well as in construction and infrastructure.

Long-term promise

While 12-month performance figures for most Chinese funds look a bit disappointing, the longer-term record is impressive. Threadneedle's fund was launched in March 2007, while Jupiter's is only six months older, yet the former is up around 25% since inception, while the latter is up 50%. Neptune and First State's funds, meanwhile, have returned more than 80% over three years. Allianz RCM's BRIC All Stars, which includes the other three BRIC countries, is up 60% since it launched in February 2006.

Such returns are not guaranteed in the future - particularly if inflation continues to rise and western economies sink - but China is a good long-term bet. "China will be the largest equity market in the world within 15 years," says Turnbull.

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