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The Year of the Dog - Will China lead the pack again?

Gary Greenberg, Head of Emerging Markets at Hermes Investment Management, doesn’t expect a ‘ruff’ time.

Although China is a market many commentators love to hate, it was anything but a dog last year. Most global and EM investors were caught off guard by the strong currency, as the market was up 51%[1], outpacing the vast majority of global markets. Industrial margin growth was stronger than expected and internet stocks surprised most observers with tremendous earnings growth, but this year the fundamentals still look pretty good, despite the market trading at a modest premium to its long term P/E. Thus, the market valuation is still sensible and the 2%[2] yield provides solid support. The economy should continue to grow at a good clip even if it slows down from 2017’s GDP growth rate of 6.8% to a more sedate 6.1%[3]. Importantly, the banking system is in much better shape than it was several years ago. The still healthy economy this year should result in earnings growth of about 14%, which should support the multiple of just under 13 times the consensus for 2018 earnings[4].

A strong recovery in profit margins in China’s materials sector (glass, cement, metals) as a consequence of the 2016 recovery in commodity prices resulted in a 58%[5] recovery in profits in this group, which in turn had the beneficent effect of bringing zombie manufacturers back to life. According to a recent industrial survey[6], the proportion of loss-making firms in this sector fell from a high of 23% in 2015 to 15% in 2017, and the number of coal firms with negative operating margins fell over 80% from Q1 2016 to Q3 2017. Add this to the established Chinese recipe of growing GDP strongly to dilute the effect of bad loans and one can see why non-performing loans have peaked.  Bank balance sheets are gradually strengthening; therefore, we see a decent if not spectacular year for the economy and the market in 2018.

However, not everything is perfect; the investment in new industrial capacity will continue at a moderate pace.  Mining and heavy industrial sectors will continue to show modest top line growth and we expect exports to slow down as well. Job growth will slow, mirrored by consumer spending.

There are other clouds on the horizon: the US-China economic rivalry is about to heat up. President Trump is changing his tone, denouncing China as a rival in his state of the union address on January 30th and he is likely to place tariffs and other sanctions on Chinese technology, steel, aluminium and other manufactured goods. In addition, he is likely to put curbs on investments in the US by Chinese companies, impose limits on student work visas for Chinese citizens in tech and place tighter restrictions on US technology exports and the ability of US citizens to work for Chinese companies.  The US Administration has already blocked Ant Financial’s takeover and Congress has blocked AT&T’s deal to market Huawei smart phones. US officials mistakenly believe that China depends so much on foreign trade and investment, and has such a fragile financial system that unilateral pressure from America will cause it to collapse; however the US no longer has the ability to single-handedly compel other countries to do its bidding. The US is also likely to increase the pressure on North Korea by appointing a hawkish ambassador to South Korea having rejected several dovish contenders.

A 10% fall in Chinese exports to the US would knock off about one third of a percent from Chinese GDP but this can be compensated for by extra infrastructure spending. Specifically, in mid 2018 China is likely to stimulate the property market again.

As the Chinese economy slows in 2018, pressure on interest rates will probably moderate and we can expect another good performance especially from higher quality businesses. Specific Chinese corporates we like include ICBC Bank, China Mengniu Dairy, Ali Baba and Nari Technology.

Every dog has its day, but China has had a good several decades. While both EM and global investors remain substantially underweight, the market and short sellers decry the fragility of China’s model, 2018 should be yet another year when the dog of financial collapse doesn’t bark and the market makes further progress.

The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.

Follow us on Twitter: @Hermesinvest

Website: www.hermes-investment.com

[1] Bloomberg as at February 2018

[2] Bloomberg, MSCI China Index

[3] Bloomberg

[4] Bloomberg

[5] Gatley (2017), The China Inc. Annual Report 2017, Gavekal

[6] Gatley (2018), Mixed consequences from the profit boom, Gavekal

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