China bull yet to show cracks

China's response to escalating trade tensions with the US has emphasised how its role in the global economy has fundamentally changed. We see Beijing as a stabilising force in the later stages of the economic cycle and our positive view underpins some of our key asset allocation positioning

One day, in the not-too-distant future, China will become the biggest economy in the world. Its journey has sometimes been fraught, as an ostensibly communist country interacts with the “free markets” of the West. In the past, that has seen China perennially cited as a risk to any bullish positioning. We believe that this is no longer the case.

Stability

We understand that there are palpable risks at play at the mature end of the economic cycle, but we continue to see decent growth across regions, even if the pace and sustainability of that growth is now de-synchronised. In other words, we remain “risk-on”, and that is partly down to our view on China.

Right now, everything looks rather positive. On 17 April, China published first-quarter growth in gross domestic product (GDP) at 6.8%, slightly ahead of consensus estimates and driven by strong domestic consumer demand. It was achieved on the back of robust real estate investment and retail sales numbers. Inflation is under control, indicating that growth is not, for now, causing any worrisome overheating. The Producer Price Index (PPI) for March was up 3.1% against 3.7% in the previous month. Consumer prices showed a similar trend with CPI up 2.1% in the month after 2.9% in February. Both numbers came in below estimates, but the likelihood is that New Year disruption and a longer–than-usual National People’s Congress conspired to make this a temporary blip.

There are some concerns over debt levels. At the macro level the International Monetary Fund (IMF) has warned that China’s debt-to-GDP ratio could reach 90% in five years’ time. But much of the growth here has come from debt that state-owned companies owe to state-owned banks, which you can argue forms part of a grand strategy. Household debt has also been on the rise, and the impacts here are more difficult to manage. However, we view the large volume of domestic savings to be a good protection against associated risks.

Overall, there is a sense of stability that is not found elsewhere, in Europe or the US. And stability in growth and prices is also evident in monetary policy and, of course, in politics. The idea of a “president for life” will rankle with many and emphasises the lack of moderating dissent in Beijing. However, the ease with which Xi Jinping established that much-discussed change to China’s constitution offers a clear contrast to the head-scratching ambiguity that characterises communications from the White House. It also serves to emphasise the advantage to long-term planning when you are not operating in 4-5 year election cycles.

The evolution of China’s currency provides its own story. The decision to revalue the renminbi (CNY) in 2005 and to relax its peg to the US dollar (USD) allowed it to appreciate further over time. It was a coming-of-age moment for China’s economy. Keeping the CNY undervalued was a crucial part of China’s early export-driven growth model. China accomplished this by substantial intervention in the FX markets, accumulating about USD4 trillion of foreign exchange reserves in the process. But as with any maturing economy shifting its focus from exports to domestic demand, China requires an appreciating currency.

Between 2014 and 2016, market fears over China’s economy and the possibility of a devaluation caused reserves to drop by roughly 25% (or USD1 tn) under the pressure of capital outflows. But a sharp reversal has taken place since late 2016. An improved economic outlook, along with effective restrictions on outflows, helped stabilise the level of China’s reserves (which have been growing a little again in recent months, by about USD145 bn), while the CNY has appreciated by almost 11% against the USD. At their simplest level, currencies are symbols that represent the relative strength of nations; the renminbi’s 2016 inclusion in the IMF’s SDR basket of currencies was a vote of confidence in Beijing’s direction of travel. But Chinese policy makers will be very aware that 30 years ago, across the East China Sea, the US succeeded in stalling the momentum of a resurgent Japan, in part by fostering an exaggerated appreciation of the yen.

Concessions on trade

Our favourable view is also encouraged by China’s measured response to what could have been (and, in fairness, might yet be) a rancorous trade dispute with the US and its President Donald Trump. To mangle a famous phrase, China has played ball, but carried a big stick. Concessions have been made on foreign ownership restrictions in the financial and auto sectors and the rhetoric has been soothing on intellectual property, but tariffs have also been slapped on a basket of US goods. These include a 179% levy on sorghum grain, in a move that some have noted targets key voters just as Trump prepares for mid-term elections. There remain risks in this scenario for China, of course, particularly to its efforts to move up the global value chain. We may never know how much genuine concern exists in the senior ranks, however, the impression has been left that China is willingly making concessions it was always prepared to make, while simultaneously, and successfully, asserting its strength.

Recent reports have also made plain the level of US companies’ sales inside China, which helps to explain why this trade dispute seems to be skewed slightly in Beijing’s favour¹. The Chinese government’s ability to manage public opinion means it would be able to effectively boycott US goods and companies without resorting to overt shifts in policy. Such measures were successfully applied during the island disputes with the Philippines and the deployment of THAAD missile defence systems in South Korea.

In short, our baseline scenario is for a volatile journey but an ultimately benign destination in the ongoing trade ‘talks’. That, and China’s economic resilience, help to underpin our bullish view on commodities. We have doubled our allocation to commodities across portfolios to 3%. A cooling of trade tensions will particularly favour industrial metals, while more broadly, we believe that supply gluts are vanishing and physical markets are tightening both in the energy and base metal segments. A period of assertive growth from China acts as a useful backstop to that view.

Centre stage

And assertive is the right word.

China has made no secret that it covets a central role in global affairs, and has clearly identified an opportunity while the US meanders towards a form of “protectionism-lite” under a president who appears willing to trade influence for marginal gains on bilateral trade deals. China has overtly pursued a “soft power” policy since the time of President Xi’s predecessor Hu Jintao but it is the vast Belt and Road infrastructure project to build overland and maritime networks through Asia and into Europe that is the most visible sign of this ambition.

This is a driver for growth in China and bolsters our case that emerging markets will outperform too (even if cyclical tailwinds are fading), but it also adds weight to our relatively bullish case for Europe, which we expect will be courted from both sides as the US seeks to counter the overtures of its eastern rival. In the meantime, we have also favoured trades which aim to offer some protection to client portfolios, including a sustained long position on the JPY and a positive allocation towards convertible bonds, which offer an asymmetrical return profile.

China has made much of its plan to move to a “quality not quantity” mode of growth. That should maintain that kind of stability and direction from which investors can unearth good opportunities, while Beijing looks forward to the moment when it finally supplants the US at the top of the GDP tree.

¹ https://www.bloomberg.com/view/articles/2018-04-17/u-s-trade-deficit-does-not-reflect-subsidiaries-in-china