The prevailing image of China in the economic imagination is a place of ghost cities, empty highways and bridges to nowhere confected by unnecessary infrastructure spending after one of the most Keynesian of stimulus experiments kept the economy going in 2009. To some, the government-sponsored growth was a miracle that enhanced the lives of millions of people. To others it was an orgy of misallocated capital laid out by a centrally run economy—a Monopoly game of government stock price and currency manipulation doomed to fail.
But how accurate is the popular image and what would it mean for the rest of the emerging markets? This is complicated because in the short-term, the pain can become a self-fufilling prophecy. Exchange-traded funds have given hot money investors an unprecedented ability to make imaginary bears real. The Institute for International Finance reportedly pegged the emerging market capital flight for 2015 at $735 billion, seven times the previous year’s number.
According to Riad Younes, portfolio manager at R Squared International Equity Fund, the recent turmoil is simply the global chickens coming home to roost. The U.S. housing bust was just Part 1 of the asset inflation problem caused by low interest rates. Part II is happening now—the end of the commodities supercycle. China has been a voracious consumer of this coal, oil and iron ore, but no more.
Furthermore, its stimulus required a lot of borrowing through state-owned enterprises. The bubble in China for fixed-investment assets was fueled with debt. Debt to GDP is still high, says Younes. (Loans for companies and households was a whopping 207% of GDP in June of 2015, says Bloomberg.) “This is very unsustainable,” he says. “All this debt was taken against investments that were worthless, so we’re going to see a lot of problems.”
China has also boasted a policy tool that other countries don’t have: It can tell investors to go into the stock market (making it about patriotism). But that push led to an equity bubble that caused the Shanghai Stock Exchange Composite Index to finally lose almost half its value between June of 2015 and January of 2016, notes Bill Mann, CIO of the Motley Fool Asset Management.
“On a dollar basis it has dropped even more,” says Mann. “One of the underreported stories of the Chinese growth model over the last decade has been that it’s been with a huge amount of debt, particularly to the state owned enterprises. So the Chinese government used its stock market as yet another arm of policy. ”
Fear eventually fed upon itself, he says, and people realized the market wasn’t really based on financial statements. Combine this with China’s meddling with its own currency. The government famously began depreciating its yuan last August, supposedly in a bid to help exporters. The global reaction was swift and merciless and speculators swooped in to take advantage of the differences between China’s onshore and offshore currencies. According to Younes and others, the problem is that China hasn’t had a freely floating currency, so the market doesn’t know what it’s really worth.
Emerging Markets
To Bert Van Der Walt, portfolio manager at Mirae Asset Global Investments, these growing pains are necessary for China to switch from fixed asset investing to consumption growth and for the rest of the emerging market currencies to find their true legs now that the commodity cycle is over. It’s going to hurt, but he says the growth will be healthier in the future, and that consumption-driven economies will be easier for outside investors to tap into than fixed-asset/infrastructure economies.
But as China moves out of its role as the chief engine of global economic growth, global commodity prices have tanked. Exporters of raw materials are experiencing their own painful adjustment. All suffered currency crises by last September. Brazil lost the most—almost half its value relative to the dollar by some reports.
Conventional wisdom holds that beneficiaries in this environment would be countries with less foreign debt, more independent central banks, and manufacturing economies that add value to commodities rather than pull them out of the ground. That model has favored Asian countries like Thailand, Turkey, India and South Korean and disfavored Brazil, Russia, Argentina and Chile.
But no country was spared the currency wreck, and those bets are off. Van Der Walt and other say there’s different criteria as well: The countries he likes are the ones that will adapt fastest and unleash their currencies to do what they are supposed to in a non-commodity-warped world and offer true price discovery in a bunch of small markets full of middle-class consumers. That’s the emerging market story the world has mostly been waiting for.
He says he’s overweight Mexico and Turkey, which, despite questions about the independence of its central bank, has made admirable adjustments and has good long-term potential. Even former members of the fragile five like Turkey and South Africa are worthy of interest in this scenario.
Brazil is the country many people are most wary of—a market with far too much reliance on China for its commodities exports, a partner that sneezes when China gets a cold. But even Brazil has shown an ability to adapt, says Van der Walt.
Jon Adams, a senior investment strategist at BMO Global Asset Management, says that his firm’s subsidiary manager, LGM Investments, has been underweight China and overweight in India, which has helped performance. His team is currently neutral to both emerging market equities and debt after removing an equity overweight in August 2015.
“We really saw more of a broader growth slowdown throughout emerging markets,” Adams says. “We also saw currency devaluation and saw a lack of currency stability across the region, which gave us some reason for concern. Even though we think that emerging market equities are relatively inexpensive at this point, we think that the headwinds from the economic slowdown, from uneven policy responses, kind of balances out that valuation signal.”
The yuan had depreciated by 6% in January, Adams says, but with the nondeliverable forward market there is still 6% factored in, making the actual deprecation more like 12%. Pressure on the yuan puts pressure on other markets to slash their currencies to make their exports look attractive.
Because Russia and Brazil are dealing with collapsing commodity prices, Adams says countries like India and Mexico are less in the way of China’s problems and less likely to get rolled over by it (Mexico is more tied to the U.S.). “If you look at India, the fundamental picture is better. If you look at some of the positive structural reforms that have been made there. The central bank there has a lot more credibility than it used to with the new central bank governor.”
It has gone from a current account deficit of 5% of GDP in 2012 to one that’s almost in balance. And it has advantageous demographics with a younger population.
Gerardo Rodriguez, portfolio manager of the BlackRock Emerging Market Allocation Fund, which invests across emerging market equity, debt and alternative strategies, says: “On the equity side, what we’ve been exploring, some sectors of countries that can be favored by the accumulation of value ... and there we like the story of Turkey. We like the story of Taiwan and we like the story of Thailand. We tend to like the information technology sector in Taiwan in particular.” But a lot of these economies are too dependent on foreign capital, which means they are susceptible to it drying up when foreign investors change sentiment and want to pull back.
It’s not clear that China is really collapsing. Andy Rothman of Matthews Asia, who spoke at an Investment Management Consultants Association conference in Midtown Manhattan in early February, says he’s heard the naysayers cry too often.
China watchers have become unnecessarily obsessed with GDP while Rothman thinks household consumption’s growing share of it is the real figure to watch. Right now it’s one-third, but it’s the largest growing part of GDP and will eventually be two-thirds of the economy, perhaps in seven years. China’s own estimate of its retail sales growth was 10.7% in 2015. One can focus on the small consumption component now, says Rothman, “or we can have a conversation today about how to invest in the part of the economy, consumption, which is growing the most rapidly. Isn’t that what we normally want to do?
“This is the best consumption story on the planet, anyway you measure it,” he says.
He even says the “ghost cities” are actually starting to fill up, and that China was simply anticipating its growth. And it’s not as expensive as people think, he says. The median P/E in all his firm’s China holdings is 13, he says.
Rothman says there are many more ways to look at China’s growth story besides GDP (and questionable Chinese government statistics). Visits from Chinese tourists to Japan in 2015 more than doubled its 2014 number, according to the Japan National Tourism Organization. “They are saying,” says Rothman, “that Chinese visitors spend twice as much as what the average visitor to Japan spends.” It’s not coming from their credit cards, he says. It’s coming from their income growth.
Adams agrees: “With China you can’t really look at GDP as your best measure of what’s going on in the rest of the economy. Most think it’s more effective to look at freight shipments, electricity consumption and credit growth to get a better assessment of what’s actually going on in the domestic economy.”