But the main thing to remember is that the Chinese economy, huge as it is, is not one thing. “Asia as a whole is going through transition, in that we’re going to see opportunities that are more service-oriented and industries creating more value-added products,” says Michael Oh, portfolio manager of the Matthews Asia Innovators Fund.
China Realigns
After enormous growth and regular annual GDP growth rates of over 8% in the previous decade, China suffered debilitating growing pains a few years ago (first quarter GDP growth was 6.4%, called its slowest in almost three decades). An enormous shadow banking system and under-the-table lending had caused inflation, and the Chinese government—more used to getting its way by fiat than democratic countries—moved to stamp it out through a painful deleveraging regime.
“They were deleveraging and cracking down on shadow banking, which had built up peer-to-peer lending with these wealth management products,” says Aditya Kapoor, a co-portfolio manager at the Ivy Emerging Markets Equity Fund. “So they were very focused on deleveraging, which was dramatically slowing down the availability of credit.”
If you look at Tier 1 cities like Shanghai and Beijing, says Oh, you see economies that almost look developed when it comes to things like car ownership and smartphone penetration. However, “there’s a lot of room for growth left in Tier 4, Tier 5, Tier 3 cities. Those areas where we are still seeing very healthy growth, a lot of growth opportunities left, especially for internet services companies to penetrate.” The latest figures suggest that the growth in disposable income has been squeezed, but Oh says that there are still healthy growth patterns across all city tiers.
His Matthews Asia strategy is to look for innovators in a deepening market, especially Chinese A shares, benefiting from steadily growing consumer disposable income. He names music streaming companies (Tencent is listed in the Innovators fund’s top 10 holdings) and health care companies like Jiangsu Hengrui Medicine, one of the largest pharmaceutical positions in his portfolio, which has a robust drug pipeline he likes. “The company has been growing 20% to 30% over the last few years.” The country is also producing strong entertainment content—good music, good movies, good drama. (China has the second largest film industry.)
“The Chinese market was sold off a little bit too much,” says Oh, “and has gotten very attractive in terms of valuation” amid the trade concerns. Though he spoke before the trade agreements stalled in mid-May, he was optimistic because China and the U.S. “have more to lose if they don’t come to an agreement.”
James Donald, head of emerging markets products at Lazard Asset Management, says the strong dollar always affects emerging markets, including China, and puts stress on currencies with current account deficits, a problem in 2018. Political noise and tariff threats have also hit the markets.
Donald says the Chinese government has been working to discipline its economy. In 2017, the country reportedly began shuttering tens of thousands of factories, or some 40% of them at different times, to examine their pollution. And though the numbers are fuzzy and hard to come by he stresses, Donald says the Chinese government has worked to improve its credit picture. It reduced corporate leverage and wealth management products. Also, “we believe that whereas three or four years ago, something like 9% to 11% of total gross loans in the banking system might have been nonperforming, we think that probably has fallen down to 6% to 7%.”
The result, he says, is that the state-owned enterprises, especially materials and heavy industry, that have survived this pruning and shuttering are performing better as the demand has remained stable, though there are worries. “I was in Beijing in January,” he says, “and there was very considerable worry about the difficulty for actually profitable private sector companies to get working capital loans. Again, the SOEs had much less difficulty because they are clearly in a preferential position to a lot of the private companies.”