On one hand, China’s a giant. A behemoth in the global economy, its GDP has grown an average of 10% a year since 1978, said the World Bank. By some measurements, it will contribute anywhere from 18% to 20% of global GDP in purchasing power parity, and by that measurement it’s the world’s largest economy.

But apparently it’s also a sensitive giant. Its growth has slowed since 2012. The Shanghai composite index plunged almost 24% in 2018. In May, the country broke off trade agreements with the U.S., which threatened to hike tariffs on $200 billion of its goods, which in turn threatened 0.3% of Chinese GDP growth. A mess, right?

Or is it all noise? China’s biggest foes usually underestimate it, mostly by assuming it’s a monolithic investing space.

The shorthand view of emerging markets investing is that it’s either all about China, all about commodities, or all about China and commodities. That conventional wisdom has been hard to shake off.

It’s even more difficult to deny China’s role in emerging markets; EM’s first-quarter success was largely due to a stock reawakening in that country. But people were reminded of the dark side of its role in mid-May when President Trump rattled sabers over trade, sending both Chinese and U.S. markets into a tailspin.

The MSCI Emerging Markets Index was up 9.5% for the first quarter of the year, and China was the big driver of that growth (the MSCI China Index returned 17.69%) as the consumer discretionary and real estate sectors took off. With the inclusion of “A” shares into the MSCI Emerging Markets index in 2018, (a class in the past available only to Mainland Chinese), the country’s heft in the index is going to be felt even more. (“In the event of full inclusion [of A shares], China equities would exceed 40% of the MSCI Emerging Markets Index,” MSCI said.)

Not One Thing

But portfolio managers are often less interested in the country’s commodity and infrastructure past and more interested in a country with an emerging middle class (which has been pegged, depending on the statistician defining it as anywhere between 100 million and 400 million people), a group that has been on a homebuying frenzy in the last few years and flexing its increasing disposable income. Many EM portfolios have thrived on the backs of tech companies like China’s Alibaba—a retailer like Amazon, but also like Amazon, so much more than that. Alibaba is growing into areas like social media, cloud computing, digital entertainment and finance, and as of last September, it had reported 10 straight quarters in year-over-year revenue growth topping 50%.

This year, it’s Chinese beverage companies that have made a big splash. Real estate also surged for the first quarter.

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.”

But meanwhile there has been a regulatory loosening up, he says—VAT tax cuts for the manufacturing and transportation sectors and a loosening of reserve requirements at banks. “My overall impression is that the banks are not keen at this stage—the country is not keen at this stage—to have a big, big stimulus like it did in the 2008-2009 period. Because that ultimately led to a lot of the poor spending and the nonperforming loan issue, and they don’t want to revisit that if they can avoid it.”

For that reason, because bank lending has been shallower, bank stocks have fallen a bit in price and are “quite modestly valued,” Donald said. Internet-related companies and retail, by comparison are relatively expensive, he said.

“The Chinese economy is fairly large,” said Jin Zhang a portfolio manager at Vontobel Asset Management. “And it’s having a significant impact on neighboring countries and EM as a whole and broadly on the global economy.” But again, the composition of that economy is more complicated than people give it credit for, Zhang says. The provinces on the Eastern Seaboard are more affected by the exporting economy, he says, but the inland cities are much less exposed to things like trade wars.

Net exports as a percentage of GDP have come down in the past 10 years in China, Zhang adds. Technology and e-commerce are playing more of a role, while consumer staples have seen more stable growth by tapping into the middle class.

“If you think about the smaller cities, people are just starting in the habit of buying things online,” Zhang says. “If you look at the number of transactions, it’s increasing. Even in rural China, people are getting into e-commerce. So that’s another area that will give e-commerce some longer-term growth.” In finance, he says Alibaba’s Ant Financial has a strong presence in the mobile payment business and the largest money market fund and is doing a lot of lending to consumers and small and medium-sized business. “The banking industry in China is not very well entrenched. … People just don’t have an affinity with the brick and mortar banks. So for someone like Alibaba, it has a good brand.”

He says consumer products helped propel the growth of Vontobel’s Emerging Markets Equity strategy in the first quarter, especially alcoholic beverage maker Wuliangye Yibin, whose A share price almost doubled in the first quarter. It was the top contributor to the fund despite the anemic economic growth.

But even consumer products have their challenges. Zhang said his fund got out of a dairy company because of the fierce competition in that industry. Despite long-term growth in dairy, “this competition in either pricing or discounting or even just advertising wars, these things are compressing margins more than we would like to see.”

Derek Hamilton, a global economist at Ivy Investments, says the Fed’s backing off higher interest rates will have a salubrious effect on all emerging markets, as would the dollar if it were to weaken. “If you look at the data coming out of China … you’ve seen the deleveraging campaign essentially come to a halt, credit is starting to reaccelerate. … It looks like infrastructure investments are picking up, housing is stabilizing. All of that should mean growth in the back half [of the year] looks better.”

“If you look at industries that are likely to benefit from the trade war,” says Oh, “they’re going to be focusing on stronger IT protection; that’s going to benefit home-grown innovative companies.” He also likes media companies and internet services companies. In China, “people rarely use credit cards or cash. They use mobile banking. … There’s an entire generation that grew up with e-commerce. They are more close to e-commerce companies than offline brick and mortar.”