China is moving from an emerging industrial economy to something more developed. Although it’s too early to call the country a developed economy, some wealth managers suggest that their fellow advisers should start treating it like one when they consider adding China exposures to client portfolios.
Scott Clemons, New York–based chief investment strategist with BBH Private Banking at Brown Brothers Harriman & Co., manages China exposure as part of a $30 billion portfolio that includes a range of emerging-markets investments. Direct China allocations, including those to Hong Kong, account for about 5.7 percent of the total, and Clemons says he’s likely to boost that position over the coming year by focusing on equities with strong fundamentals.
“We have been allocating assets based on the broad theme of finding companies that will meet growing domestic demand for goods and services, as opposed to the more historic China story, which has been export-driven,” he tells Institutional Investor.
The places where Clemons is finding opportunity look a lot like growth sectors in the U.S.: consumer goods, cars, e-commerce — the basics of any services-driven economy but with the added ingredient of being in an emerging market. That diversification may end up as a bright spot in an otherwise middling equities portfolio as the U.S. bull market begins to slow and European weakness persists, he contends.
Though the long-term outlook for China is strong, investors should brace for a rocky start to 2016, warns Hao Hong, Hong Kong–based managing director of research at BOCOM International Securities, a subsidiary of Bank of Communications Co. “We cannot fully explain what is happening through big secular trends,” Hong says. “The interest rate rise in the U.S. and a slowdown in construction domestically are having an immediate impact, resulting in volatility.” That volatility could continue if China further devalues its currency, as some expect it will in the first quarter of 2016.
Activity on the Shanghai and Shenzhen markets on Monday underscored those risks. A weak December manufacturing report sparked heavy selling that triggered a market circuit breaker, suspending trading for the day after the CSI 300 blue-chip index fell by the maximum daily limit of 7 percent. The sharp plunge reverberated in markets around the world.
Yet many wealth managers maintain a positive long-term outlook on the market.
Robert Bao, portfolio manager of Fidelity Investments’ $1.3 billion China Region Fund, agrees with Clemons on the base case for China. An actively managed equities portfolio that picks specific companies, instead of investing in broad sector indexes, mitigates local economic risks and any unforeseen exposure to the volatile commodity and currency markets, he says.
“People are paying too much attention to these high-level data points like PMI or PPI and are getting caught up on the volatility,” Hong Kong–based Bao asserts, referring to the purchasing managers’ index and the producer price index. “We’ve built our portfolio by finding good individual companies, and if the share price drops on these macro themes, then I get to buy at a discount and wait for it to go up. That’s a win.”
Bao is investing in companies like Changan Automobile Co., one of China’s Big Four automakers, and Summit Ascent Holdings, which develops luxury resorts in the Far East. He says the key is to find businesses with a clear growth pathway and sound governance. Often the companies Bao invests in are involved in reform projects outlined in the Chinese government’s current five-year economic plan, which launched in 2011.
“I’m not just going to say, ‘Okay, we’re going to invest in construction,’ for example,” Bao says. “I’m going to find the cement company that’s doing urbanization in Beijing. You have to dig into subsectors and regions and pick out strong players.” Companies that focus on health care or sustainable development can also be good long-term opportunities, he adds.
Bao and BBH’s Clemons say such investments are uncorrelated to the macroeconomic concerns that markets have been focused on since last summer’s currency volatility, when China devalued the renminbi to bring it in line with its reference rate. December’s round of economic and production data confirmed that the slowdown in the Chinese economy is likely to persist and will settle below the government’s 8 percent target, but Clemons argues that we aren’t seeing a wholesale contraction, just part of China’s move toward a service economy.
“If you take a look at the import numbers, they have increased slightly month-over-month, which is indicative of domestic demand,” he says. “Another indicator to look at is rail freight. That number has consistently gone down, but if you look at highway freight, more goods are being transported that way.”
As the Chinese government continues to back urbanization projects in Beijing and Shanghai to support growing populations in those cities, roads will be busier than rail. In another encouraging sign of consumer activity, movie ticket purchases and online shopping sales have risen by 40 percent and 50 percent, respectively, in 2015.
Gross domestic product is also relatively robust. Immediately after the financial crisis, Chinese GDP growth slowed to 6.2 percent in the first quarter of 2009 — still well above that of other major economies at the time. China has since recovered even further: GDP expanded by 7 percent in the first half of 2015, according to state figures, before dropping slightly, to 6.9 percent, in the third quarter. Meanwhile, unemployment has remained low, at just 4.05 percent through the third quarter. The GDP numbers are widely believed to be inflated, but even a 4 percent to 5 percent growth rate still puts the country ahead of the developed world. With demographics working in China’s favor, thanks to low unemployment and a growing consumer class, there will be enough local consumption to power the shift to a service economy, Clemons believes.
BOCOM International’s Hong believes the trick will be to maintain discipline: Wealth managers must stick to finding bottom-up opportunities and to avoid more episodes of volatility, and the Chinese government must take a measured approach to giving investors access to the country’s capital markets. “China has made all the right moves heading into 2016,” he wrote in a recent research note. “In the new year, the challenge is that we become too complacent with our reform achievements, and lose sight of risks of financial contagion as China’s financial system gradually opens up. Like Deng Xiaoping once remarked: ‘Opening the window will bring in fresh air, as well as flies.’”
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