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INVESTING
What China Problem?
Are the naysayers right about China’s demise this time, and will the other emerging markets
feel the butterfly effect of fluttering currency? By Eric Rasmussen
T
he prevailing image of China in the eco-
nomic 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
march 2016 | financial advisor magazine
investing
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
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 neces-
Conventional wisdom holds that beneficiaries
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 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
financial advisor magazine | march 2016
sary 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 noncommodity-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 relativewww.fa-mag.com
investing
ly 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.”
Opinions and estimates contained in this article are subject to change without notice, as are statements of financial market trends,
which are based on current market conditions. This article originally appeared in the March 2016 issue of Financial Advisor Magazine.
All rights reserved. Charter Financial Publishing Network, Inc.