The rising Tiger

RYAN  By Guest Blogger Ryan Lewenza

Last week my colleague Doug outlined how China is going through transformative change like mass urbanization and rising consumerism, which is helping to reshape their economy from a largely agrarian society to an industrial powerhouse. He also mentioned my nonexistent Porsche, but that’s a topic for another day. This week I expand on the China topic, focusing on China’s economic outlook and investment implications.

Anyone who has basic knowledge of China’s economy and has not lived under a rock for the last decade knows that China’s GDP statistics are about as reliable as Kathleen Wynne’s strategies on addressing Ontario’s soaring hydro costs. Even China’s Premier Li Keqiang doesn’t believe in their GDP statistics as he was once quoted as saying the GDP figures are “man-made” and “for reference only”. These comments were made at a private dinner and came from a leaked memo via WikiLeaks.

So with this understanding one must look at alternative economic indicators in trying to assess China’s economic trajectory. For that I focus on three key economic indicators which are less susceptible to government manipulation. They include: 1) the Caixin Manufacturing PMI; 2) electricity consumption; and 3) freight traffic volume.

The Caixin PMI is an independent survey of 420 different manufacturing companies in China and it currently sits at 51.2 which is above the important 50 level indicating expansion in the manufacturing sector and is near its highest level since 2014. With manufacturing representing 40% of China’s economy, an improving manufacturing PMI suggests stronger economic activity from the world’s second largest economy.

China’s Manufacturing Sector Is Rebounding

Source: Bloomberg, Turner Investments

Similarly, China is experiencing a significant uptick in electricity consumption and freight traffic, further evidence of economic acceleration. On a Y/Y basis electricity consumption is up 17% and freight traffic volume is up 15%. Following a slowdown in early 2016, China’s economy is clearly on an upswing which bodes well for the global economy.

China’s Electricity Consumption is Up 17% Y/Y

Source: Bloomberg, Turner Investments
China’s Freight Traffic is Up 15% Y/Y

Source: Bloomberg, Turner Investments

Moving from the economy to China’s stock market, there are a few important bullish supports for Chinese equities. First, Chinese stocks are attractively valued when compared to global equity markets. For example, currently the MSCI China Index trades at 15x earnings versus the MSCI US Index at 22x, resulting in a P/E discount of 7 points. Now Chinese stocks should trade at a lower multiple compared to the US given the strong rule of law in the US, more mature financial markets, lower corruption, and the plethora of great US companies like Apple, Google, and Tesla to name a few. Despite this we see Chinese stocks as attractively valued which is one bullish argument for having some exposure.

The second support for Chinese stocks is the bullish technical trends for the region. Currently the Shanghai Index is trading in a solid uptrend and above its rising 50- and 200-day moving averages.

So with an accelerating economy, strong technical trends, and attractive valuations this is generally a good investment combination, and why we recommend our clients have some exposure to the region.

Chinese Stocks Trade At a Discount to US

Source: Bloomberg, Turner Investments

Now it’s not all roses for China’s economy and their equity markets. Corruption and poor environmental conditions continue to dog the region but our biggest concern remains China’s high and rising corporate debt load. China has been on a spending binge over the last decade as they modernize their cities by investing in critical infrastructure projects like roads, airports, and railways. Many of the projects were sound and necessary to bring China’s economy into the 21st century, however, some of the infrastructure projects are likely to prove excessive and fail to deliver much economic value. Case in point is China’s “ghost cities” which are dozens of newly built cities housing 1 million+ people that remain largely vacant. They were built in anticipation of people moving from rural communities to cities, however it is very likely that they overbuilt resulting in the high vacancy rates and likely future bad loans. I believe that some developers and banks may end up going under as a result of these questionable projects and that this could have economic consequences down the road.

Despite this longer-term risk, we still view China as a good area to invest in which we access through broad-based emerging markets ETFs. Currently we hold a 4% weight to emerging markets in client portfolios with the potential to increase the weight further. For this we would like to see a weaker US dollar (emerging markets have a high negative correlation to the US dollar) and continued improving technical trends.

With the huge gains made in developed markets like the US since the financial crisis, we believe investors should increasingly look to the emerging markets. In my view, the rising tiger that is China still has many years of strong economic growth ahead, which investors should look to capitalize on.

Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.