The China Saga: Short-term risks versus Long-Term Payoffs
Investing indirectly in China, rather than acquiring Chinese equities, may be the way to go – at least for those investors with a longer time horizon.
For most of the last decade, investors’ eyes have been fixed firmly on China. Spoken or unspoken, the belief of many pundits was that during any future economic crisis, the fundamentals driving Chinese growth – the surge in productivity, the GDP growth, the emergence of a real middle class – would remain largely intact, and investors would find that maintaining an allocation to China, or to themes tied to Chinese growth, would be one way to ride out turbulence in other parts of the global financial markets.
Of course, as recent events have shown, it hasn’t worked out quite that tidily. It has proved impossible for China to shield itself entirely from the turmoil in Europe, since about 20% of its exports are bound for European markets. Another 20% are destined for the United States and while the US economy is growing, it is doing so at a more sluggish rate than first thought and without generating as many new jobs as had been expected. China simply can’t insulate itself from those trends. The country’s retail sales rose at their slowest pace in more than a year in May; investment in fixed assets in the first five months of 2012 is the lowest China has recorded in nearly a decade. No wonder that strategists and economists are paring their estimates for the country’s economic growth to below 8% for 2012, with the current second quarter likely to prove the weakest period of all. Some government sources quoted in this recent Reuters article suggest that second quarter GDP growth could drop below an annual rate of 7%.
The uncertainty surrounding China’s economy already is taking a toll on sectors that once boomed because of the country’s turbo-charged growth. This has been seen most dramatically in the commodities markets, where once-insatiable Chinese demand for copper and other key industrial commodities has fallen sharply. While imports of oil and copper did rise sharply last month, analysts warned against reading too much into this data and suggested that many of these shipments were destined for storage facilities, as demand shows signs of remaining muted. The general bearishness has weighed on commodities prices and on materials stocks generally, as can be seen clearly in the chart below.
Chinese policymakers are doing whatever they can to ensure that the country’s economy doesn’t suffer a hard landing, including a surprise cut in interest rates late last week. The government also pledged that it would put major infrastructure projects on a fast track, offering some hope that the demand for commodities will climb somewhat later this year.
Investing in luxury retail goods stocks – at the opposite end of the spectrum from commodities – has also been a popular way for investors to play the China theme over the last decade, especially among those who wanted a less volatile and more indirect route to profiting from Chinese growth than by investing in Chinese stocks themselves. As the level of affluence in China has soared over that period, with more new millionaires minted each year than in any other nation, demand for trendy cellphones, clothing, handbags and even luxury cars (Beijing’s Rolls Royce dealership has been among the company’s busiest worldwide) has soared. The rate at which luxury goods stocks have outperformed the broader market has reflected that, and while the spread between returns on those stocks and the broader market has contracted slightly of late, the trend remains intact. Meanwhile, new purveyors of upmarket goods are looking for ways to move into the Chinese market: American designer Nanette Lepore, who still makes the vast majority of her women’s wear in the United States, plans to open boutiques in major Chinese cities soon.
That relative resilience on the part of luxury goods stocks is one reminder that there is still a case to be made for outperformance on the part of China on a long-term basis. True, as we have reported, there are reasons to be wary of Chinese stocks; the StarMine Predicted Surprise for Chinese equities (the percentage point spread between analysts’ consensus forecasts and the StarMine SmartEstimate predictions, which puts a greater emphasis on the most recent forecasts by the highest-ranked analysts) stands at a worrying -2.0%, a signal that analysts remain too bullish on the growth prospects for earnings at most Chinese companies.
Still, it may continue to make sense to look for indirect ways to maintain exposure to China. In contrast to the developed markets in North America and Europe, China has both monetary and fiscal firepower at its disposal to stimulate its economy, if policymakers choose to pursue that option. Certainly, the country’s move last week toward interest rate liberalization – China’s banks now can offer loans at rates as much as 20% below the key lending rate, double the previous maximum discount, while lenders will be permitted to offer depositors rates up to 10% higher than the benchmark – are a sign of that flexibility. Assuming that luxury goods stocks offer no company-specific signs of stress, that sector may be a good long-term call option on the long-term growth prospects for Chinese prosperity, particularly since the group isn’t completely dependent on China.
Whenever European policymakers find a way to contain the crisis in the eurozone, it could well be China’s economy – still one of the world’s most resilient as well as one of its largest – that pops back to life most rapidly. Looking for indirect ways to play that secular trend would certainly be more productive than standing by and worrying over what will happen in the shorter term.
Learn more about how Datastream can help you better analyze macro data and quickly identify data trends and relationships.
Request a free trial today.