Improving China is good news for shares

By Patrick Ho, AMP Capital China Growth Fund

A year ago, investors were sceptical of the outlook for China. Words such as "hard landing" and "stalled growth" were commonly used in discussions about the Chinese economy, and concerns of an economic slowdown were overwhelming.

Many economists around the globe focused on the negative headwinds China was facing - a bursting property market bubble, massive factory closures due to abating overseas exports and the rapid formation of non-performing loans in the Chinese banking system. So where are we now?

Looking back, some of these concerns now seem overdone. As it turned out, the world's second-largest economy continued its expansion in 2012, albeit at a slower pace than during the high-growth years.

Chinese share markets delivered investment returns at the upper limit of investors' initial expectations. Chinese companies listed in Hong Kong returned an average of 18.50 per cent in 2012 (HSCEI Index, Hang Seng China Enterprises Index in Australian dollar terms) and the domestic China A share market also reversed two consecutive years in the red to return 9.29 per cent in 2012 (S&P/CITIC 300 Index in Australian dollar terms).

Outlook for 2013

To understand the outlook for China in 2013, it's important to consider what happened on the government policy front in 2012. The most eye-catching event was the National Party Congress in November. The new standing committee was formed, with new faces to steer the national policy in the coming five to 10 years. During Congress, there was considerable debate about possible tensions between reform-oriented and conservative leaders, which in turn created some conflict and market volatility.

However, there might be too much debate on such tensions without any tangible evidence that the key players will struggle to work together. What is important is that China needs to find a way to maintain a sustainable growth model, regardless of who is driving the change. The previous strong growth phase came with some imbalances, such as the widening gap between the rich and poor and increased pollution. These, among others things, need to be addressed if China is to continue to enjoy strong economic growth.

After the Chinese economy experienced a modest slowdown in the third quarter of 2012, signs of stabilisation in economic conditions became more evident in the final quarter of the year. After a low in real GDP growth of 7.4 per cent year on year in the third quarter, encouraging signs began to emerge that the economy was responding more positively to the government's monetary and fiscal policy stimulus than earlier in the year. Inflation continued to soften against the yearly average and such favourable conditions point to less need for further monetary and fiscal policy tightening in the near term.

China share markets recovering

There is emerging consensus that China's share market is moving into a recovery phase. Market stabilisation has been largely attributed to the recent strength in fixed-asset investments in infrastructure, with the government speeding up project approvals and addressing financing bottlenecks.

It is encouraging to see the gradual recovery in the Chinese economy's growth rate. However, it's worth noting that the country's growth rate entering 2013 will still be below the 10 per cent average growth during the boom period.

China cannot be complacent about its past achievements. In years to come, there are accumulating issues, such as the widening gap between rich and poor, which could potentially lead to social instability if policy does not address these problems effectively. As a result, the market's reaction to the good economic news is expected to be moderate.

Given the improved macroeconomic outlook, the current attractive valuation of Chinese companies (forward price earnings (PE) multiple of HSCEI and Shanghai A are both at around 10 times) is a good catalyst for attracting new flows into the markets.

However, we still need to see one more driving factor to turn the key - improved earnings. The market consensus for earnings for Chinese companies has continually been adjusted downwards since October 2011. Earnings have been revised downwards by around 20 per cent over the past 12-14 months, though it appears earnings numbers are beginning to stabilise. A continued improvement in corporate earnings in the coming months should not only fuel the equity market but also spark the next private-sector investment cycle and continue to drive Chinese economic growth.

What it means for Australian investors

All in all, we have a positive outlook for China in 2013. But what does this mean for Australian investors and how can you benefit from China's growth?

In the recent past, Australian investors have been able to access China's growth through Australian resource companies, but this approach may not be as beneficial in the next phase of Chinese growth.

In 2012, China was Australia's largest two-way trade partner (A$121.1 billion), with iron ore and coal the two key items exported to China. As a result, it is not surprising that Australia gets excited when Chinese economic growth resumes a stable path. The recent iron ore price rebound from the September 2012 trough was a clear indicator that the market is foreseeing a better outlook for China's economy.

However, it's worth noting that the strong relationship between rising resource prices and an improving Chinese economy that was observed in the past may not always be the case in the future. For example, China's annual steel demand has grown nearly 15 per cent a year in the last 12 years, outpacing nominal GDP growth. But the last decade was a peak infrastructure spending period in China, and Chinese steel production could see a slower growth phase ahead. Chinese steel output is already nearly 50 per cent of total world production. Even if it resumes its previous growth pace, the way China will consume steel will be quite different from the previous cycle. As a result, simply assuming the demand for iron ore from China will pick up might be presumptuous.

Consumption-driven China

The Chinese economy is set to enter a more consumption-driven model facilitated by accelerated urbanisation, enhanced social welfare and fast changes in lifestyle. The shift from the consumption of basic necessities to discretionary products and services has sparked another round of growth in China. This is definitely different from the good old days for Australian investors when consumption of coal (for electricity) and steel (for infrastructure and property) fuelled demand for Australian resources. And yet, the new phase of consumption-driven Chinese growth could offer Australian investors a diversified investment with an attractive upside.

There is currently a low correlation (the strength of the relationship) between Australian and Chinese shares, which could offer investors great diversification opportunities. The correlation between Australian and global shares over the past three years was 0.88. The correlation between Australian equities and the S&P/CITIC 300 Index (local China A share index) was only 0.58.

Exposure to China A shares would therefore offer Australian investors a great way to diversify their portfolio and capture the potential benefits of China's next growth phase.

About the author

By Patrick Ho is fund manager of the AMP Capital China Growth Fund (listed on the ASX as AGF).

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