November 19, 2012
|Mark Edwards, portfolio manager of the T. Rowe Price Global Emerging Markets Equity Strategy.|
Many analysts have warned of a "hard landing" in China for over a year, but recent headlines have turned more negative as evidence grows that China's economy is rapidly slowing. Predictions range from a mild downturn to system-wide collapse for the world's second-largest economy. While we don't agree with the most bearish forecasts, uncertainty about the economy is a key reason why Chinese stocks have trailed the broader MSCI Emerging Markets Index for the past three years.
The current slowdown comes as no surprise to us. China's leaders have long signaled their intention to rebalance the drivers of the economy as it seeks slower yet more sustainable growth. Restructuring China's economy is a complex and challenging task. However, we believe China has many policy options to counter a severe downturn. And after tightening credit to fight inflation for most of 2011, China has started to gradually relax some policies, which should lead to a more stable economy going forward.
The following points reflect the views of Mark Edwards, portfolio manager of the T. Rowe Price Global Emerging Markets Equity Strategy, as of October 22, 2012.
Growing debt. Signs of weakness in China's economy emerged in the spring of 2011 as the impact of a huge stimulus program announced in late 2008 began to fade. The program helped China skirt the global recession, but much of the spending and lending wound up in unprofitable ventures financed by local governments. As a result, China's total debt to gross domestic product (GDP) has climbed to about 160%—high by emerging markets standards.
In addition, Chinese banks tightened lending criteria in 2011, leading many individuals and small businesses to seek out informal and more expensive kinds of financing. Because a significant portion of the funds used in this kind of financing is facilitated by banks, the informal lending surge has raised worries that bankruptcies in the private sector could have ripple effects that affect the formal banking system.
- We believe that nonperforming loans do not pose a systemic risk to the entire financial system, although we expect that nonperforming loans in China will increase and weigh on banks' profits.
- China's banks are very well capitalized. And because the government controls the banking system, it can force banks to roll over debt and spread the pain over a number of years.
- However, uncertainty about the size of banks' nonperforming loans and their impact on earnings may weigh on bank stocks in the near term (commercial banks accounted for 25% of the MSCI China Index as of September 30, 2012).
A deflating real estate market. After years of bubbly growth, property prices in major Chinese cities have cooled since last spring. News about China's real estate slowdown has drawn comparisons to real estate bubbles in the U.S., raising fears that China is headed for a housing crash.
- We would note that China's softer real estate market is due to the success of government measures to make housing more affordable by cracking down on real estate speculation. Most news has focused on excess investment in high-end property in Beijing and Shanghai, but demand remains strong, and affordability is more reasonable elsewhere in the country.
- Unlike in the U.S. and Europe, buying property in China requires large deposits, and many transactions are done in cash. Average loan-to-value ratios are fairly low. Prices have fallen significantly this year, but we don't see a rebound in real estate prices anytime soon as government policy will keep prices down in the near term.
- One outcome of the government's measures is that new construction activity has slowed significantly from a year ago. Since construction accounted for as much as 12% of China's GDP growth last year according to some estimates, the building slowdown will inevitably weigh on the economy.
The weak global economy. Sluggish overseas demand has hurt China's vaunted export sector. Recent indicators show that China's export growth has slowed significantly from a year ago, reflecting the eurozone crisis and muted U.S. recovery.
- Unlike the 2008-2009 downturn, weak export growth has not translated into rising unemployment. We continue to closely monitor the health of China's export sector, whose contribution to overall GDP has declined recently but remains a critical employer.
- Over time, China aims to increase the "value add" of its export sector by moving up the value chain and improving productivity gains.
Corporate earnings risk. Most analysts believe Chinese companies in aggregate will show little earnings growth in 2012 as consensus expectations have been ratcheted down. Earnings for economically sensitive sectors such as consumer discretionary, materials, and industrials are expected to decline this year.
- We believe current stock prices largely reflect China's weaker near-term outlook, particularly stocks in consumer-driven sectors. However, we believe the outlook remains challenging for other sectors such as steel and banks.
Political change. China installs a new generation of leaders every 10 years. The next leadership transition, set to begin on November 8, 2012, has been upset by a string of scandals culminating in the arrest on corruption charges of Bo Xilai, a high-level official who was once tipped to become a member of the Politburo Standing Committee, China's most powerful body.
Uncertainty about the new leadership lineup, their ability to manage the economy, and the potential for policy drift until they are installed has, until recently, hurt investor sentiment. However, most analysts believe the new leaders will continue to follow the economic goals set out in the 12th Five-Year Plan, released in March 2011, which provides a road map for economic policy issued by China's highest leadership.
Recognize the near-term risks but maintain a positive long-term outlook
- China's economy still appears strong by many measures. According to the government, its foreign exchange reserves are over $3 trillion, the largest of any country. It has a current account surplus, and its 2012 budget deficit is forecast to be just 2.5% of GDP. Despite the slowdown, GDP growth is expected to exceed 7% this year.
- All of this gives China plenty of flexibility to provide more economic stimulus if needed.
Realize that China's slowdown is intentional and will occur over a long time.
- After 30 years of rapid growth, China is transitioning from an export- and investment-led economy to one driven by domestic consumption. We expect this transition will happen gradually over many years.
- Fixed-asset investment, which includes spending on real estate, factories, and infrastructure, fueled much of the growth in the past decade. But in the coming years, we believe the economic emphasis will shift to more sophisticated manufacturing and technology and toward greater domestic consumption of goods and services.
- Companies that are driven by such consumption, which remains resilient due to hefty wage increases this year, appear attractive. Other sectors that we believe offer good growth potential include discretionary retail, consumer staples, Internet-related services, financial services, health care, and technology.
- China's domestic stock market performance has been disappointing over the past few years. However, we believe it has generated excellent opportunities to increase returns through individual stock selection. We expect this to remain the case in the coming years.