Beware China's slowing economy | Capital Group Canada | Insights

Insights

ARTICLES  |  MARCH 2019

Beware China's slowing economy

Featuring
Stephen Green, economist

China's economy will likely continue slowing over the next few years as government stimulus measures fall short of market expectations.


Key Takeaways

  • China's economic growth rate has declined to a nearly 30-year low.
  • The U.S.-China trade dispute has hurt import/export activities in both countries.
  • Despite these headwinds, select companies should continue to thrive as consumption grows in the world’s most populous country.

 

The outlook for China’s economy in 2019 and beyond hinges on two crucial questions: Will Beijing unleash a new stimulus program to help counteract a clear deceleration trend? And, if so, will it be large enough to make a difference?

So far, equity markets are taking a positive view. Chinese stocks rallied nearly 15% during the first two months of the year, as measured by the MSCI China Investable Market Index. After a dismal 2018, investors appear to be hopeful for an economic rebound, coupled with a near-term agreement to avoid a full-blown U.S.-China trade war.

We may indeed see a trade agreement soon, but in my view, China’s economy will continue to weaken as stimulus measures fall short of market expectations and China’s traditional investment-led recoveries of the past fail to materialize. Yes, I’m saying it will be different this time.

chart-china-pmi-gdp-916x476

Simply put, this cycle is unique in the decades-long history of China’s remarkable economic rise. Major segments of the economy are slowing in a coordinated fashion — housing, exports, manufacturing, consumer spending and business confidence alike. A bit more spending on railways isn’t going to reverse that momentum. It will take time for this cycle to play out.

Taking a step back and looking at the big picture, China’s growth rate is slowing because of major long-term trends in the economy, such as a declining workforce and lower productivity growth. This is the inevitable maturing process that occurs when an “emerging market” essentially outgrows that label. Add to that more cyclical factors — such as the government’s deleveraging efforts with State-Owned Enterprises (SOEs), a crackdown on the shadow banking system, and attempts to cool the housing market — and all of it puts a crimp on short-term growth.

Stimulus minimus

Moreover, there appears to be no desire in Beijing to replicate the massive government stimulus measures launched in 2015–16, which boosted the economy and sent Chinese stocks soaring in 2017. The worry today is that another huge stimulus injection would cause the housing market to further skyrocket into bubble territory and exacerbate China’s daunting debt challenge. We’ve already seen a small stimulus package — in the form of minor tax cuts and lower reserve requirements for banks — but it’s not enough to move the needle significantly.

One key economic metric that I follow closely is the rate of credit growth, as it tends to be a reliable leading indicator. Year-over-year growth in credit, the lifeblood of any economy, has been experiencing a powerful downward trend since 2010. My estimate shows it moving up a bit in 2019 but, again, not enough to drastically change the slowing pace of China’s GDP growth.

chart-china-credit-growth-916x476

GDP growth estimate

Keep in mind, China’s economy — according to official government numbers — is still growing at an annual pace of 6.6%. That is a far cry, however, from the double-digit growth of a decade ago. (I am not going to delve into the reliability of the government’s economic statistics. Let’s just say, from here on, these are my own estimates.) In my view, China’s GDP growth will decline further in the years ahead, based on one of two scenarios outlined below.

For the record, my growth estimates were more optimistic a few years ago, based on a series of market reforms promised by government leaders, including reducing the dominant role of SOEs and fostering greater entrepreneurship in the private sector. Unfortunately, even though the government repeated these goals earlier this week, progress on these and other reforms have been largely disappointing.

Scenario #1: Reform restarts

China’s economic growth will slow to roughly 5% on average over the next five to six years, assuming at least some level of significant progress is made on the reform front. This reform-based scenario could benefit from a favourable compromise in U.S.-China trade negotiations, since it might give officials the opening they need to push through more aggressive market-oriented measures.

Scenario #2: Little reform

In this scenario, growth slows to 3%, in my view, principally due to negative overall productivity growth. Essentially, the productivity gains generated by innovative technology companies such as Alibaba and Tencent would be erased by loss-making SOEs and other government-oriented vehicles.

A mix of these two scenarios over the next few years is likely, in my view. Facing cyclical downturns, Beijing will try to do a bit more reform but will likely pull back from the most important steps. An average real growth rate of 4% through 2025 wouldn’t surprise me.

A continuing trade battle with the U.S. could hurt. We’ve already seen a significant dip in Chinese trade during the latter half of 2018, although the numbers have bounced back a bit early this year. The hit to confidence among the Chinese private sector has far outweighed the tariffs themselves. The U.S. also has suffered billions in lost trade and higher prices for its consumers. So both parties have a big incentive to at least reach a near-term deal that reduces existing tariffs and perhaps opens up additional limited trade opportunities on both sides of the Pacific. We may find out as early as this week.

chart-china-trade-growth-916x476

Stock selection is key

Although China's slowing growth reduces the effect of a macroeconomic tailwind, it does not diminish investment opportunities that may be identified through bottom-up, fundamental, company-by-company research. Investors with a cautious and selective approach may find compelling opportunities among secular growth companies inside China, as well as multinationals that do business in China, such as Apple, Nike and Starbucks.

Select opportunities may be found among domestic and foreign companies that offer financial and travel services to China’s growing middle class, or innovative technology firms that design and manufacture semiconductor components for mobile devices and industrial automation.

In the fourth quarter, a number of American multinational companies warned of slowing revenue growth from China, and those reports contributed to a sharp selloff in global markets. That is something to keep in mind, but so are the long-term prospects for selling smartphones, tennis shoes and coffee in the world’s most populous country.

Among China-based publicly traded companies, aggregate valuations are certainly more attractive today than they were in 2017. Investors may also want to consider the implications if China further opens up to foreign companies as part of any future trade agreements.

In addition, China’s Stock Connect program has made it easier in recent years for international investors to buy into domestic A-share companies. Chinese software firms, for instance, are beginning to gain traction in the domestic market, and the fight is on to provide cloud-based services. A U.S.-China trade agreement might also boost protections for intellectual property, which would benefit the strongest domestic firms in this sector, as well as multinationals operating in China.

As always, selectivity and deep research are the keys to identifying these opportunities, especially against a challenging economic backdrop.

 

About

 

Stephen Green
Economist

Stephen Green is an economist with 14 years of investment industry experience, four at Capital Group. Previously, he was head of economic research for Greater China at Standard Chartered Bank. He holds a PhD in government from the London School of Economics and a degree in social and political sciences from Cambridge. He is based in Hong Kong.


Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

Unless otherwise indicated, the investment professionals featured do not manage Capital Group‘s Canadian mutual funds.

References to particular companies or securities, if any, are included for informational or illustrative purposes only and should not be considered as an endorsement by Capital Group. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds or current holdings of any investment funds. These views should not be considered as investment advice nor should they be considered a recommendation to buy or sell.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and not be comprehensive or to provide advice. For informational purposes only; not intended to provide tax, legal or financial advice. We assume no liability for any inaccurate, delayed or incomplete information, nor for any actions taken in reliance thereon. The information contained herein has been supplied without verification by us and may be subject to change. Capital Group funds are available in Canada through registered dealers. For more information, please consult your financial and tax advisors for your individual situation.

Forward-looking statements are not guarantees of future performance, and actual events and results could differ materially from those expressed or implied in any forward-looking statements made herein. We encourage you to consider these and other factors carefully before making any investment decisions and we urge you to avoid placing undue reliance on forward-looking statements.

The S&P 500 Composite Index (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright © 2019 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC.

Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, "Bloomberg"). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, "Barclays"), used under licence. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

MSCI does not approve, review or produce reports published on this site, makes no express or implied warranties or representations and is not liable whatsoever for any data represented. You may not redistribute MSCI data or use it as a basis for other indices or investment products.

Capital believes the software and information from FactSet to be reliable. However, Capital cannot be responsible for inaccuracies, incomplete information or updating of the information furnished by FactSet. The information provided in this report is meant to give you an approximate account of the fund/manager's characteristics for the specified date. This information is not indicative of future Capital investment decisions and is not used as part of our investment decision-making process.

Indices are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

All Capital Group trademarks are owned by The Capital Group Companies, Inc. or an affiliated company in Canada, the U.S. and other countries. All other company names mentioned are the property of their respective companies.

Capital Group funds and Capital International Asset Management (Canada), Inc. are part of Capital Group, a global investment management firm originating in Los Angeles, California in 1931. The Capital Group companies manage equity assets through three investment groups. These groups make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organization; however, for securities with equity characteristics, they act solely on behalf of one of the three equity investment groups.

The Capital Group funds offered on this website are available only to Canadian residents.


Related Insights