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Mid-Year Outlook 2017 | Looking East



Our Mid Year Outlook investigates the myriad opportunities and challenges facing China today

The backdrop to this edition of Outlook is a political environment still capable of springing surprises. Last year we had the UK’s vote to leave the EU, then the election of Trump. 2017 has seen the youngest ever President of France come to power, when his year-old party, En Marche, swept up a massive parliamentary majority. 

And Theresa May’s call for a snap election to provide a ‘strong and stable’ negotiating force for the UK has resulted in a hung Parliament and yet more political uncertainty. In honour of Macron’s victory we recall the phrase ‘plus ça change, plus c’est la même chose’. The more things change, the more they stay the same.

However exciting or concerning these events may appear, investors have become accustomed to change. Volatility in markets has been much lower than it has been historically. There are some technical reasons for this. Principally, however, shareholders are reassured that companies are delivering earnings growth amidst a backdrop of a stable global economic environment, and that generally speaking equities are better value than fixed income for the long term investor.

Our investment philosophy remains consistent – trying to find good assets at reasonable valuations. Uncertainties do abound – particularly political. It would seem foolhardy to predict the length of the Trump presidency and if and when the promised infrastructure spending and corporate tax reductions come to pass. The Brexit negotiations are also unpredictable, with a wide range of possible outcomes given the initial posturing by both sides. Whether hard or soft, or somewhere in between, the negotiations of a weakened UK Government will undoubtedly have dramatic twists and turns. However, life will still go on.

Our Mid-Year Outlook heads East to explore the myriad opportunities and complexities of China. It is a sign of our ever-changing world that the Middle Kingdom seems for now more predictable than the democratically-led political change we see in the West.

We hope you enjoy it. 


Dickson Anderson

Head Of Investment

  • 01

    Welcome Aboard The Express Train

    The Chinese call their state the ‘Middle Kingdom’. This concept goes back to centuries ago when China truly was at the centre of the world – economically, culturally and scientifically. On the evidence of the past 30 years of progress, they will soon resume this role.

    Having slipped to below 2% of the world economy in 1987, China has gone through an astonishing transformation in the past 30 years, unparalleled in history for its size and speed. It is now the world’s second largest economy, representing 15% of global GDP. Continued prosperity is crucial to the current and future profits of many western businesses, from Scotch whisky to Swiss watches, Roll-Royce jet engines to BMW cars.

    How did they get here and what issues lie ahead? The father of the modern Chinese economy is Deng Xiaoping. Deng’s ideas sparked a period of dramatic modernisation and economic growth in the 1980s. In the thirty years since then, GDP rose from $300 per capita to $8000. This quantum of growth took 150 years for western economies to achieve in their industrial revolutions.

    China invested vast sums into improving agriculture, industry and technology which saw them outspend western economies by a factor of three on infrastructure projects. Productivity soared as rural residents moved to megacities such as Shanghai, Beijing and Guangzhou to work in factories and offices. And finally, in 2001, they joined the World Trade Organisation, allowing them to sell their manufactured goods across the world.

    This ushered in an era that some economists call ‘Chimerica’. Americans bought Chinese goods with dollars and China then recycled these trillions of dollars into US Government bonds and dollar assets, which kept interest rates in the US low and allowed consumers there to keep spending. 

    “China has gone through an astonishing transformation, unparalleled in history for its size and speed”

    The model is now changing. Issues are emerging that mean the trajectory of growth in the future will not be so dramatic. The challenges include the effects on demographics of an ageing population, high levels of debt and a developing threat to free trade from the West, as we digest Trump’s rhetoric and the UK’s vote to leave the EU.

    The One Child Policy, in place from 1979 to 2015, has serious ramifications. The working age population has peaked and will start to decline over the next couple of years. 

    The megacities in the east are now so expensive that few in outside areas can afford to move there – or want to, given the pollution. And their success has seen wages grow to the point they are relative to other Emerging Markets, an expensive place to make things.

    One solution to this is to move into more advanced manufacturing, and you can see this move up the value chain in the plans to build nuclear power stations overseas, including in the UK, and the development of a passenger jet, the Comac C919. To accelerate this further, we are seeing Chinese companies taking over western ones to access technology, such as Syngenta, the Swiss agricultural chemical company. And Chinese tech companies are rapidly emerging as winners in the age of the smartphone.

    Another is the ‘One Belt, One Road’ project in which it is using massive infrastructure investment in sea and airports, roads and energy pipeline to open up new trades routes to Europe, Asia and Africa, and to help redistribute wealth within China towards western provinces. 

    Much of the growth is financed with debt. The picture is not so bad when you simply look at the government or personal debt levels. However, company debt is now reaching worrying levels, comparable with the situations we saw in Japan and Spain just before their financial crises.  Some economists are relaxed about this – as long as growth remains high and interest rates low, the debt is affordable, the government has trillions of dollars in reserves and other assets; however many suggest that if growth were to stumble, China would find it hard to recover quickly especially as several industries have too much capacity already. 

    The election of Donald Trump and the growth of populism in the West is also a concern. On the campaign trail, Trump threatened to punish China with import taxes and other restrictions on trade as he painted it as “stealing American jobs”. In office, especially after meeting Chinese President Xi in April, Trump’s rhetoric has been far more muted (“we’ve developed a friendship”) but there is no doubt that any push back on free trade and globalisation is a threat to the future ambitions of China, as are problems with North Korea.

    Xi should be reselected as President and head of the Chinese Communist Party this autumn, starting the next 5 year political and economic planning cycle. Is it inevitable that this political system will change as wealth grows and the country opens up? No. The Chinese have a different view of the state to westerners, a view formed from a completely separate history, culture and philosophies to those that shaped the West in the past 500 years. Proponents of democracy such as Rousseau, Hobbes, Washington and Pankhurst are not widely celebrated in the Middle Kingdom.

    China is already the second largest economy in the world, and a hugely important source of demand for the West. Whilst challenges abound, it’s important to remember that on a GDP per capita basis China is far behind, having not yet hit the top 50 of countries worldwide. There is plenty to go for.

  • 02

    Demographic Dilemma

    China introduced the One Child Policy owing to fears that the surging population would result in social, economic and environmental problems for the country. It created the 4-2-1 phenomenon where four grandparents and two parents support one child through education, marriage, home buying and so on. This has been good for consumption, especially housing. The reversal of the policy in 2016 was in response to different fears – that curtailing the population would soon weigh on growth.

    China will age quicker than any other country apart from Japan. The Dependency Ratio – the proportion of the population that does not work – is anticipated to hit 44% by 2050, with 330 million Chinese people in retirement. Older people spend less, and healthcare costs will surge. In short, the One Child could find themselves supporting their parents and grandparents.

    Furthermore, the working population will soon peak so the days of easy economic growth as a result of moving millions from farming to work in factories and offices may be drawing to a close, hence new ideas such as the Belt & Road Initiative.

    Despite the end of the One Child Policy, the idea of having small families now seems embedded in the culture and there has been as yet no sign of a pick up in the birth rate. Even if there were, it would be a generation before this could boost the economy. 

  • 03

    One Belt One Road - Make China Great Again

    The ancient Silk Roads connected Asia and Europe, enabling the transport of exotic fabrics, spices and horses (and the Black Death!) from the East. Chinese President Xi Jinping now wants to create modern infrastructure along these same lines. ‘One Belt, One Road’ is one of the biggest global economic drivers of the next ten years. Having set up the Asian Infrastructure Investment Bank with $100bn of funding to start the process, China now wishes to take a direct lead in improving Asian infrastructure by creating a road and rail ‘Belt’ and a maritime ‘Road’ from east to west.

    The massive series of projects seeks to build roads, air and sea ports, high speed rail networks and energy pipelines across 68 countries representing 60% of global GDP, at a cost of several trillions of dollars.

    There are many reasons for this initiative. From a Chinese perspective, it is about China and its future growth. One lesson they drew from the crisis in 2008, when trade collapsed, is that they could not rely on western consumers and dollar funding forever – they were going to need to cultivate new markets and internationalise the renminbi.

    The ability to send their goods to new markets and source raw materials such as oil, gas and metals into China should help maintain economic growth levels as well as re-balancing the Chinese economy away from the wealthy eastern port cities to far less developed regions in the centre and west. It gives them new markets for their concrete and steel. And finally it will allow them to move up the value chain in manufacturing as they will be running complex projects, such as building nuclear power stations and high speed rail networks.

    There is surely an element of ‘soft power’ as well. From an economy on the margins of the world 40 years ago to the world’s largest trading nation now and soon the largest economy, Xi believes China must now start to look outwards and face the world with confidence. We live in strange times indeed when the leader of the Chinese Communist Party is the world’s foremost advocate of free trade.

  • 04

    Land Of The Super Apps

    PCs, DVDs and JPEGs – the technology industry loves acronyms. In the stock market, FANG – short for Facebook, Amazon, Netflix and Google – has become shorthand for the modern internet in the West, disrupting and decimating traditional industries as they develop.

    The internet in China is more like an intranet, with the authorities blocking any sites they dislike, known in the West as ‘The Great Firewall of China’. As a result, they have developed their own versions of these known as ‘BAT’ – Baidu, Alibaba, Tencent.

    Initially they were copies of the FANGs; however they now offer something different. If you want to know how our internet might work in the future, look to China.

    “The concentration of highly personal data in the hands of a few companies and governments is an issue everywhere.”

    The most successful is the WeChat app developed by Tencent and now with 937m monthly users*. This is a Swiss Army Knife of an app, allowing users everything you would expect – messaging, reviewing, buying, dating, gaming – as well as things you wouldn’t. You can see the menu, book a table and order before you arrive at your restaurant of choice. Hospital booking systems run through WeChat. Heatmaps help people avoid congested areas. All these things are on one single super app making it hugely convenient for consumers and service providers.

    The downside of this may be the enormous quantity of data that Tencent gathers on its users: where you are, who you are with, what you are doing. This is not unique to WeChat. The concentration of highly personal data in the hands of a few companies and governments is an issue everywhere.

  • 05

    Consumption Becoming Conspicuous

    There is already vast wealth in China with nearly 600 dollar billionaires* and around 1.5m people who earn over $500,000. Their spending has driven up the profits of many western companies, especially luxury goods businesses, and in markets like art and fine wines.

    The Chinese white collar middle class number around 150m – half are on the public payroll and most tend to live in the large cities in the east. Although Chinese and other Asian companies are improving the quality of their goods, these people tend to favour western products – such as German cars or Australian baby milk.

    The fastest growing segment is the group of 240m people below this.

    How will the newly wealthy spend their money? The majority of income is spent on food and housing, however discretionary items will jump, in particular areas such as travel, eating out, sport and cinema, as well as western consumer goods.

    You can see the growing influence of Chinese consumers on western companies in everything from car designs to characters and locations in films. The Chinese consumer should increasingly help earnings to grow at our drinks, luxury goods, healthcare, and financial services shares and is one reason we hold these names.

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Key Takeaways

China has grown dramatically in the past 30 years, the nature of the growth is changing but is likely to remain infrastructure led for many years to come. We have little direct exposure to China - we do not own or intend to own Chinese shares directly and most of our collectives are underweight in this region. We do, however, have plenty of indirect exposure - through holdings in Asian Banks, and companies in the healthcare, consumer and commodity sectors. We are mindful of the risks – for example debts are rising and demographics will be challenging

About Adam investments

We offer discretionary investment management to individuals and their families, and to charities. We take a long term approach to investing and we believe this gives us an advantage in a world where markets and media are increasingly focused on short term news.

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