Angus Tulloch, joint managing partner of First State Investments in Edinburgh, is one of the UK’s best known and most experienced Asian investors, having first moved to Hong Kong as long ago as 1981. Debating the outlook for China with Anthony Bolton of Fidelity last week at an event organised by fee-based advisers Saunderson House, he gave his reasons for being cautious about the prospects for China and the rest of the Asia Pacific region. (I was chairing the Q and A session at this debate. You can read a full length interview with Anthony Bolton about China here shortly).
Setting the scene
If any of you be hoping for a confrontational debate, you are likely to go home disappointed, because I am a dyed in the wool Asiaphile! Ever since I moved to Hong Kong in 1981, I have been a passionate advocate of the Asian growth story. I have watched China develop from an iron rice-bowl, inward-looking economy to becoming the undisputed factory of the world. I have witnessed India emerge from the fetters of the licence Raj to produce some of the globe’s most confident, dynamic, effective and internationally aware business leaders around.
Every time I return from a trip to the region, I despair at the way we are living on past glories and on the family silver. The growth pendulum seems to swing ever further in an easterly direction. I certainly do not believe that this good news story is over – for China, India or indeed any other part of Asia. In Vietnam, for instance, it has hardly begun.
However, I see my role today as that of Devil’s Advocate. The best stories usually contain a dark chapter or two. Even where this is not true, a good story – as we all know to our cost – may prove a poor investment. In playing this role, I will first ask the question “Is the Chinese Economy in Trouble?” Secondly, I will highlight some of the political factors that might yet derail progress in the region. These are too often overlooked. Finally I will make a few observations on valuations and other relevant stockmarket inputs.
Is the Chinese economy in trouble?
It is a well known fact that China has embraced stimulative financial and fiscal policies with the same, if not greater, fervour than we have in the West. Fear of unemployment leading to social dissent has always been at the heart of Chinese economic policy.
The Global Financial Crisis struck China with the same collapse of business confidence and paralysis of liquidity as experienced elsewhere. Its Government thus moved rapidly to prevent growth falling off a cliff. Banks were told to lend and this being China, they did (well over one trillion US dollars worth of loans were made in 2009, almost double the figure for 2008). Purchase taxes on cars and household durables were reduced and, together with the banks, the public authorities orchestrated a massive housing construction program. The pace of domestic economic recovery has been truly remarkable.
But, as in the developed world, the jury is still out on the long term success of quantitative easing. China like the West has yet to jump off the treadmill of artificial stimulus. It remains to be seen whether the huge amounts of liquidity that have been injected into the system, will cause speculative bubbles in the real estate and stock markets. Recent evidence suggests that loan growth continues at an unsustainable level, and that residential property prices are still rising too rapidly.
A report issued last year by Pivot Capital Management provides a welcome counterpoise to the usual ‘China is wonderful’ commentary issued by deal-seeking investment banks and we asset gatherers as well. The author points out how much of China’s recent growth has been dependent on capital spending, and on how well developed the country already is in terms of physical infrastructure. He argues that capital spending will fall sharply and that, as consumption growth cannot take up the slack, we should expect much slower rates of growth in the future.
In support of these arguments the report points out that capital spending accounted for over 70% of growth in 2008 and 90% in 2009. The ratio of gross capital formation to GDP is expected to exceed 50% in the current year, a much higher level than ever recorded in the German, Japanese or South Korean development boom periods.
Since the beginning of the decade, domestic credit has expanded at 50% more than GDP. With a credit to GDP ratio of 140%, China is already beyond the levels where credit crises have occurred elsewhere in the past; indeed if loans were to continue growing at their historic rate of 35% per annum, the credit to GDP ratio in China will be close to 200% by the end of 2010 – and that is even assuming 10% economic growth in the current year.
Among other highly relevant points evidenced in the Pivot Report are the following:
• Chinese exports have benefited enormously from the global credit bubble with net exports rising ten times between 2003 and 2008;
• The effectiveness of domestic credit in generating growth in China has collapsed;
• Chinese Government debt is vastly understated (by as much as 40%) as is the degree of the country’s urbanisation (by 20%);
• China has 32% excess capacity in steel and 25% in cement, but already produces more steel and cement per capita than the USA (although China’s GDP per capita is one eighth of the USA’s);
• China has been building 15,000 bridges every year for the last decade and now has more bridges than the USA, though boasting only one fifth of its rivers.
To add to this gloom, I would point out that a number of observers, including the Government and industry participants, are already indicating that they regard the local property market as overheated. Real estate prices have trebled over the last five years. Moreover, we can only expect the USA to become much more aggressive on the dollar/renminbi currency link in this congressional election year.
I certainly do not think that we should assume Chinese growth rates of 10% per annum from now on. A soft landing (6%-8%) would be tolerable and should allow careful stock pickers to produce reasonable returns. A hard landing (under 5%) could give rise to serious social unrest and political turbulence. It is of course impossible now to look at much of Asia, or even the world, separately from China. If China sneezes much of the world, especially commodity producers such as Australia, Brazil and Russia, will catch a cold. In Asia, the Indian sub-continent would be least affected and Hong Kong, Taiwan and Korea the most. Cyclical industries everywhere would suffer.
Will politics become more relevant?
We have become very blasé in Asia, and for that matter, in all emerging countries on the subject of politics. The region has been largely free of major strife for many years now and democracy seems embedded in most countries of the area, albeit in some places more firmly than others, Burma, China, North Korea and Vietnam being the exceptions.
There are, however, a number of geopolitical issues which we should not overlook. Pakistan is far from stable, and the Kashmir issue continues as a running sore between that country and India. With the Himalayan glaciers providing the main water source for almost half of the world’s population, arguments between China, India and South East Asia over river diversions have already begun. There is no sign yet of North Korea wanting to behave as a responsible international citizen. China is inevitably becoming more conscious of its economic power, and is no longer prepared to let ‘Pax Americana’ rule the waves. Problems with minorities such as the Tamils in Sri Lanka, Uighurs in China and Muslim secessionists in the Philippines are unlikely to disappear overnight.
The most likely source of major political difficulty in East Asia over the next decade is Mainland China. I believe that it is only a matter of time before the Communist Party’s hegemony in that country will be challenged – probably at a time when economic progress falters and a leadership contest ensues. This fear is clearly at the forefront of the current leadership’s thinking. Although some progress has been made in terms of elections at local level and also in tackling corruption, there have been no signs under President Hu of a more tolerant approach to political dissidence. Recently, the opposite appears to have been the case.
Very few surrender absolute power voluntarily, and it is hard to see a transfer of power taking place in China without significant accompanying turbulence. Such turmoil preceded the establishment of democracy in both South Korea and Taiwan, and there is no reason that China will be any different. Yet, overlooking the very sad human dimension that such turmoil involves, this transition will provide one of the most exciting buying opportunities of the twenty-first century.
With the benefit of hindsight, one would of course have been much better ignoring this and other latent political issues over the last twenty years. However, I suspect that if we did see an economic slowdown in China, political developments could suddenly have a seriously negative impact on Chinese and most, if not all, regional stock markets. Inflation could well be key here – Tiananmen Square was preceded by a period of rising prices.
Are Asian stockmarkets overpriced?
The brief answer, taking a short view at least, is yes but not ridiculously so. On trailing price to book and price earning ratio terms, the Asia ex Japan Index is priced near the top of normal range but somewhat below its peak. Earnings growth estimates come in at over 20% for 2010 and most observers expect a currency fillip too; but we all know that such projections can prove very mercurial at the best of times. Asian governments are showing very little desire to raise interest rates in the fear of attracting hot currency flows, though both China and India now appear to be trying measures other than interest rates to pre-empt the formation of bubbles. Higher food and raw material prices are already leading to sharp upward revisions of inflation. From the bottom-up, we currently find it particularly difficult to find reasonably-priced companies in China and India; wage pressures and skill-shortages have also recently emerged in both countries.
Fund flows from abroad have been substantial with GEM funds overall taking in four times as much in 2009 as they lost in 2008. GEM markets tend to perform best when the global appetite for risk is increasing; judging by the very low current VIX Index level, and the spreads between GEM and US Treasury debt, it is hard to envisage that this appetite can grow much further. A major short-term concern is the large amount of GEM capital raisings in the wings figures of around US$250m in the region, of which US$150m relates to China, are currently being forecast. Anecdotal evidence of hubris would include large amounts of empty and underutilised commercial property in China, and the Rusal aluminium flotation in Hong Kong and Paris. With Asia Emerging markets up 84% from their March low, I would not be adding aggressively to the region as a whole, especially China, at this time.
But money can still be made
Putting aside these potential pitfalls, careful stockpicking can make all the difference in this area. The region is much less well researched than the West, and what research exists is much more deal driven too. With Asia’s large aspirational population, the scaleability of successful concepts, (such as the Li Ning brand in China) never ceases to amaze. Above all the calibre of company management and corporate governance is improving at an astonishing pace. However prone to hubris these markets may be, anomalies still abound. Contrarian investors like Anthony will flourish in these markets…… but we at First State would hope to do even better!
Jonathan Davis 