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Guest Comment: China - The "Re-Emerging" Market, Says Wells Fargo AM

Anthony Cragg

Wells Fargo Asset Management

1 February 2013

Editor’s note: This article, by Anthony Cragg, a portfolio manager at Wells Fargo Asset Management, part of the California-headquartered banking group, looks at developments in Asia’s biggest economy and the investment views that derive from it. We are grateful to Wells Fargo for this guest article but as ever, stress that this publication does not necessarily share the views expressed and feedback is welcome.

Hong Kong listed China equities have rallied significantly in the fourth quarter of 2012 as, one by one, investors’ concerns have faded. The first worry that had depressed the market for Chinese shares was that of rising inflation. When the consumer price index hit 5 per cent some observers forecast it spiraling to 10 per cent-plus. In fact, today it is closer to 2 per cent.

Next came the widespread fear of a “hard landing”. That has now largely receded as China looks to have successfully engineered a soft landing from previously overheated gross domestic product growth rates of low double digits, to a much healthier and more sustainable level of around 7.5 per cent, which was the stated growth rate target in the 12th Five Year plan.

The third and most recent anxiety has been over the political succession of the new generation of party leaders. Despite the usual behind-the-scenes jostling and despite or perhaps because of the removal of the contentious figure of Bo Xi Lai, the transition appears to be going ahead smoothly and as planned. The new generation of leaders led by soon-to-be President Xi Jinping and Premier LI Keqiang, while not exactly radicals, do at least appear to be more reform-minded than their predecessors and to be men of action rather than just words. Only time will tell if they really are but witness for example the appointment of Wang Qishan as the new head of the Discipline Commission, the government’s anti-corruption agency.

Whereas previous leaders have paid lip service to cracking down on bribery and influence peddling, the appointment of someone like Wang, who earned a reputation for transparency during the SARS epidemic, seems to indicate a genuine commitment to the effort this time around.

Wealth gap

Another stated goal of the new politburo is to further invest in social programmes designed to reduce the wealth gap and to promote a more “harmonious” society. These plans range from low-cost housing to medical programmes to investment in education, and between them should begin to constitute something of a “safety net” for Chinese people. This should encourage them to draw down some of their “precautionary” savings and thus help stimulate already-strong domestic consumption. The pool of consumers will also continue to grow thanks to the ongoing trend of urbanisation which creates 20 million new city dwellers every year.

Once it became apparent that the feared monsters of hyper-inflation, a hard landing and political turmoil had failed to materialise, some investors began recently to question both why the market was priced at such depressed valuations and indeed their own underweight position in the second largest economy in the world. China’s largest bank, for example, ICBC, still trades on a forward price to book of 1.2 times, a price-earnings rate of 6.5 times earnings and a yield of 5.3 per cent, even after its stock price rise of over 30 per cent since the beginning of September.

Local Chinese A-shares, which at one stage traded up to as much as a 50 per cent premium to the H-shares, are now at a discount. In my opinion, that will not last for long and the A-share market will play catch-up. Indeed, if Chinese economic data continue to improve, local China shares could be one of the most rewarding global investments from now and for much of 2013.

Growing pains

This is not of course to argue that China doesn’t have plenty of risks and problems of its own, only to suggest that too much negativity has been priced in. Any emerging nation, especially one of the scale of China, has its growing pains but just as the Great Depression and so-called “robber barons” of the late 19th Century and 1930’s America did not derail the US from becoming the world’s predominant power, so investors today have no fundamental reason to conclude that China will not surmount its shorter term challenges.

Among these fairly obvious challenges are:

§         corruption, as already mentioned

§         potential defaults from the shadow banking system

§         an aging population, due in part to the one-child policy

§         severe environmental pollution

Perhaps the biggest mental obstacle for investors in China to overcome is the “new normal” reality that the “boom” is over and that while that is a good thing in terms of the overall health of the economy, it inevitably means lower earnings-per-share growth rates. In some ways the easy money has been made but the more sustainable and solid investment phase is ahead.

What could be called the “cottage industry” of China-bashers will no doubt continue to issue dire warnings about the imminent meltdown of China. Some of these “perma-bears” are negative as a result of genuinely held convictions, some as part of a shorting strategy and still others on the grounds of their political ideology (“how can Communists be successful capitalists?”).

As an international portfolio manager, my job is not to be an advocate for any particular country but nor is it to be an advocate against it. Instead it is to try and see and seize investment opportunities wherever they arise. Many years of experience have taught me that such opportunities often do arise when a negative consensus is too resolutely entrenched as is the case today with the tidal wave of anti-China sentiment amongst the media, laymen and professional investors alike. To all of them we would just make two, not so much warnings, as observations:

-- The first is that it has historically been wrong to underestimate China, and that is especially true now that it has foreign exchange reserves of around $3 trillion.

-- The second is that China should more properly be viewed not as an “emerging” market but as a “re-emerging” one, given its long and illustrious history of trading prowess, culture, wealth and technical innovation.

False fears

While many in the West may sincerely believe, or in some cases even hope, that China’s collapse is upon us I wouldn’t recommend them to hold their breath. In 2001 a much-publicised book was published called “The Coming Collapse of China”. Here we are on the brink of 2013, the Chinese economy has more than doubled in size and China is now the world’s largest consumer of many important items, not to mention the fact that millions of Chinese have been lifted out of poverty.

Not bad for a country that was supposed to collapse nearly 12 years ago.