Although most investors focus on the US economy, China as the second biggest economy in the world, with US$11 trillion GNP needs close scrutiny. In addition it has an outsized impact, probably bigger than the US, on all its Asian trading partners and many emerging countries in Africa and Latin America. For even some of the leading members of the European Union, such as Germany, China has become significant factor in their external trade. Therefore, we are trying to dig down into the monthly data of the Chinese economy on a regular basis to understand the current trends.
In April, we have seen China’s economy slow down to a 6.9% growth rate with the PMI falling slightly to 51.2%. The People’s Bank of China (PBOC) has tightened up policy with M2 growth falling to 10.5% and sales volume in property also falling 10% yoy. Some commodity prices such as iron ore weakened as a result of the slowdown in China’s infrastructure spending and construction demand. As a result of tighter control on foreign remittances by Chinese citizens, the Renminbi has remained steady against the dollar, and foreign exchange reserves rose slightly to over US$3 trillion.
Last week, we have seen the “One Belt, One Road” forum held in Beijing with President Xi Jinping, making commitments of up to US$130 billion in loans and infrastructure spending in Central Asia, Pakistan, Sri Lanka and in South East Asia. The impact on smaller economies such as Pakistan, Sri Lanka, Laos, Cambodia, Thailand and Vietnam is significant, and it appears now that over 130 countries including most of the European nations have committed to join China’s efforts in the Asian Infrastructure Investment Bank and the new Silk Road vision. This could prove an epochal transformation in many areas of Eurasia over the next 20 years, compared by some observers to the Marshall plan, promoted by the US in Europe in the late 1940s. This time China is the leading player in promoting trade and globalisation, whereas the US, under Trump, appears to be retreating from its trade and military commitments in Asia. It therefore becomes more than ever important that China’s own domestic economy continues to grow and have the financial strength and health to support these ambitious overseas projects.
For some time, we have been conscious of the growing risk of the domestic debt which is estimated at between 250 to 300 percent of GDP. However, like Japan in 1990, this is almost entirely internal debt owed by local municipalities to the Central government or by state owned SOE’s to state banks. It is therefore within the power of the PBOC to regulate and reorganise as they have done before. This fact is often forgotten by Western observers who wrongly speculated on a severe slow down or even crash in China in early 2016. It has not happened. On the contrary, China has re-accelerated its infrastructure spending and its industrial growth. The latest GDP figure shows a steady 6.9%, but, as Premier Li Keqiang famously observed, we should disregard the headline number and look at railway freight (19.6% yoy), electricity usage (7.9% yoy) and exports (8% yoy).
The most remarkable recovery in the 1st quarter in 2017 was seen in the property sector across China, which has shown a strong rebound, and share prices of Chinese property companies have risen 25 to 30%. However, we now see some monetary tightening by the PBOC and an excess of new supply of residential and commercial space in many cities which is beginning to weigh on prices. The artificial stimulus to the real estate sector was in part caused by the November 2016 clampdown on capital outflows in order to stabilise the Renminbi and maintain China’s forex reserves at US$3 trillion. This may, however, be a short-lived phenomenon and our opinion is, that property values in many leading cities in China, as well as second tier cities, will begin to fall in the second half of this year. What is harder to ascertain or predict, is the impact that this may have on consumer sentiment, and on consumer spending, as well as tourism, travel, education, healthcare and e-commerce, which are the leading growth sectors, in which we have invested. We tend to believe that these sectors will maintain double digit growth, in the face of a slowdown in the state owned sectors of heavy industry including steel, aluminium, energy and construction in China. That is also why we are carefully watching the prices of iron ore (down 25% this year), copper (down 5%), steel, and of course oil and gas. Australia, as one of the principal suppliers of iron ore, coal and LNG to China, may be one of the regional economies which is most severely affected by a cut back in Chinese orders in these raw materials.
One recent example of China’s outsized influence was in South Korea, where in July 2016, the Americans announced the Terminal High Altitude Area Defense (“THAAD”). The Chinese authorities reacted with fury and cut back immediately on purchases of Korean made goods, and tourism numbers from China to South Korea plunged by 60%. With the election of the new liberal President, Moon Jae-in, who is taking a softer line on North Korea (and may request the removal of the THAAD), we expect that China trade with Seoul will quickly recover and consider some Korean consumer companies to be undervalued on that basis.
The key issue will be what happens in US-China relations? On April 8, when President Xi Jinping visited Donald Trump in his “winter White House” in Florida, what was mainly discussed, apart from North Korea, was the issue of trade. Wilbur Ross, the US Secretary of Commerce, announced that they were commencing a 100-day review of China’s trade practices especially in sensitive areas such as steel and aluminum. We therefore expect some actions to be taken by the US Commerce Department, by the beginning of July, and believe that this could have a shock effect on investor sentiment, which has so far viewed Trump, while eccentric, as following a sensible pro-business policy with regard to China, in contrast to his outlandish campaign promises to brand China as a currency speculator and so on. In fact, the Renminbi has been abnormally stable against the dollar since Trump’s inauguration in January. We expect that if some US trade measures are announced, that China will quickly retaliate, and perhaps a devaluation of the Renminbi would be more probable in the second half of the year. In any case, a tussle between the two elephants of the world economy will certainly mean that the lesser economies, especially the Asian exporters which are tied into the supply chain for technology, among other sectors will be trampled on.
India, however, is of course an exception to this view of Asia, because it has little direct trade with China and not that much with the USA. The one area, which we have already seen affected by the H1B visa situation becoming more uncertain, is the IT sector, with companies like Infosys and Tata Consulting being negatively viewed. Also some Indian pharmaceutical companies have come under the purview of the FDA which has also held back share prices. For the other 80% of the Indian stock market, we have seen strong performance in domestic consumer companies, as well as the financial sector, led by banks such as Yes Bank, ICICI, HDFC and smaller names like Gruh Finance and Shriram City which have all benefitted from being go ahead private sector banks, innovative, and prepared for the digital transactions which have multiplied since the demonetisation on November 8 last year. In addition, the Indian Rupee has surprisingly appreciated by 5% against the US dollar since the beginning of the year. We are, therefore, looking at gains of nearly 15% in our Indian Ocean Fund in the past few months, and our broader Bamboo Asia strategy is up 22% year to date. We remain somewhat cautious about the next 3 to 6 months and intend to try and lock in these gains and preserve capital as much as possible.
Most of our companies have been producing very good earnings results, for instance, China Lodging came out with some very good numbers, net revenue grew 10.8% yoy and net income grew 113% yoy to RMB148 million. China Lodging now has 3,336 hotels or 335,900 hotel rooms with average hotel occupancy rate at 83.9%. As of March 31, the company’s loyalty program had 814 million members who contributed more than 77% of room nights sold in 1Q2017. TAL Education’s latest numbers showed net revenues up 81% yoy driven by student enrolments up 70% yoy to 1.34 million in a quarter. Among the Indian holdings, Gruh Finance and HDFC Bank among the financial reported excellent quarterly numbers with growth in Net Interest Income by 18.6% yoy and 21.5%, respectively and good control over the asset quality, while Maruti Suzuki surpassed our expectation with revenue growth of 20.3% and profit after tax growth of 15.8% yoy.
In our broad Bamboo strategy, which has 25 “conviction” positions, we also have some defensive shares such as Link Reit and AIA in Hong Kong, and our Malaysian exposure in BAT and Public Bank, which has not performed yet but we see as a defensive diversification. We also have some exposure to gold and oil through Evolution Mining in Australia and PTT in Thailand. The oil price has been fairly weak recently but we expect that it will recover towards the second half of the year.
We are wholly focussed on picking great companies which we intend to own for five years, and believe that this “buy and hold”, dollar cost averaging, low turnover approach, which we have especially followed in our Indian Ocean Fund because of liquidity constraints, will be the most successful route to consistent outperformance of the passive indices and benchmarks. There is a real opportunity today for a return to traditional stock picking instead of low cost indexed products and we aim to consistently outperform our benchmarks in order to justify our existence.
Robert Lloyd George
15 May 2017