China: Remaining Mindful Of The Need For Stability
While we (Janus Capital) believe the economic transition is in its early phase, the ambition to switch the economy is undeniably clear and ongoing, says Mr. Pitt Miller. China wants a more self-sustainable, consumer-led economy; they do not wish to rely on external consumers for growth in the model of postwar Germany or Japan. Nonetheless, evolving the world’s second-largest economy is a massive undertaking.
Portfolio Manager Guy Scott, CFA, notes that it took the U.S. 40 to 50 years to make a similar transition. China is moving much more rapidly, and perhaps faster than most realize. E-commerce has severely diminished the importance of physical storefronts. The Internet, in combination with advanced manufacturing technologies, will accelerate China’s transition, as it skips past the era of brick and mortar based consumption and straight to e-commerce.
Now, it’s a matter of the old economy versus the new economy, says Mr. Scott. How fast can the new economy grow, and can the old economy be stabilized? Key to stabilization efforts will be how Beijing manages the employment consequences of this change.
SOEs largely remain a drag on growth, but stabilization is underway via government-led reform initiatives.
To mitigate overcapacity, for example, the government shuttered underperforming mills and mines, and substantially lowered the number of average working days in the coal industry. We’ve also seen an increase in the approval of mergers and layoffs. Domestically, these reforms have dramatically increased profitability for a number of SOEs, and the coal and steel industries have benefited, as evidenced by climbing prices of the respective commodities.
Reducing investment in construction and imposing property-market controls also speak to the government’s commitment to rein in credit growth. We see positive side effects from anti-corruption efforts as well, including the funneling of capital into productive areas of the economy, versus into unproductive sectors.
Mr. Scott confirms that investment into low-return projects is now a flag for potential corruption, particularly in industrials and oil and gas, and is attracting the attention of anti-graft government officials.
We believe these reform initiatives are linked to the recent uptick in the Producer Price Index (PPI) (see chart on page 14). China’s September PPI data turned positive for the first time in nearly five years, and October saw a 1.2% rise in the price of manufactured goods.
Following years of deflationary pressure, companies are regaining pricing power as inflation creeps in, which is positive for both capital expenditure and the bottom line. Nominal growth acceleration may also afford more room for a lower real GDP target.
Regardless, China will need to confront the need for retraining and re-employment of its workforce.
Of additional concern on the road to transition are the yet-to-be-determined policies of U.S. President Donald Trump. Pro-growth, fiscal stimulus initiatives in the U.S. would be beneficial to China, but this benefit could easily be nullified by the imposition of tariffs. Additionally, U.S. (and by extension European) rhetoric about Chinese currency manipulation may also heat up as the yuan depreciates due to slower economic growth and near-term capital flight.
Barrington Pitt Miller is an Equity Strategist with Janus Capital. Gareth Yettick CFA, Equity Research Analyst and George Maris CFA, Equity Research Analyst, co-authored this piece. This is Part 1 of a series on China.
Photo Credit: ARTIFACTS, University of Missouri.