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China: Short-Term Gamble, Long-Term Necessary Investment

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The Chinese civilization may go back 4,000 years, but its stock market is younger than many millennials, panelists reminded the audience at a session focusing on investment in China at the Morningstar ETF Conference in Chicago.

“It’s important to keep in mind that China’s a relatively new capital market,” said Dodd Kittsley, head of ETF strategy in the Americas for Deutsche Asset and Wealth Management. “[It’s internal stock markets] didn’t even exist until 1990, and investors were not able to margin or short until 2010.” Margin was a big part of the recent stock market collapse, he added.

Commentators have blamed this youth for the volatility of China’s stock market since June. The Shanghai Stock Exchange Composite Index ran up 118% from October 2014 to June, when it fell 44% through September, leading to government intervention in the stock and currency markets as well as regulatory changes, which may have exacerbated the fall.

Brendan Ahern, CIO of KraneShares, said that the market’s ride up didn’t have anything to do with economic fundamentals, noting that during the stock rally, “the entire time there was a deceleration across the economy, not just on investment side, but on consumption side as well. It really was divorced from the economic fundamentals.”

Despite this, both Kittsley and Ahern were bullish on China. Ahern noted domestic consumption was strong now, with sales reports showing more than 10% growth in June, July and August. Kittsley agreed, using a hockey metaphor: “China is where the puck is going … It’s just too big to ignore.”

Both saw positives, from changes in market indexes to reflect a better mix of Chinese business and industry (“Now the MSCI China is very geared to old China,” Ahern said).  

“The biggest [point] to deliver here is the different flavors of China,” Kittsley noted. “To paint China with one brushstroke is short-sighted and you lose opportunity China has to offer.” He pointed out one huge growth potential: only 3% of A-shares in the stock market are owned by investors outside of China. That will change as the market continues to mature and open, he said.

Less ebullient on China, especially in the short term, was panelist Dan Rohr, director of basic materials equity research for Morningstar.

“We need to look at the interplay of investment and consumption,” Rohr said. “Looking back historically at these episodes of economic rebalancing, you find some profound linkages between the two, such that when investment growth decelerates … you see a deceleration in consumption growth … accompanied by asset price inflation.” He said that in next five to 10 years Morningstar sees “significant slowing, weakness and deceleration on the consumption side,” and projected 5% growth in gross domestic product.

Ahern opined that “GDP is so overemphasized,” and though the country itself is “fascinated” by GDP, the number doesn’t matter because “China’s base is so large. So if China grows 5% this year, the size of the growth is three times larger than the Singapore GDP … Even when it is growing slowly, it is the second largest economy in the world.”

Deutsche sees 6% GDP growth now, but 5% going forward, Kittsley noted. But he added that so much else is happening in China — changing from an agricultural to urban society, and a mass move to the middle class — that opportunities abound.

But Rohr wasn’t convinced saying “digging into the underlying numbers makes me more worried,” adding that he had “little faith” in those strong retail sales numbers noted by Ahern earlier. He said Morningstar looked at “harder to fudge” numbers like value-added tax receipts, which were growing at 2%-3%; large durable goods like vehicle and appliance sales, both which were sharply decelerating; and even smaller goods, like instant noodles and cigarette sales, which were down as well. 

“Yes, there may be pockets, like Apple and Nike [that are strong], but what you’re seeing with Chinese consumers is a more meaningful deceleration than observed in headline retail sales figures,” he said.

Kittsley still believes China is the place to be, and that A-shares and Red Chips — companies based on the mainland but listed in Hong Kong — would be a good start, but there are “levels of granularity,” he said.

Ahern noted that the 5th  Plenaria meeting, in which the Chinese government will work out its five-year plan, is coming in November. “China is so transparent when they put out this five-year plan,” he said. “They are saying, this is what we care about for the next five years, and I want to buy what the Chinese government is going to drive policy toward.”

Rohr agreed that China was a long-term investment because it would be tapping into a large Asian economy that will grow. However, he cautioned, “Short-term investments would be like allocating a portion of your portfolio to a Blackjack table; the result is it has absolutely no tie to economic fundamentals. And it’s a casino that may decide you don’t get to take your winnings home…Great opportunity long term, but short term? Yikes!”


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