China: A Crisis or A Consolidation?

2015-09-16

In recent months, there has been a significant amount of talk about China. Many people are wondering whether the country is in crisis, or is experiencing a consolidation.

The People's Bank of China cut the yuan reference rate against the US dollar by approximately 2%. This was a shock to the entire developed world of finance as well as in emerging markets. When the yuan was cut, it led to a drop of more than 2% on the yuan value for offshore trading. Many people have been looking at alternative investments because the decline also triggered a significant amount of speculation, including whether the Chinese would win a race to the bottom of the various currencies in Asia.

Beijing announced that the adjustment was created to fix some of the distortions between yuan trading rate and the rate it should have been set at. They also said that subsequent larger shifts would be unlikely.

The International Monetary Fund said that the move could potentially lead to a free-floating yuan and the stock market started to experience negative returns and massive outflows. While many people believe that China is a developed market & economy, the move that we noticed in the financial markets are proving that it still behaves like an emerging market.

Chinese state media has also issued warnings to retired officials to ensure that they stay out of politics and not misuse their previous prestige and networks. They wanted to make sure that there is no mention of a crisis in order to cause concern within the financial markets.

While every foreign analyst warned investors about the potential contagion risk and the need of a proper risk management related to China, the Chinese policy makers were stating that they are in a state of consolidation, not crisis.

There has been a lot going on throughout China in the past several months. During the middle of August, they experienced one of the worst accidents industrially in years. There were several explosions that occurred at a short-term storage facility for chemicals in Tianjin, a port city. Approximately 100 people were killed due to the series of explosions, and government was required to launch an investigation into the storage. It was found that there were improper safety procedures as well as illegal storage.

It is more than just an industrial accident. Citizens have begun demonstrations to demand that the government reports for damages. The public is asking for the government to publicly charge the standing committee member with corruption to ensure that the public can trust the government moving forward, otherwise it could be seen as a conspiracy behind the Tianjin blast.

Some bearish financial analysts say that China is in the midst of a crisis because the model of government has changed, as has the economy; in the days of Deng Xiaoping, things were different.

In recent years, starting in the 1980s, China made several initiatives to help with growth and development for the future. This included localized freedom within the economy, preventing one person from dominating the political system, and to be careful internationally, such as not showing any kind of military strength overseas. The latter of the three initiatives would allow China to focus on internal cohesion socially and economically.

The bullish financial analysts are stating that China seems fine. They would argue that there is no crisis going on and that there have been some subtle consolidations, like in any other emerging markets. The fact that China has been the engine of the "post-2008 Crisis's" recovery and that it represents an important political and economic player, makes that we speak more about it and that it shows how fragile are the develop economies, if China were to be in recession.

The reality is that both bullish and bearish analysts are correct: there is not a perfectly brilliant or an absolutely dark situation in China.

Like many other economies, China is a cyclical economy. It has been climbing the value chain within the manufacturing industry and exports for years. It has been slowly evolving the various components of its economy in order to find some stabilization. It is a very large country with lots of moving parts and it is lagging some of the experience of developed countries' policy makers (they are probably not the only one). It will certainly do other mistakes in the future, but we'd need to judge its ability to rectify these mistakes.

One cannot underestimate that some reforms have taken place in China and that the recent market correction (a drawdown of 27% from the highs of May) will not stop those reforms.

A good number of companies (include some state-owned ones) will float their shares in the stock market in the coming 12-months, making the Chinese stock market a broader market.

Market corrections offer sometimes interesting opportunities and the difficulty for an asset manager is to identify if the investment has to be viewed as a strategic allocation (hence, the market multiples are low and the investment can be held for a long period) or as a tactical allocation (hence, the technical of the market may offer an opportunity for a medium term rebound).

Because the Chinese market still trades at high P/E multiples and there is an important dispersion between sectors, we'd rather bet for a tactical allocation. Some areas, like the banking sector and the real estate sector are trading at very low valuation. There are opportunities to select some good names there. One can play it by investing into a sectorial ETF, for example. More conservative investors could also consider looking at some bonds, being investment grade or high yield bonds (in particular in the real estate sector).

Whatever decision you, as investor, take, we would recommend having a close eye at the macro data. It is important that the Chinese macro indicator reflect some improvement in the short and medium term … the future will tell us.