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Don't underestimate China

Don’t Underestimate China

| By Matthew Snider

Evergrande Group recently made headlines as a key contributor to some short-term downward pressure on U.S. markets. The Chinese company is the country’s second largest property developer and was a catalyst for selling after it defaulted on $300 billion in debt. 

U.S. market fears weren’t being driven just by Evergrande specifically, but rather by concern that there may be some ripple effect through the Chinese financial systems, similar to what transpired in the U.S. banking system back in 2008. At this point, however, this does not seem to be very likely given the Chinese government has stepped in to try to help Evergrande work through its financial difficulties. That being said, they still have a number of hurdles to overcome.  

China Still Reported Growth 

The negative development of Evergrande was in addition to a number of items like supply-chain disruptions, semiconductor shortages, port shutdowns, COVID-19 outbreaks, higher commodity prices and increased regulations plaguing the world’s second largest economy.  

Add on top of this the recent power outages due to higher coal prices, and an effort by the government to reduce energy consumption. These items have contributed to a contraction to Chinese manufacturing back in September that ended 18 months of expansion coming out of the pandemic for China. 

One caveat to this, and something that many may not know, is China was the only major economy to report growth in 2020. Remember, the pandemic originated in China, so their experience was essentially first in and then first out. This, my friends, is largely the reason for positive growth.          

Actually, A Positive Push

However, all of these negative developments have pushed Chinese markets lower by almost 17% this year. So, in light of some of the struggles this market has faced recently, does it still make sense to have any exposure to this region of the world?  

There are a number of factors that would support investments in China. To start, stock valuations are at a 13 P/E ratio, which is more in line with the historical average of 12.3, suggesting that this market is not overvalued. And then, economic growth was 7.9% through the second quarter of 2021. 

Granted, while growth has slowed in China over the last few years, as the country transitions its economy from investment spending toward domestic consumption, the growth rate is still strong especially in comparison to the rest of the developed world. In spite of a crackdown on some of the large Chinese tech companies by the government, we’ve seen the emergence of a strong technology sector in China. This is likely due to increased spending on research and development that has taken place over the last few decades leading to a dramatic rise in patent applications. In fact, over the last decade, China has now exceeded Germany, Japan and, most recently, the U.S., in the number of patent filings. Given the world’s increased dependence (or reliance) on technology, we could see more technologic developments coming out of China.  

Moving Forward

Perhaps the biggest economic driver is the emergence of their middle class. In 2020, roughly 40% of the Chinese population was classified as middle class. That percentage is expected to jump to over 70% by 2030. 

If we translate this into the number of people, this growth would move 453 million people into the middle class. By comparison, estimates in North America over the next decade are for just 10 million people to transition into the middle class. 

As an aside, if you were impressed with China’s figures, India’s transition is expected to be even more dramatic with estimates of 883 million going to the middle class. It is yet another case for having some investment in emerging markets. 

Global Consumption

Tied to the emergence of the middle class is global consumption. If we break it down by country, the U.S. accounted for 25% with China not far behind at 22%, as of 2019.  Currently, both countries account for almost 50% of global consumption. If we went back to 2000, the U.S. was at 35% and China was at 8%. 

Perhaps a better way to illustrate this is by looking at our holiday shopping season. If you look back to 2020 and compared ours to China’s Singles’ Day, their unofficial holiday to celebrate single people, held on November 11, their Singles’ Day had over $74 billion in merchandise sold compared to almost $45 billion during the U.S. holiday sales. The expectation is for this trend to continue. One would expect that this massive growth would certainly continue to provide companies the opportunity to sell goods and services to millions of new consumers in the future. 

Finally, I recently mentioned that within our Investment Advisory portfolios we utilize American Funds New World Fund as our emerging market investment vehicle. The fund has had a very good year compared to the benchmark given that it has only an 18% allocation to China, whereas, the benchmark has over 40%. One of the telling trades that the portfolio managers made was to sell 84% of Alibaba, which is a large Chinese technology company that does business globally with a focus on e-commerce. They began selling shares in the second quarter of last year. At the time, it was the 4th largest position in the fund. For the year, the stock is down roughly 36%. Capital Group suggested that when looking at investing in China, it would be wise to invest alongside the Chinese governments’ priorities and not against them. The Alibaba trades are a great illustration of New World’s portfolio managers following that advice.

DISCLAIMER: Past performance does not predict future results. This report is based on data obtained from sources we believe to be reliable. Hefren-Tillotson does not, nor any other party, guarantee the accuracy or completeness of this report or make any warranties regarding results obtained from its usage. All opinions and estimates included in this report constitute the firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation to buy or sell the securities herein mentioned.