Emerging markets: Why China is unlikely to face a Japanese-style ‘lost decade’ despite its cloudy outlook

Despite a cloudy narrative, Pendal’s emerging markets team remains overweight in Chinese equities via a highly selective set of stocks. Here, they explain why

• China bond market moves look rational
• Good results among domestic companies
• Find out about Pendal Global Emerging Markets Opportunities fund

THERE’S been a lot of focus recently on what bond market signals are telling us about the outlook for growth.

This is true for emerging markets such as Brazil and Mexico as well – though investors have tended to overlook some dramatic moves in Chinese bonds.

The US five-year bond yield has fallen slightly this year.

Medium-term bond yields have risen in many emerging markets, amid concerns that a strong US dollar might delay interest rate cuts, or even (as is the case in Indonesia) prompt interest rate hikes.

In China, though, the five-year bond yield has fallen from 2.4% to less than 1.9%.

This has led China’s central bank (also known as the People’s Bank of China or PBoC) to worry about a bubble in Chinese government bond prices.

As a result the PBoC has been gently intervening in markets to try to prevent bond yields falling too far or too fast.

Bond yield moves look rational

Despite the central bank’s concerns, these moves in yields look rational to us.

Inflation in China is low and quite possibly negative. The latest inflation measures are +0.5% for CPI, -0.8% for PPI (both to July) and -0.7% for the GDP deflator.

Deflation increases the real yield on bonds, while real estate and equities are potentially hurt by deflation in a leveraged economy.

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As well as the signal from inflation, the credit environment is also signalling an ongoing deflationary economic slowdown.

July lending data shows a contraction in bank loans as corporates and households look to pay down debt.

This is the first contraction in lending in the economy since 2005, including during Covid and the GFC.

Given the historical pattern of a decade-long, debt-driven real-estate boom followed by what looks like a debt-deflationary slowdown, there is a temptation to see China falling into the same kind of balance sheet recession that Japan experienced after its late 1980s boom.

Only just this year has Japan’s Nikkei equity index exceeded its 1989 peak.

Do Chinese equities also face a similar “lost decade” as Japan did in the 1990s?

One group that might be worried are the western multinational companies that have been reporting sharp downturns in their China sales in recent quarters.

From beer to luxury products to cosmetics to cars, a clear pattern has emerged of results commentary warning about Chinese demand.

We feel a more detailed look at company results shows a different, more promising pattern.

Good results among Chinese companies

In the above consumer segments – as well as areas such as travel, tourism and e-commerce – many Chinese domestic companies are reporting good results and earnings growth.

Consensus estimates of future earnings are also being revised up.

We feel this reflects Chinese consumers pivoting to different products and lower price points, as well as a new preference for domestic Chinese brands.

For example, foreign car makers have fallen from 64% market share in China to 38% over the past four years.

A similar pattern is emerging in other products, including beer and cosmetics.

With these companies performing well, China’s broad equity market weakness in recent years (especially for Hong Kong-listed names) has pushed some stocks to attractive valuations – especially compared to falling bond yields.

Yes, China’s economy is struggling for growth.

Its credit environment is particularly difficult and there has so far been no turnaround in the wider real estate market.

Yet there are opportunities to be found in Chinese equities.

We remain overweight Chinese equities in the portfolio, with exposure to a highly selective set of stocks.

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
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