Convulsion: a sudden, violent, irregular movement of the body, caused by involuntary contraction of muscles and associated especially with brain disorders such as epilepsy; a violent social or political upheaval

Our long-planned trip to visit companies in China could not have been better timed. A breakdown of negotiations between the US and China prompted President Trump to impose higher tariffs on a wider range of product imports from China. Combined with the imposition of sanctions on Chinese telecom and technology giant Huawei, this has convinced almost all seasoned observers of geopolitics that the ‘genie is out of the bottle’. The posturing and counter-moves by the two global economic giants is just the start of what could be a long lasting ‘economic war’ for ideological dominance in the decades to come. It is beyond my remit to posit on this development, yet suffice to say all countries will need to rethink and adjust as we undergo a massive change to the current global political and economic order.

“Overall the mood in China was combative and downbeat”

Most of the companies we met were cautious to downbeat. To generalise, as industrial profit growth in China slows sharply and export orders come under a cloud, almost every firm is understandably affected. There was a common thread running through most companies’ future expectations: government policies will save the day. I met a few companies which rank very high on the quality and growth score (in the health care and consumer space) but valuations reflect a lot of positivity. Those are on my radar to buy in case markets face further challenges, but overall the mood in China was combative and downbeat.

Our working assumptions are that growth rates (in China and globally) will moderate while volatility of growth will increase. In what is not just a case for China, governments and central banks across the world will increasingly try to cushion negative outcomes for growth in almost every country. Hence, risk of policy mistakes – knowable only in hindsight – will exacerbate asset price moves. Corporate capital expenditure and consumer spending might reflect a high degree of caution as confidence and clarity is diminished.

Pumping life through the economy

In other news, election results in Indonesia and India have given an increased mandate to incumbents. Both leaders face similar challenges: revitalising growth, job creation, growing income levels and infrastructure investment are the priorities. These challenges have no immediate solutions. In a challenged external environment bordering on protectionism, government subsidies will play an increasing role to help the lower strata of society. The constraint will be the fiscal deficit of both countries, but, from what I have read, the initial thrust of both governments will be on devising strategies towards this end. By way of example, Indonesia’s actions of the past few years may be indicative of policy direction for its peers.

Indonesia: Purse wide open     

Source: CLSA Securities

Despite these efforts, growth has been difficult to come by. In Indonesia’s case in particular, there is an urgent need to address relatively inflexible labour laws. This has been the most cited reason for the lack of significant relocation of manufacturing at a time when firms are looking for alternatives to China.

Cautious, yet confident

From a portfolio standpoint, there is a fair bit of defensiveness through most of our holdings. I have tried to focus on companies that have managed the disruptive forces of online commerce and stand a better chance of success. With uncertainty emanating from restrictive trade policies, vigilance on monitoring second order effects (like moderation of consumer demand) will be important. There is genuine concern over the economy in China, yet even in these times there are pockets of growth. With this in mind I am keen to add to a couple of names in the ‘A’ share market if there is a further sell-off.

 

“While we anticipated some challenges in key emerging markets, we did not foresee the magnitude of the economic deceleration, particularly in Greater China. In fact, most of our revenue shortfall to our guidance, and over 100 percent of our year-over-year worldwide revenue decline, occurred in Greater China.” 

Apple Q4 2018 results commentary

Since the middle of 2018 we have been expecting US corporate results to reflect the broad slowdown in many emerging markets (including China), and Apple has very much met our expectations with its latest quarterly commentary. However, at the same time there has been much media commentary about various stimulus policies being enacted in China, creating mixed news flow regarding the economic outlook in China.

As a starting caveat, we feel that Apple may be overstating the degree to which the Chinese economy is the cause of its disappointing results. Market share data has shown strong growth in Chinese smartphone sales by local producers, particularly Huawei, while Apple has struggled. This is because the dominance of integrated multi-purpose platforms (WeChat, Taobao) which reduce the costs of switching from iOS to Android for Chinese users. As always, it is important not to read too much into a single data point and explanation.

But there is plenty of other evidence of a deep slowdown in China. In the first nine months of 2018, domestic consumption tax revenues averaged RMB109.8b per month, however October saw revenues of RMB32.1b and November was only RMB17.0b. Car sales in October were down 13.0% from a year earlier. More industry-linked measures (e.g. rail freight turnover, cement consumption) look healthier but the trend is certainly down. Finally, stock markets are not economic data, but the Shanghai Stock Exchange Composite Index fell 28.7% in US dollar terms in 2018, reflecting the extent of negative domestic investor sentiment.

“Credit is now growing more slowly than the economy”

None of this particularly surprises us. We believe China remains an essentially domestically-driven economy (exports as a proportion of GDP is about 20%, compared with  40% for South Korea; we feel this also makes concerns about the impact of tariffs overstated), and that growth in domestic demand (and hence, economic growth) is substantially driven by the change in credit. That change in credit has been slowing since 2016 and increasingly hurting the wider economy.

Following the stimulus in 2015, the year-on-year growth in the financial system (we track all-system claims, including shadow banking products such as bankers’ acceptances and trust loans) peaked at +22.2% in the year to January 2016, but that growth rate has steadily declined. The increase for the year to November 2018 was only 8.0%; with real GDP growth for the year estimated at 6.6% and the latest CPI print of 2.2%, credit is now growing more slowly than the economy. This negative credit impulse is a significant drag on economic activity in China, and a very different environment to that which has existed since the renminbi was floated in 2005.

Various stimulus packages have been announced, with an alphabet soup of lending programs from the People’s Bank of China (SLF, MLF and PSL were recently joined by TMLF). However, the reality that we believe matters, as seen in the data, is that monetary policy in China is tight, fiscal policy is broadly neutral, and there is no immediate reason to expect a turnaround in the economy. We remain cautious on Chinese equities (especially A-shares, where we remain zero- weighted), cautious on commodities and commodity economies, and continue to expect disappointment from global companies that sell into China. At some point, probably given the weakening renminbi, Chinese policy will turn more stimulative, but we believe it will pay to wait until that turn is tangible.