Trade Wars, ESG and Demographics in China

In this Q&A, May Ling Wee, a Portfolio Manager for the Chinese Equities strategy, responds to key concerns for investors in China, including the impact of trade friction; environmental, social and governance (ESG) factors; and demographic issues.

What are your latest thoughts on U.S.-China trade friction, and what has been the impact on the Chinese economy so far?

News flow about the relationship between the U.S. and China is in a constant state of flux; we would be hazarding a guess as to the final outcome. As it currently stands, our expectations for a near-term trade deal are low. The trade war between China and the U.S. is not just about trade but also a battle for technological and economic superiority and geopolitical influence. We therefore expect this “war” to be long-lasting with no easy resolution.

The first and most direct impact on China has been on domestic business owners’ confidence and their willingness to invest. We have already seen Chinese trade numbers take a hit; total trade in China has weakened, whereas trade data from alternate supplying countries, such as Vietnam and Taiwan – which also export to the U.S. – have been more resilient.

The Chinese manufacturing sector has also suffered. Investments in electronics equipment and light industry manufacturing have barely grown year-to-date, a substantial change compared to the consistent single-digit to low-teens growth over the past few years. China is a key part of the global supply chain for electronics, an area where both private domestic and foreign investment has grown consistently. The relocation of the manufacture of lower-value goods to nearby Asian countries had already started before the onslaught of the trade wars, as China had already lost its advantage in low-cost, lower-skilled labor to countries such as Vietnam, Cambodia and Indonesia. The process of relocation will continue, if not accelerate, as every business owner evaluates the benefits of diversifying production bases.

The crux of the trade war is on technological supremacy bringing about a geopolitical and economic advantage (the latter through productivity gains). Tariffs and non-tariff measures will only harden China’s resolve for self-reliance and technology independence. The U.S. has many non-trade levers to pull. A key weak point for China is its dependence on foreign technology, especially semiconductors.

Semiconductors are a vital component used across many industries today and being short of just one component could mean a system failure for the end product. China will be even more determined to move toward ensuring it supports and develops its own domestic companies to be competitive and self-sufficient in the technology supply chain. As a result, we expect to see a lot more spending and support for research and development (R&D) by Chinese technology and industrial companies to ensure self-sufficiency.

As a condition of China’s entry into the World Trade Organization, China agreed to increase market access for foreign companies. China has been protecting its domestic industries by requiring foreign companies to operate through joint ventures with local partners, such as in the automobile and life insurance industries. China does not want to be perceived as isolationist and wants to continue to be a significant player in the global trade of goods and services.

As a result, we have seen a recent acceleration in foreign ownership deregulation in the Chinese automotive and financial industries. The lifting of restrictions should allow foreign insurers, securities companies and asset managers in China to fully own their operations and expand geographically, bringing best practice to the financial industry, foreign expertise, improved product range and healthier competition.

China’s rapid growth in recent decades has resulted in some negative impacts on society and the environment. At the same time, the country is facing issues such as rising inequality and an aging population. How are ESG factors affecting investment opportunities in China?

The investment case in China is complex. In terms of the environment, China has put a lot of resources into renewable energy after years of investment in heavy and extractive industries, textiles and electronics manufacturing. It is now a richer economy, where its people demand a better living environment. To ensure sustainable growth, Chinese policy has included subsidies and investments in renewable sources of energy. The government is also demanding higher standards of environmental enforcement in its heavy industrial sector, a move that disqualifies many smaller enterprises without the scale and resources to invest in these environmental facilities.

These policy initiatives can create investment opportunities. In China’s natural gas distribution industry, the government’s blue-sky initiative (a three-year plan for cleaner air) and effort to switch coal for gas in North China should continue to drive gas demand growth for a sustained period of time. But looking solely at areas that the government has identified as focus points is not always good enough. In many instances, subsidies and efforts to promote an industry often mean that a lot of private and public capital is drawn in. This was evident in the wind, solar and electric vehicles industries, which ultimately led to excess capacity and little pricing power for industry participants.

China has a large economy, a population of 1.4 billion and large land mass. Each province in China is almost a separate market. Inequality exists, and China’s Gini coefficient1 is high, with contrasting spending power across different provinces and regions.

We often find that companies with a national brand, presence and scale are often able to develop a product range – sometimes with multiple brands – that allows varied price points to suit affordability for a diverse customer base. For example, a successful home appliance manufacturer may employ multiple brands to address the varying levels of affordability of their consumers.

Today, more than half of China’s population generates a per capita GDP below the national average of $10,000 (USD). However, sustained urbanization is expected to create 150 million urban citizens in the next 10 years, offering the chance for upgrades in consumer products as income levels grow. This creates an opportunity for a national brand to cascade its product offering upward as each segment of its consumer group becomes more willing to consume a higher-value, more premium product.

We cannot deny that China’s demographic decline will be a growing challenge over time. The working age cohort (15-64 year olds) is no longer growing, while the 65-plus age group continues to rise. Nevertheless, China still has a large number of new workers entering the workforce each year. In manufacturing industries, companies that continue to invest in R&D to increase automation and streamline production processes, raise productivity and reduce the number of workers required for production lines could be well positioned.

However, we also believe that the aging population’s collective wealth could benefit service sectors, such as life insurance, wealth management and travel. Insurance penetration is low in China relative to GDP, resulting in a large protection gap. For the maturing workforce and China’s many entrepreneurs, the desire for wealth protection and asset growth becomes stronger as this group considers the generational transfer of wealth as well as retirement.

How do Chinese stocks look now from a valuation perspective? In your view, which sectors are currently well positioned?

Since the Global Financial Crisis, the Chinese domestic onshore market (the CSI 300 Index) and the Hong Kong market (the Hang Seng Index) have been trading below their average earnings multiple, while offshore Chinese equities (the MSCI China Index) are trading at around the average earnings multiple.

We continue to think the consumer segment in China is well positioned. This includes not just consumer staples and the discretionary segment, but also broader consumer-facing areas, such as life insurance, health care, autos and the internet. The trade war and further tariffs will undoubtedly have a negative impact on both consumer and business sentiment. However, consumption demand is relatively more stable and less volatile than corporate and business demand. This is due to lower ticket prices and affordability of consumer products as well as the ability of consumer companies to upgrade and adjust their product offering.

We are seeing rising penetration and adoption rates, as well as market share gains, by leading companies in areas such as online travel, e-commerce and after-school tutoring. This is occurring despite a weaker macroeconomic environment. The Macau gaming sector is another area of strength, in our opinion, as cash-flow generation in this space is strong and mass gaming (a large portion of profits for some service providers) is showing resilience, especially given the better infrastructure access for mainlanders into Macau.

1Gini coefficient: a commonly used measure of income inequality that condenses the entire income distribution for a country into a single number between 0 and 1; the higher the number, the greater the degree of income inequality.