In this Q&A, China portfolio managers Charlie Awdry and May Ling Wee, discuss China’s unexpectedly strong economic growth this year, which has been driven by a robust pick up in industrials. They explain why sector reform and rising producer prices could turn this into a more sustainable trend.
At the start of 2017, many investors worried about a sharp slowdown in China. There were expectations that the country’s property market would soften and that the government would tighten monetary policy and rein in speculative investments and illegal activities. So far, however, economic growth this year has been surprisingly resilient. During the second quarter, China’s gross domestic product (GDP) rose by an annual rate of 6.9%, well ahead of most forecasts and above Beijing’s target of around 6.5% for the year. Even more interestingly, much of that growth could be attributed to a rise in industrial output – or China’s old economy.
Q: What is driving China’s surprisingly strong economic growth this year?
A: We believe that China’s economic growth has been stronger lately because the cyclical improvement in Chinese corporate profits has exceeded analyst expectations, both in the size of the upswing and in how many different sectors of the economy have benefited. This upswing is due partly to the return of rising prices, in particular industrial prices as measured by producer price indices (PPI), helping commodity-driven sectors. Improving consumer confidence and expenditures, as well as product innovation and the rise of social media advertising in the internet sector, have also aided economic growth.
Q: Why has China’s old economy, which includes the industrials and materials sectors, delivered strong profits recently?
A: Although the old economy is expected to slow down, the companies that make up this segment – steel producers and packaging and paper manufacturers, for example – generally delivered positive earnings during the corporate reporting season. State-mandated capacity cuts and environmental regulations have led to the shutdown of inefficient operations, improving the pricing and profit margin environment for many industries. We also believe analysts have underestimated the positive operating leverage that is coming through corporate income statements as a result of improving top line growth.
Q: How sustainable is the rebound in industrials and other areas of China’s old economy?
A: Returns on capital employed and returns on equity in many of these old economy industries may have bottomed. In fact, these metrics appear to be improving, as companies have scaled back expansion plans and capital expenditure just as the economic cycle and cash flows improve. Currently, this is translating into higher dividends for shareholders. We think any sustainable improvement in return on assets in the current economic cycle would be a very bullish sign for China, so we continue to watch this closely.