Why investors are making a big mistake on China

Turning bearish on China seems to have become a trend in the investment world

Why investors are making a big mistake on China

Turning bearish on China seems to have become a trend in the investment world. Many investors are following a gloomy and widely accepted narrative that overleverage, overbuilding and overcapacity are plaguing the economy and making China a risky bet. In addition, residential home prices remain elevated and a large, opaque shadow banking system poses a systemic risk to the entire credit system.

The conclusion, therefore, should be a simple one. Avoid China at all costs and look for the next growth juggernaut, right? Well, no. Not according to Forstrong Global’s President and CIO Tyler Mordy, who views China in a different way altogether.

“Yes, China had a rapid industrialization phase between 2002 and 2014, which drove the promotion of commodity markets and prices, but the big story in China is the emergence of over one billion consumers who are making their way into global markets,” Mordy says.  “China’s rebalance, as Western economists have called it, is moving away from being a country known for exporting cheap goods to a country that is moving up the value chain, growing its income rapidly, and introducing protections to its middle classes that are the norm in Western countries.”

China bears are quick to point to the slowing of economic growth (GDP growth averaged 11% in the 2002-2011 decade and is now under 7%), but that slowdown has been coordinated by policy. The new leadership is urging a move away from building up infrastructure and heavy industry to what Mordy calls the “resource efficiency stage”, where the priority is profits and ensuring returns on investments.

“The days of thinking of China as a country that stocks the dollar store and has bloated capacity need to be put into the historical dustbin,” Mordy says. “Investors should instead think of China’s future path, which, although it will be slower, will be all about higher quality growth.”

Mordy believes that the Western media plays an integral role in shaping investor perceptions of China. He describes what he sees as a “huge knowledge gap” in how the Chinese economy is actually operated and has identified a variety of misinformation and chronic “China crash” false alarms in Western media.

“Today, investors naturally worry whether equity prices can keep rising even as the economy keeps slowing, but this is the wrong question,” Mordy says. “Headline GDP should not be the focus. In fact, GDP growth tends to be negatively correlated with equity markets - most likely because investors overpay for headline growth. The most important facts about China today are not the problems of slowing growth and high leverage. Rather they are the shift away from exports and capital spending to consumer-led growth, improving margins and financial liberalization.”

The makeup of China’s stock market is also changing and Mordy urges Canadian investors to examine the country’s IPO market, which he describes as booming. The result, Mordy says, is that the Chinese stock market will come to more closely resemble the underlying economy as a whole, rather than being dominated by state-owned enterprises.

“Short interest for the biggest China equity ETF (FXI) continues to be massive, totaling about $790 million in assets. Yet, now is the time to be investing in an unloved sector,” Mordy says. “As China makes progress in the face of the many naysayers, equities have much room to be revalued upward. The recent decision by MSCI to add 222 China A-share stocks starting in May 2018 is icing on the cake.”