Consumer rising in China

E*TRADE Securities1

09/26/18

Why invest in China? The answer may be in the “middle”.

Many market observers pin the transformation of China’s economy on the rise of its middle class—both in number and influence. According to one recent estimate, by 2022 China’s middle class will number roughly 550 million people, equivalent of the third most populous country in the world.1

What’s more, the means by which consumers wield their growing spending power, driven in part by technology- and service-related employment, has created what could be a sustainable growth story.

Still, investing in the world’s second largest economy carries risk. After all, China remains a developing economy with a per-capita GDP that ranks 70th out of 170 countries, according to the International Monetary Fund.2 What this could mean, though, is that China has an extended runway for growth. For some, that could create investment opportunities in a previously unexplored market.

Let’s jump into the middle of that market here.

Sustainable trajectory

“China may have found its economic footing,” according to Andrew Mattock, China Fund portfolio manager at the investment firm Matthews Asia. “China’s growth trajectory could be sustainable for several reasons."

"First, real household income rose by 130% over the last decade, compared to an 11% growth rate in the US. Second, household debt is low, consisting mostly of mortgages for primary residences with high cash down payments required. Third, household savings is very high, backed by strong consumer optimism.” 3

One way to gauge consumption power—and consumer confidence—is to analyze periods of heavy national spending. In China, one example is Singles Day, which started 1990s as an anti-Valentine’s spending celebration for singles. The day’s adoption by e-commerce giant Alibaba in 2009 has made the annual November 11 event a consumer staple. In 2017, Singles’ Day sales totaled $25.3 billion, which was more than the combined sales for Black Friday and Cyber Monday in the US.4

Connectivity as opportunity

China is logging on, and it is doing so on the go. Of China’s population of 1.36 billion, 723.6 million accessed the internet using a mobile phone in 2016—that’s roughly double the US population and about a third bigger than European Union’s.5

Drilling deeper, mobile internet as a primary payment vehicle is a pronounced theme in China. The National Bureau of Statistics of China estimates mobile will represent 74% of total online sales by 2020, well ahead of the 46% estimate for the US. (For context, online sales in China totaled $750 billion in 2016, more than the US and UK combined.4)

Helping to connect China’s domestic markets are companies like Alibaba and Tencent, both of which rival Amazon in terms of market cap. It began with e-commerce giant Alibaba’s payment platform Alipay, which the company transitioned to a mobile amid the rise of the smartphone. Tencent and its WeChat app is Alipay’s main competition. It combines social messaging capabilities with mobile pay functionality, making it something of a one-stop shop for users.

Extending its reach

Statements from Xi Jinping at the 19th National Congress of the Communist Party of China, at which the party sets its national policy goals, suggest China’s wants to connect global markets, too. Xi calls it part of the “great rejuvenation of the Chinese nation.”6

One goal is to be more of a creator than just a manufacturer. China wants its companies to compete in the world’s largest developed markets, backed by Xi’s pledge to “stimulate and protect the spirit of entrepreneurship.” In 2017, China became one of the top five in US patents recipients for the first time, trailing the US, Japan, Korea, and Germany.7

Xi also highlighted how China is embracing globalization through its ambitious “One Belt, One Road” project. Dubbed a modern Silk Road, the $1 trillion plan involves China-led infrastructure projects that will connect more than 60 countries across Asia, Europe, the Middle East, and Africa.

How to invest

Buying any emerging market stock, let alone enough to build a portfolio has its challenges.

“Historically, commingled investment vehicles such as mutual funds and exchange-traded funds (ETFs) have been the most efficient ways to gain exposure,” according to Andrew Cohen, Director of Investment Strategy at E*TRADE Financial. “They offer diversification by sector and holdings, with the added benefit of professional trading and management.”

Currently, US Investors gain access to most Chinese stocks through American depository receipts (ADRs) trading on US exchanges or through Hong Kong (H-shares). Notably, in a move that signals further integration with global capital markets, US index provider MSCI gave investors exposure to Chinese A-shares through its MSCI Emerging Markets Index and the MSCI All-Country World Index starting in June 2018. The MSCI indexes have included shares of Chinese companies listed offshore, but not those that trade on China’s two main domestic exchanges in Shanghai and Shenzhen (A-Shares).

As of July 31, 2018, emerging market benchmarks had roughly 30% weightings in China, many of which tilted toward some of China’s traditional sectors.8 For those interested in pure exposure to China, there are a number of country-specific ETFs and mutual funds. With China innovating, this could be a way to gain access to segments with higher growth potential.

Technology is one such area. For example, many companies could be poised to benefit directly and indirectly from a secular growth in data consumption. “The migration of 4G wireless technology to 5G is driving up wireless telecom capital expenditures,” according to Tiffany Hsiao, China Small Companies fund manager at Matthews Asia. Hsiao also highlights the Internet of Things, which is introducing smart technologies to everyday appliances like refrigerators and creating a new generation of digital appliances.

Proceed with caution

Despite its growth, China is still an emerging market. As a result, investing in China could increase the risk of loss more than investing in a developed market, given, among others, greater political, tax, economic, foreign exchange, liquidity, and regulatory risks. Other risks more specific to China include:

  • Trade/tariffs. The Trump administration imposed tariffs on various Chinese imports in the middle of 2018, and it has threatened more, amounting to the hundreds of billions of dollars. If this develops into a protracted trade war, it could be detrimental to the Chinese economy.
  • Growth slowdown. The ongoing transformation from a government-led, export-driven economy to a more capitalistic, entrepreneurial economy may cause growth to slow.
  • Hard landing. The more extreme version of a growth slowdown is a hard landing—i.e., when growth is unsustainable and drops drastically over a short time. The risk is especially acute for export-heavy economies. For China, the risk should continue to ease as its economy becomes more balanced.
  • Debt problem. China has relied on government stimulus and debt to meet its growth targets following the Global Financial Crisis. If it fails to curb its debt expansion, it could lead to heightened risk of a sharper slowdown.
  • Government intervention. Chinese authorities have made a habit of stepping in to support their markets. Typically, though, the result has been more, not less, volatility. For example, in 2015 the government let the yuan depreciate nearly 2% versus the US dollar, which led to a brief but sharp, global market sell-off.9
  • North Korea. Heightened tensions along the Korean Peninsula could have ramifications for China, given its ongoing trade relationship with North Korea.

The bottom line

China is evolving in ways that make it increasingly similar to the US economy and society. The goal, according to Xi, is to develop “an economy with more effective market mechanisms, dynamic micro-entities, and sound macro-regulation.”4

An argument can be made that the consumer, driven by its burgeoning middle class, has surpassed industry as China’s primary economic engine. And what comes from this transformation could start to have global ramifications, especially with US policy appearing to lean protectionist under the current administration.

But there are risks to rapid development. One such risk is that such growth is not backed by high-quality development. For investors looking for exposure, that could be a theme worth tracking as a more open China creates potential investment opportunities.

1.       Kim Iskyan, “Why you should be investing in China’s high-flying middle class,” Stansberry Churchouse Research, November 16, 2016, http://stansberrychurchouse.com/china/why-you-should-be-investing-in-chinas-high-flying-middle-class/

2.       International Monetary Fund, World Economic Outlook Database-October 2017, International Monetary Fund. https://www.imf.org/external/pubs/ft/weo/2017/02/weodata/index.aspx

3.       Q2 2018 data from the National Bureau of Statistics of China and CEIC.

4.       “Alibaba’s Singles’ Day Goes Global With Record $25 billion in Sales,” Bloomberg, November 12, 2017, https://www.bloomberg.com/news/articles/2017-11-12/alibaba-singles-day-goes-global-with-record-25-billion-in-sales

5.       Ash Alankar, “Options Market Likes China’s Mobile-First Revolution,” Bloomberg, August 24, 2017, https://www.bloomberg.com/view/articles/2017-08-25/options-market-likes-china-s-mobile-first-revolution

6.       “Full text of Xi Jingping’s report at 19th CPC National Congress,” China Daily US Edition, November 4, 2017, http://www.chinadaily.com.cn/china/19thcpcnationalcongress/2017-11/04/content_34115212.htm

7.       Susan Decker, “China Becomes One of the Top 5 U.S. Patent Recipients for the First Time,” Bloomberg, January 9, 2018, https://www.bloomberg.com/news/articles/2018-01-09/china-enters-top-5-of-u-s-patent-recipients-for-the-first-time

8.       MSCI Emerging Markets Index (USD), July 31, 2018, https://www.msci.com/documents/10199/

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9.       Virginia Harrison, “Global stock markets plunge on China currency decline,” CNN Money, August 12, 2015, https://money.cnn.com/2015/08/12/investing/china-yuan-stock-markets-sell-off/index.html

Index definitions

The MSCI Emerging Markets Index captures large- and mid-cap representation across 24 emerging markets (EM) countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI All-Country World Index captures large- and mid-cap representation across 23 developed markets (DM) and 24 emerging markets (EM) countries. The index covers approximately 85% of the global investable equity opportunity set.

Disclaimer

Investing in emerging or developing markets involves exposure to economic structures that are generally less diverse and mature, as well as to political systems that can have less stability than those of more developed countries. These securities may be less liquid and more volatile than investments in US and developed non-US markets.

The economies of Asian countries differ from the US economy. Investments involve currency fluctuations and currency controls, political and legal uncertainties, and the risks of confiscatory taxation and the nationalization of assets. Local governments' actions can have a significant effect on economic conditions, which in turn could adversely affect the volatility, value, and liquidity of investments.