The road ahead for China's economy

Investors should probably keep changes in the Chinese economy in mind, despite its incredible growth over the years, Janine Mace reports.

When it comes to emerging markets, investors the world over have been fixated by the stunning growth in the Chinese economy, and this has fuelled the expansion of many other economies.

Australia in particular, has been a beneficiary, and this has translated into good performances by many local stocks.

However, the key question for Australian investors now is what the future holds for the Chinese economy and what this means for both emerging markets and Australian equity investments.

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According to Pengana Capital, emerging market investors will need to take more care with their stock selection in the future, with many Australian stocks also likely to face a tougher time going forward.

“Over the next three years the structural shifts in China will be very important,” explains Diane Lin, senior portfolio manager for Pengana’s Asian Equities Fund.

“In the past decade, growth has been driven by capital investment, exports, housing and infrastructure. However, this is changing and has now shifted to the domestic economy and new industries. These changes in China are not necessarily good for Australia.”

Lin points out the Chinese Government’s 12th Five-Year Plan for 2011-15 has reinforced its target to restructure the economy from a manufacturing to a service-driven emphasis.

In 2012, the Government will implement an aggressive fiscal policy designed to encourage development of a service industry in China. This includes new tax benefits designed to encourage entrepreneurship and small businesses in the service industry.

“We believe the development of the service industry will help China grow its economy without over-reliance on natural resources and energy,” Lin says.

She believes it is important for emerging market investors seeking to capture the growth potential of China to keep this restructuring in mind when selecting investment funds.

“Now the key word is diversification and how much of the mining, financials and service sectors you have exposure to. The service sectors are going to be more important going forward, and we believe this will be increasingly recognised in 2012 as we see the result of the policy shifts in China.

"These will reduce demand for building materials and this will eventually be reflected in company earnings,” Lin says.

“We expect small and mid-cap companies – typically from the new industries such as retailing, IT services and industrials – to outperform large caps, which are more prevalent in the old industries such as banking, property, building materials and coal.”

This means financial advisers will need to carefully select their investment benchmark and emerging market fund to ensure they gain exposure to service industries, rather than the traditional sectors of the Chinese economy. 

Lonsec senior investment analyst, Steven Sweeney, agrees investors need to keep the changes in the Chinese economy in mind when investing – both in emerging markets and local equities.

“Australian equities have done very well over the long-term and can be seen as almost an emerging market, as the index is dominated by resources.

However, as emerging Asia becomes more consumer-driven, performance will shift away from being resources-driven,” he says.

“Investors definitely need both Australian equities and emerging markets, and over time they need to increase their exposure to emerging markets. We have had a great run in Australian equities, but the future performance may be different.”

Lin agrees times are changing: “Going forward, the Australian market’s concentration on the mining industry will be less beneficial.”

This means looking to sectors of the equity market outside resources.

“Investing in Asian equities with a tilt towards structurally growing industries that Australian equities do not provide exposure to – such as IT, healthcare and consumer – is essential for Australian investors,” she says.

“A lot of Australian investors have not recognised the impact of these changes [in China] as they have not happened yet.”

Landing: soft or hard?

While shifts in the Chinese economy are important in the medium-term, over the next few months questions about the appeal of Chinese stocks turn more on whether the economy is in for a soft or hard landing.

Lin believes the Chinese Government has considerable room to loosen its monetary policy and stimulate domestic demand. “In terms of fiscal policy, China is taking a very different approach to developed markets through structural tax change,” she says.

“China is almost going in the opposite direction to the Western world, and this means there is a good investment environment for emerging market equities.”

Sweeney remains cautious: “Asian managers have been bearish on China for 18 months to two years.

However, this could be changing as Chinese inflation is coming off and the Government appears to be engineering a soft landing, so managers have gone back to a neutral weighting as valuations are attractive.”

He believes a key point for investors to remember is that “GDP growth in Asia – and especially in China – is not necessarily reflected in sharemarket performance”.

Despite the concerns, Chinese investments retain their fans.

HSBC head of global investments in Australia, Geoffrey Pidgeon is positive. “China will have a challenging six months, but valuations are good,” he says.

According to HSBC data, the Chinese market is currently trading on about eight times 2012 earnings, making it an attractive prospect.

Fidelity Australia investment commentator, Michael Collins, agrees the outlook is good, particularly given the level of government support.

“China has some problems, as local authorities are pushing for reflation versus the central authority wanting to slow, but the outlook is sound and the opportunities are enormous,” he notes.

“It has a good outlook, with growth for the next few years expected to be in the high single digits. This will come down in time as it rebalances to domestic demand, but it will still be good.”

Collins believes another factor for investors to consider is that most China-based investment funds are largely centred on Hong Kong companies – many of which have been hit by the uncertainty over European debt.

“However, they have great potential to bounce back when concerns over Europe dissipate,” he says.