Markets

Fading anti-corruption measures could add boost to China recovery

Our recent trip to the country meeting companies revealed that the impact of the anti-corruption drive may have been underestimated by investors, and so too might the impact it will have as it fades.

07/02/2017

Michael Zorko

Portfolio Manager, Business Cycle - UK and European Equities

Introduction

Since the dark days of 2015, China’s economy has new-found momentum driven by government stimulus. Markets have reacted to this increased activity, with industrials and commodity stocks responding particularly positively.

During our recent trip to China the businesses we visited confirmed the environment was strong and improving

The twice-a-decade party congress is approaching in November and with economic stability a stated priority of government, continuing momentum seems a sensible assumption. Given this focus on stability, Trump’s surprise election could not have come at a worse time for China.

Despite being portrayed as juvenile and inexperienced by the Chinese press, he is being taken extremely seriously by party leaders and avoiding a trade war this year is a particular priority in our view.

Returning to the matters raised by the businesses we visited, a common theme was how significantly President Xi’s popular corruption crackdown which began in 2012 has impacted decision-making.

Whilst the direct impact on the luxury goods/beverages/leisure sectors is clear, the impact of wider investment seems less thoroughly appreciated by investors.

Having seen many of their colleagues arrested and assets seized, officials in both the public and private sectors have been reluctant to award any new contracts or even renew existing ones, for fear of being accused of corruption.

Clearly this behaviour hurts almost all sectors of the economy when decision-making stops, but as it washes out it could offer an interesting recovery tailwind.

Quantifying the impact is difficult given its inherent opacity but could garner more investor attention, particularly when the market contemplates the potential duration of the current phase of government stimulus and a new regime of tightening monetary policy.

We expand on these themes below.

Corruption crackdown hurting growth

China’s economy slowed from growth of around 8% per annum in 2012 to approaching 6% by 2016.

The majority of economists explained China’s slowdown as being principally down to a maturing economy suffering from overcapacity while managing a rebalancing away from industrial manufacturing towards consumption and services.

While both of these factors undoubtedly played their part, it seems this underplays the impact of President Xi’s aggressive crackdown on corruption which began in 2012.

Chart showing China's structural growth decline from fourth quarter 2010

While the corruption crackdown’s impact on the luxury goods (fewer high-end watches for businessmen), beverages (fewer high-end liquor sales) and leisure sectors (fewer no-expense-spared dinners between suppliers and customers) is understood (and our trips to restaurants in Shanghai can confirm there is certainly oversupply), the impact on wider investment seems less thoroughly appreciated by investors.

A theme that came up consistently during our meetings with companies in China was how the crackdown has impacted decision-making more broadly.

Having seen many of their colleagues arrested and assets seized, officials in both the public and private sectors are reluctant to award any new contracts, or even renew existing ones, for fear of being accused of corruption.

Even if the official knows they have performed a fair process, how do they know their counterparty has acted properly? To give an example, valve manufacturers we met complained that orders were hurt dramatically from this effect.

The impact of this behaviour can hurt almost all sectors of the economy when decision making stops, but as it washes out offers an interesting recovery tailwind.

Quantifying the impact is difficult given its inherent opacity but could garner more investor attention, particularly when the market contemplates the potential duration of the current phase of government stimulus and a new regime of tightening monetary policy.

Given the sensitivity of this issue, perhaps we shouldn’t be surprised the impact might be underplayed.

President Xi has flatly rejected any accusation that the anti-corruption drive has slowed growth stating “anti-corruption efforts have not hurt the economy”.

Clearly his comments are targeted at the Chinese people, with whom this policy is very popular, rather than external investors.

However, it’s not just the government pushing this message; many official China commentators do too. We think this reflects how widely under-appreciated the impact of the anti-corruption drive is.

Congress dominates 2017, with Trump the unwanted wild card

Key to understanding the government’s objectives for 2017 is that the Communist party will be holding its 19th National Congress in November.

A far-reaching change in the make-up of the party leadership will take place at the event, though Xi Jinping is likely to retain his seat as General Secretary of the party and president.

As this twice-a-decade process approaches, the party wants a stable backdrop to ensure a smooth transfer, avoiding any criticism of the regime.

Donald Trump becoming president is unwelcome in Beijing. Despite being portrayed as juvenile and inexperienced by the Chinese press, he is being taken extremely seriously by party leaders and avoiding a trade war this year is a particular priority in our view.

Not only is his rhetoric particularly aggressive towards China, but his unpredictable approach and uncertainty around the details of his policy mix is just what China wants to avoid heading into the congress.

Image illustrating the Chinese media's view of Trump

Will this added uncertainty encourage the authorities to prioritise economic progress and stability more than ever?

Early indications are that Trump will follow through on his more confrontational approach to China (e.g. breaking convention by taking a call from the leader of Taiwan) and has not really toned down his rhetoric since his inauguration.

It remains to be seen if Trump’s talk of a trade war is more than rhetoric, but one thing’s clear: Trump's victory could not come at a worse time for China.

Monetary tightening with fiscal stimulus, remind you of anywhere?

Perhaps the first signs of the government trying to “stage manage” the economy into the congress was the increased investment that started in 2016.

The chart below shows the fixed asset investment growth with a distinct pickup in 2016.

Talking to companies on the ground in China it seems this step-up in investment is continuing with the private sector picking up the public sector’s lead. So before Brexit and Trump’s victory, China was already engaged in fiscal easing.

Chart showing China's pick up in investment through 2016 but still lower than 2008

The Chinese government would be happy to see a gently depreciating currency, but coupled with the rally in commodities and house prices, consumers could come under increased pressure in 2017.

Consumer prices rising faster than 3% is officially a concern and the government has already changed its official monetary approach from “flexible” to “neutral” and more recently raised the rate on medium term lending by 10bps.

Perhaps the rate rise is to reduce lending to the housing sector, which has been particularly strong, but also to reduce capital outflows in anticipation of further rate rises in the US, in addition to increasing rules on cross border capital movements.

The narrative that China’s depreciating currency will export inflation to the world looks less assured.

Chart showing the China's currency midly appreciating since November 2016

The prospect of tightening monetary policy with fiscal stimulus is not one that suggests growth will accelerate.

Perhaps after the congress Trump’s aggressive anti-China rhetoric will be used as an opportunity to push a more reformist agenda and remove the restrictive growth target.

Mining shares consensus underweight but cheap

Given the authorities’ clear desire for stability we suspect the market may be positively surprised on the economic outcome in 2017.

As discussed above, RMB/capital outflows remain a key concern but absent a full blown run on the currency, RMB depreciation should be manageable at around 5%.

So given China is the key importer of many commodities we view the backdrop as broadly supportive for end demand.

Following our trip we suspect the equity market may be being too harsh by ascribing mining companies double digit free-cashflow-yields.

While commodity prices may be extended near-term on seasonality or financial speculation, the magnitude of correction needed to justify the current share prices is looking increasingly pessimistic, so we have increased our mining holdings across our portfolios.

Table showing how mining valuations remain relatively cheap