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Chinese growth is recovering as services and domestic consumption take a greater share of GDP, says Chinese Equities fund manager Victoria Mio.
Encouraging first-quarter data shows that China’s much-vaunted economic restructuring to convert from an exports-led to a domestic-orientated economy is bearing fruit, she says. That bodes well for investing in Chinese companies which are in tandem adopting more domestic-demand based business models.
The latest macro data revealed that China’s real GDP growth slowed down to 6.7% on an annualized basis in the first quarter of 2016, which was better than expected and remains above the new national target of 6.5%. Crucially for the success of the economic restructuring program, the services sector’s share of GDP rose to 56.9% in Q1.
Nominal fixed asset investment growth also picked up, rising to 11.1% year-on-year (YOY) in March from 10.2% YOY in January and February. Nominal retail sales growth picked up to 10.5% YoY in March from 10.2% YOY in the initial two months. And there is still life in exports, which grew 11.5% YoY in March.
Revolution in services
“For many investors that we talked to, it was a surprise to find out that the services sector already accounted for 51% of China’s GDP, roughly 90% of GDP growth, and 41% of China's workforce in 2015,” says Mio. “Investors are so used to the idea that the industrial economy is slowing drastically and are therefore puzzled by the strength of GDP growth. What is really driving the economy?”
The answer lies in the revolution in services, after the country recognized in its latest five-year economic plan that reliance on exports was unsustainable, particularly following austerity programs in the major economies of the West. The charts below show just how far the Chinese services sector has come since 1995:
The services sector as a percentage of GDP. Source: NBS, Deutsche Bank, Robeco
Nominal GDP Growth by Industry. Source: Haver, NBS, Bernstein, Robeco
“The services sector has been growing consistently faster than the industrial sector,” Mio says. “In China, services to corporates are not well developed, so the majority of the services sector is related to consumption. Therefore, higher growth in services sector means that the shift towards a more consumption-driven economy is already underway.”
However, she cautions that there may be a flipside: “The major question is: if the industrial sector enters a recession, will employment be negatively impacted, and will this drag down consumption? It depends on employment levels.”
“The services sector has absorbed more migrant workers from the agricultural sector than the industrial sector. And, as it continues to grow at a double- digit pace, it is likely to gradually absorb excess labor from the industrial sector.”
Four key investment areas
Mio sees four areas with the biggest investment opportunities over the next five years. “We continue to like ‘new economy’ themes such as consumption, technology and innovation, healthcare, and the ‘New Silk Road Initiatives’ as these are very much aligned with the 13th Five Year Plan,” she says. “However, we do not favor those sectors with supply-side adjustments, or financial sectors negatively impacted by interest rate declines, such as banks and insurance.” Her key themes are shown in the chart below:
Focusing on the ‘new economy’
In terms of which equities that foreign investors can buy, there are 700 Chinese companies listed in Hong Kong and the US, but with differing prospects. During the recent 2015 earnings season, financial services, health care and utilities companies linked to the transformational theme saw earnings rise, while more traditional industries such as energy and materials saw profits fall. Even consumer stocks have begun to experience lower earnings as Chinese people wean themselves off luxury goods and focus more on personal services, travel, health care, better housing and insurance.
E-commerce is a good example of the transformational theme, as China’s Internet sector took in CNY 390 billion (USD 60 billion) in revenue in 2015, and is expected to grow at a Compound Annual Growth Rate of 30% in 2015-17. New emerging segments still have huge growth potential, such as mobile e-commerce, cloud computing, online payment and social advertising, Mio says.
“The new economy will outperform structurally, but we still should be selective,” she says “We believe the main investment opportunities are related to the long-term structural changes relating to the new economy. In general, we prefer sectors with reasonable valuations and sustainable growth, and companies with high dividend yields that can successfully withstand economic cycles.
“At the same time, we understand that the new economy, which is driven by consumption, innovation and policy support, will continue to command a valuation premium as it delivers stronger organic growth. However, the valuation of some sectors is still at very high levels, so we need to be cautious and selective to avoid those areas that lack sufficient fundamental support such as earnings visibility or sustainable business models.”
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