Whither China and its stock market? In 2009 the Chinese market defied most critics and skyrocketed almost 75 percent (in local currency terms), making it one of the world's best performing stock markets in a year replete with strong performances from many countries. The large stimulus package put in place by the Chinese government helped buoy economic growth. “China implemented a $585 billion stimulus program in an economy with a gross domestic product of less than $5 trillion.? They put all of it to work relatively rapidly.? The United States has a $787 billion stimulus program in a $14 trillion economy and only 30 percent of it has been spent,” notes Byron Wien, now market strategist at the Blackstone Group.?
To many bulls on China, this outperformance is no surprise. The Chinese economy has defied critics for years, as its ongoing transformation has continued unabated since reforms were instituted in the 1980s and 1990s. In recent years China has grown into both an economic and political powerhouse, dramatically altering the global landscape.
“China now makes and buys the most cars in the world. There are 13.5 million sold in China versus 10 to 11 million in the U.S. during 2009,” says Richard Gao, the manager of the Matthews China Fund. In addition, the high savings rate of Chinese consumers and the vast foreign currency holdings of the Chinese government have given the country a newfound power. Consider that the Chinese now hold almost a trillion dollars of U.S. government debt.
But in recent months the chorus of skepticism regarding China's economic and stock market performance has reached a greater crescendo. Famed short seller Jim Chanos has joined the fray, and has been warning of an incipient disaster for several months. How credible are the naysayers, and, if they are right, what are the implications for U.S. investors in China?
Recent disputes between Google and China illustrate the strain of doing business in a free market economy ruled by an authoritarian government. Google has threatened to pull out of China completely, following attacks on the company in China and government attempts to hack into the email accounts of Chinese activists. And the list of complaints about intellectual property theft there is long: Gucci says it is being knocked off, while copying of iPhones, German locomotive designs and Japanese SUVs has been reported. The lack of true intellectual property rights may leave the Chinese economy unable to develop into anything more than an exporter of low-priced goods intended for U.S. consumption.
A Real Estate Bubble?
In Chanos' view, the stimulus package helped to create a credit bubble which drove real estate prices in China to unsustainable heights, leaving China poised for a real estate crash similar to the U.S. experience since the 2006 housing peak. “Bubbles are best identified by credit excesses, not valuation excesses,” Chanos says. “And there's no bigger credit excess than in China.” There is ample evidence to support the notion that credit excesses have emerged in China — lending in China doubled to $1.35 trillion in the first 11 months of 2009, a growth rate not usually associated with sound lending practices.
In fact, China's performance in 2009 may have been too dependent on the enormous, non-recurring stimulus package for it to repeat in 2010. As Wien notes, almost $600 billion was put to work in 2009, leaving 2010 without a similar boost. And this package drove the economy — for the year, export growth in China was negative, a huge change for an economy which has prospered by becoming the supplier of choice for American consumers. GDP growth in China for 2009 was driven entirely by domestic consumption, which benefited enormously from the stimulus package announced in late 2008 during the height of the financial crisis.
For many China bulls, these concerns are real and legitimate, but do not dampen their positive outlook for Chinese markets. In the view of Guang Yang of Templeton funds, who manages the Templeton Global Opportunities Trust (ticker: TEGOX) , which is currently overweight China, strong evidence of a real estate bubble is apparent, and has been for some time. Says Yang, “In terms of a real estate bubble, there is definitely a bubble in certain parts of the country, but I have been saying that for several years. For at least 5 years, if not 7, prices have been too high for real estate, but overall, there is a very powerful urbanization going on, and this will support the rest of the market.”
Yang looks at real estate prices compared to personal income and rent yields, which measure the return of investment of a real estate investment which is rented out, to reach these views. Housing prices in the largest Chinese cities, like Beijing and Shanghai, are twice as expensive as Miami real estate, yet personal income in these cities is only 1/3 of Miami's average, leaving real estate prices 6 times as high on an income valuation basis. “Rent yield in Beijing and Shanghai is probably 2 or 3 percent, whereas in the States, it is 6 to 10 percent,” observes Yang.
Yang joins Chanos in attributing some of the creation of this bubble to China's massive stimulus program. “Last year China tried to inject liquidity into markets to stimulate the real economy, but some found its way into real estate and the stock market. In 2009 [there were]10 to 15 percent gains in real estate, [and the] stock market [jumped] up more than 75 percent,” Yang notes. For bears, this is ominously similar to the U.S. experience, where massive liquidity injections from the government following the tech crash in 2000 and 2001 helped create the real estate bubble.
In yet another telling anecdote, Yang observes that China has developed a bubble in French red wine, as flush Chinese consumers flock to foreign luxury items. The famed Chateau Rothschild in France now sees 95 percent of its red wine consumed in China.
Still, Yang remains bullish on China as a whole, basing his view on the massive socioeconomic transformation that remains ongoing today. He has positioned his fund to benefit from Chinese infrastructure growth, investing in Chinese coal companies and equipment suppliers to power generation projects.
Yang also has the flexibility to invest outside of China, and is bullish on South Korea in particular. “South Korea valuations are at a much lower level, and they are competitive globally, like Samsung. The South Korean market currently trades at 22 times trailing earnings, and some companies, such as Samsung electronics, are trading less than 15 times expected PE this year. Chinese companies are not as competitive technologically at the current time but they have a huge home market.”
Gao, the manager of the Matthews China Fund (MCHFX), takes a longer term view, but acknowledges the risk and believes governmental response will help mitigate these issues. “In the short term, especially in some specific areas like high-end residential property and cement and other commodities, we do see some signs of overheating, and believe there is some short-term risk in those specific areas. However, the Chinese government is aware of potential overheating in those areas, recently increasing its bank reserve ratio requirements to limit credit overexpansion, and fine-tuning its monetary policy to control asset inflation. It is clear the government is aware of these short-term issues,” says Gao, whose fund is overweight stocks that will benefit from growth in domestic consumption in China, like the retail sector, hotels, education companies and IT firms. He is avoiding pure commodity companies and pure export companies.
But is betting on Chinese consumers really wise? Granted, their personal income growth has been tremendous, and the personal savings rate leaves them with the funds needed to increase domestic consumption. With a cooling or crash of real estate prices seeming highly likely, it is hard to imagine Chinese consumers becoming more profligate when their largest personal investments — their homes — become caught in a downward trend and the effects of the 2009 stimulus package recede. This will mean any continued strength in Chinese performance may be dependent on a resumption in export growth, making a bet on the Chinese stock market similar to wagering on a recovery in the U.S. consumer — not necessarily a bad bet, but not one that diversifies the portfolio of a U.S. investor who is already invested in the domestic market.
So how can advisors concerned about China properly position their clients' portfolios, given the need for international diversification? For starters, consider trimming exposure to funds invested solely in China. Given the huge run in 2009, convincing clients to take profits shouldn't be too difficult. Reps can also focus on global funds or emerging markets funds that are diversified across either the Asian region or the world as a whole. Funds like the Templeton Global Opportunities Trust, which had a 27 percent weighting in Asia as of September 2009, with only 6 percent in China, may be a good bet. The Franklin International Small Cap Growth Fund (FRSGX), which has a 5-star rating from Morningstar, currently focuses on opportunities in the U.K. and Japan, as well as Germany, and the Mutual Global Discovery Fund (TEDIX), which also carries Morningstar's highest rating, focuses on the U.S. and Europe.
With the help of Morningstar, we also came up with the following mutual fund options, looking at the universe of 4- and 5-star rated funds and evaluating their exposure to China, both relative to their benchmark and on an absolute basis. We looked for emerging markets and Pacific/Asian funds with 20 percent or less exposure to China, based on reported holdings as of December 31, 2009. The AIM Developing Markets Fund (GTDDX) ranks well on return, and has a very low weighting in China. The Class “A” shares carry a 5.5 percent load. For strictly Asian exposure, consider the Matthews Pacific Tiger Fund (MAPTX), which holds 56 percent of its peers' average exposure to China.