The Four Trends Driving China's Future Growth

In case you have just woken from a decade’s long slumber, China is shifting from an export-driven, low cost producer economy, to a consumer one. They used to make Happy Meal toys. Now they want to build the machines that make the plastic that goes into the Happy Meal toys.

According to U.S. Trust’s wealth management division’s chief market strategist, there are four trends that will drive China’s growth even if it grows less than the 7.5% it produced in the second quarter.

As China’s economy opens up and reforms, there will be hiccups along the way.  Joseph Quinlan, U.S. Trust’s strategist in New York, isn’t naive to China.  Like many bears, Quinlan sees annual real GDP growth falling to as low as 5% within 10 years.

Notwithstanding this gradual downshift in the Chinese economy, “China will remain a critical pole of global growth,” he says. “As we continue to highlight, there are only three economies in the world that really matter: the United States, the European Union and China.”

A Shanghai morning.  The sky seems to be the limit, but the China consumer narrative is probably over-crowded. (Photo credit: jamesfischer)

Quinlan outlines four trends happening in China’s economy. In his words below:

Trend 1. The shift in investment: from “mining” to “dining”

Owing to the massive build-out of China’s physical infrastructure over the past decade, the nation’s strategic M&A focus has long been directed toward the acquisition of natural resources. Think “mining” or strategic investments in Canada, Australia, Africa and South America. Steel, copper and iron ore acquisitions fall under this umbrella, with Chinese acquisitions in the mining sector totaling $30 billion in 2008. The value of mining deals dropped sharply in 2009, thanks to the global financial crisis, but averaged nearly $20 billion per annum over 2010-2012.

Beginning in 2013, however, China’s strategic M&A focus shifted. As the government reeled in excess lending to the overheated property market, demand for “mining” assets declined; the priority shifted toward “dining” or
acquisitions directed toward satisfying the growing demands of China’s more affluent middle class. The
wealthier a population becomes, the greater the level of consumption—i.e., the greater the demand for
protein, fast/convenient food, beverages and related items, among other things. Against this backdrop, Chinese acquisitions within the “dining” space soared to nearly $13 billion last year, a record high, and have remained quite strong over the first half of 2014.”

Investment implications: Quinlan expects more Chinese mergers in the U.S. food industry — like the recent purchase of Smithfield Foods — and related sectors. Chinese inbound investment in the U.S. is bullish for some U.S. equities in this space.

My Two Yuan: Investors will need a magical crystal ball to decipher which agribusiness giant is the next Chinese takeover target.  Look for equity analysts that cover the sector and see what they say about possible M&A candidates. China, Mexico or Brazil would be the likely foreign buyers.

Trend 2. The shift in capital flows: two-way instead of one-way 

For decades, inbound investment flows were strongly encouraged, while outbound investment flows were highly restricted. China preferred that its scarce capital stay at home to promote growth, along with strong capital inflows. China is awash in excess capital. China’s international reserves are presently in excess of $3 trillion, an abundance of wealth that China’s underdeveloped financial system cannot absorb. Hence the need to allow greater capital outflows. As part of this trend, Chinese demand for global real estate has soared over the past few years, with the United States a primary target. To wit, Chinese buyers plunked down $12 billion in U.S. real estate last year.

Investment implications: The U.S. residential and commercial real estate markets will remain prime targets of Chinese investment. So will hard assets like timberland and farmland, according to Quinlan.

My Two Yuan: The only winners of China real estate investment in the U.S. will be real estate brokers, or millionaires with high end property in desirable neighborhoods. No way to truly play this as an equity story.

Trend 3. The shift in consumer leverage: more, not less

The rising use of credit, notably among younger Chinese consumers, will be critical in driving personal consumption expenditures in China in the future. Buying a car in China is still primarily a cash transaction, but things are changing. U.S. and foreign car makers, through their financing arms, are changing the rules of the game by encouraging/pushing car loans in the world’s largest automobile market. Outstanding car loans in China were 10% higher at the end of the first quarter than the same period a year ago, helping to propel overall auto sales in China.

Investment implications: When it comes to loan-financing a car, China is way behind the rest of the world. However, a one-time cash practice is shifting; auto financing is catching hold in China, a bullish prospect for U.S. automobile makers, says Quinlan.

My Two Yuan: China  has around 300 auto makers so investors will want to pick the ones that are going to be buyers. The rest are simply too weak and have no market share to speak of. U.S. automakers do well in China, but their stock price will move primarily on American sales and not Chinese.  Great Wall Auto Company has taken a beating this year, but it’s a big brand with potential and trading at just 9x. This one is for those who like to buy when there’s blood in the streets.  BYD, the electric car company, is up over 40% year to date. Be warned.

 

Trend 4. The shift in shopping: online shopping (ecommerce) explodes

Total retail sales in China in the first half of the year rose 12.1% from a year ago. That’s not terribly robust by Chinese standards, but the more telling story is this: Online retail sales over the same period soared 48.3%. Online sales in China are now greater than comparable sales in the United States, a trend that speaks to the growing use of the internet in China and the e-commerce culture that is taking hold in China. A decade ago, there were very few e-commerce platforms in China, and the nation lagged in the development of payment systems and physical delivery mechanisms to underpin e-commerce transactions. Today, much has changed. With some 600 million internet users in China, e-commerce revenue growth has grown at a 70% compounded annual average over the past few years. These figures speak to the growing sophistication of Chinese consumers and their underlying purchasing power. It also speaks to the underlying dynamics of China’s internet capabilities; unbeknownst to many investors, the mainland’s internet infrastructure is much more developed than commonly thought.

Investment implications: The soaring use of e-commerce in China is part and parcel of the nation’s shift toward more consumption-led growth. There is tremendous upside for China’s e-commerce market, but many U.S. firms have found it very tough to crack the market, thanks to intense local competition and government regulations. This is an indigenous Chinese play; think local when investing in China’s e-commerce.

My Two Yuan:  Tencent is your man. Also, wait til Alibaba goes public and buy on the lows.  This is China’s Amazon on steroids