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What’s driving the Chinese economy?


How can China's opportunities and risks be explored within a goals-based investment framework.

 

China is a country in transition. After decades of strong economic growth as a low cost manufacturing economy driven by investments and exports, China is shifting its economic priorities. Policy makers are focused on strengthening domestic consumption and shifting from goods-based to services-based growth.

While this rebalancing is likely to result in lower average GDP growth over coming years relative to the last 20 years, we expect that the culture of innovation and change from Chinese companies will create tremendous investment opportunities for SMSF investors.

Outlook

Profound changes are already underway with specific companies and sectors experiencing rapid growth during this transition period. We believe that investors who focus too ardently on the weaker GDP growth numbers could risk a missed opportunity to capture the behavioural changes of consumers or the companies that are thriving through this great rebalancing.

These companies are contributing to the disruption of the former growth mode companies and are flourishing towards a ‘future state.’ Importantly, the growth of these companies, particularly those in the technology, healthcare and consumer sectors, reflects the broader global transition to an environment dominated by technology penetration and globalisation.

We have identified a number of themes that are expected to shape the investment landscape in China in the medium to long term, with specific implications for equity investments.

Innovation propels Chinese companies up the value chain

For years, Western companies and consumers have benefitted from cheap Chinese manufacturing particularly in basic electronics, hardware and clothing. But China is no longer just the assembler or component supplier in the manufacturing chain and has rapidly moved up the quality curve in a range of industries in which the US, Japan, Korea, Taiwan and Europe have historically had a competitive advantage. Through innovation, China has already increased its market share of higher value manufacturing. China is now recognised as an equal peer for equipment manufacturers and engineering firms in heavy industries, competing with companies such as Caterpillar, Komatsu and Outotec.

Most recently, China has successfully produced its own high-end smartphones and motor vehicles, entirely using its own components and software. Chinese smartphone brands (such as Huawei, Lenovo, Meizu and Xiaomi) have increased their global market share from 15 per cent in the fourth quarter of 2013 to 27 per cent in the second quarter of 20151.

China’s research and development spending has surpassed the EU at almost two per cent of GDP while patent registration in China is now the highest in the world.

China policy makers want China to supply more of its own needs. In May 2015, the State Council announced the 'Made in China 2025' policy, which focuses on building indigenous capabilities in high-end precision manufacturing. Semiconductors are the first priority segment. The goal of this policy is to have China increase its self-sufficiency rate for integrated circuits to 40 per cent by 2020 and to 70 per cent by 2025. If that were to occur, our global equity team estimates all incremental foundry capacity installed globally during the next ten years would be in China.

In addition, Chinese consumers are beginning to favour domestic brands where there is a noticeable quality improvement and/or cost advantage. The trend presents tremendous challenges for developed market companies and we envisage multiple, cascading impacts:

There are two important implications for investors. First, Chinese companies exposed to this theme are likely to experience solid growth. Secondly, these companies represent a potential competitive threat to companies in developed markets.

As a hedge against this competitive threat, SMSF investors could consider allocating to the most dynamic Chinese companies exposed to this theme. Investors could also challenge their fund managers to identify the potential threads and opportunities in their portfolios of Chinese companies increasing market share in previously uncontested markets.

1Sanford Bernstein, 2015

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