Investment Strategies

GUEST ARTICLE: China - It's All About Fundamentals - Lombard Odier Investment Managers

Salman Ahmed and Jan Straatman Lombard Odier IM 11 November 2015

GUEST ARTICLE: China - It's All About Fundamentals - Lombard Odier Investment Managers

A great deal of ink has been spilt on whether China's recent market falls presage a more serious decline, or are part of a healthy correction in its situation. The Swiss private banking house offers its views.

Salman Ahmed and Jan Straatman, of Lombard Odier Investment Managers, examine one of the biggest issues of the time: Is China’s slowdown a sign of worse things to come or just one of those inevitable, even healthy, corrections?

It has been impossible to escape the bearish sentiment surrounding emerging markets in recent months. But we believe investors must block out the white noise and focus on the fundamentals.

The Red Dragon of China, once a potent symbol of huge emerging market growth potential, is slowing. This slowdown was inevitable as it is impossible to sustain such a fast growth trajectory given the sharp build-up of debt. But we think the likelihood of a full-blown financial meltdown in the world’s second largest economy remains low.

And, there is still, in our view, value to be garnered here. China's equity market, for example, offers value and is cheaper than India and the Philippines on both price earnings and price-to-book measures. Furthermore, China's consumer discretionary sector has been getting cheaper over the last five years relative to developed markets, relative to MSCI World and relative to the emerging markets consumer universe.

The underlying fundamentals for many emerging markets remain solid when compared to 1997. Inflation, for example, has fallen significantly with 17 of the 19 emerging market countries having inflation below 10 per cent in 2014, compared to just nine in the run up to the 1997 emerging markets crisis. Mexico, Turkey and Romania stand out as particular examples here, having reduced their inflation rates by over 15 percentage points.

The all-important level of foreign exchange reserves, without which an economy is paralysed, are for most emerging economies significantly higher than they were in 1997/98. External debt is also lower and exchange rate regimes are flexible, which allows emerging economies to adjust to economic shocks.

Some emerging markets importers, for example India, are actually benefiting from sustained lower commodity prices. Others including South Africa, Brazil and Chile, face challenges. China has shifted its official economic policy away from commodity intensive investments as part of its new approach to economic management.

Overall it seems that despite macroeconomic and geopolitical concerns, emerging markets are adapting to an environment of slower growth. With stronger fundamentals in place in many countries we don’t believe the current slowdown is likely to lead to another widespread systemic crisis in emerging markets.

China is a resilient beast, with high foreign exchange reserves, and the strong policy drive behind economic rebalancing is bearing fruit. Remember the Chinese government has the financial flexibility to support growth with a central government debt-to-GDP ratio of 41 per cent of GDP in 2014 (UK debt-to-GDP hovers around 90 per cent). China’s large foreign exchange reserves are available if needed to provide support in the case of financial stress. Total international reserves stand at around $3.5 trillion of which $1.2 trillion alone is in US treasuries.

To engineer a soft landing in growth China is supporting a transition to consumption and is visibly assisting in channelling resources away from fixed asset investments (mainly large infrastructure and other projects). To that end, the government is committed to a number of reforms.

For instance, the government has in its 13th five-year economic plan prioritised a rebalancing of the economy towards consumption spending. One example is a commitment to ease the one-child policy. This should help boost consumer spending among younger households.

Other reforms will target the gradual introduction of a social safety net through broadening of a pension system and setting up a system for providing healthcare. One of the reasons that household saving is currently high is the need for consumers to provide for their own safety net.

China will continue to promote investment in services and consumer sectors to build a more robust economy. This process is only just beginning and so for investors who can look beyond the gloomy predictions we think there are opportunities to be found, both in China and, given increased differentiation, within the wider emerging markets.

As ever, the underlying strength of different emerging markets must be assessed on a case-by-case basis. It should be no surprise that so far in 2015 the fundamentally weighted emerging market local currency bond index has outperformed the market-cap weighted index by around 5 per cent.


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