BY NICK YEO, Aberdeen Standard Investments

It’s an odd time to talk up Chinese stocks. China is locked in a bitter trade war with the U.S. and it was the world’s worst-performing major market last year.

It's an inefficient market 

Retail mom-and-pop investors account for 80% of trading turnover on the country’s stock exchanges, which, until recently, were closed to overseas investment. They tend to be swayed by breaking news rather than cool-headed analysis of company prospects. The result is a volatile, sentiment-driven market.

But this creates opportunities for investors to pick up good companies trading below fair value. Sentiment can change quickly. Two drivers that could inspire a turnaround are a U.S.-China trade deal and China’s inclusion in global indices.

A prolonged trade conflict would hurt corporate profitability. Tariffs dent the earnings of companies that benefit from global supply chains, many of which are listed on U.S. exchanges. This may have been a factor behind last December’s S&P 500 Index slump.

It’s in the interest of both sides to resolve this dispute. The catalyst could be another market rout. President Trump is already risking backlash from rural Republicans impacted by Chinese duties.

While we expect talks to continue, we’re confident a deal will be struck — especially with a U.S. presidential election on the horizon. Any deal would likely be received positively by markets, giving companies greater clarity on their revenue prospects and spending plans.

At the same time, global index provider MSCI is doubling the number of Chinese stocks — or A-shares — in its emerging-markets index. Within five years, it’s estimated they could account for 20%. This would draw in capital from foreign institutions that track the index passively.

This is long-term money, stickier than today’s sentiment-driven flows. It will expose Chinese company managements to global standards of accountability and best practice.

Improving governance tends to enhance corporate performance and helps to realize value for shareholders. We believe it’s better for investors to get ahead of this curve.

Back to the future

So why invest in China? The answer is growth. Despite frequent bulletins on China’s slowing GDP growth, it is still above 6% a year — faster than advanced economies.

At the start of this year, consensus 2019 earnings forecasts for A-share stood at 15%. Investors will struggle to find many markets offering double-digit growth.

Perspective is important. China and India used to account for half of global GDP growth, before the industrial revolution gripped the U.S. and Western Europe in the 18th century and reduced both to a statistical irrelevance.

It was only in 1978 that Communist Party reformists set in motion a process of industrialization and urbanization on an unprecedented scale. China is now the world’s second-largest economy in nominal terms.

Within 30 years, China and India are again forecasted to account for 50% of global GDP growth. It points to the mother of all mean reversions.

Today 60% of China’s population lives in urban areas — and this figure is rising. People gravitate toward cities to find better jobs, health care and education services. It means they get wealthier, too. In 1960, China’s GDP per capita was $100. Today it’s $7,500, and in Shanghai it’s $20,000.

Some 39% of the population is classified as middle class now — from 2% in 1999. That’s half a billion consumers. Life expectancy has also more than doubled since 1960, to 76 years.

Rising wealth and living standards mean China is moving to higher-value goods and services. Investors can buy into listed companies poised to benefit from this structural growth. We have found quality stocks in areas including travel, food and beverages, luxury goods and Chinese medicine.

China’s exchanges also have low correlation to global markets. Chinese policymakers are steering the economy away from manufacturing and exports to reliance on domestic consumption and services. The latter make up more than half of China’s GDP growth today.

Domestically focused firms are less tied to global-economic and interest-rate cycles. They are also more insulated from the worst effects of the trade war. In this way, A-shares can bring valuable diversification benefits to a portfolio.

So investors prepared to look beyond today’s trade war and focus on the long-term opportunity will be well placed to ride on China’s future consumption growth.

Important information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries. Diversification does not ensure a profit or protect against a loss in a declining market.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Aberdeen Standard Investments or TEXPERS.

About the Author
Nicholas Yeo is the director and head of the China/Hong Kong Equities team at Aberdeen Standard Investments. Yeo holds a bachelor's degree in Accounting and Finance from The University of Manchester and a master's degree in Financial Mathematics from Warwick Business School. He is a CFA charterholder.

BY NIKOLAJ SCHMIDT, T. Rowe Price

Volatility returned to markets in mid‑May after trade talks between the U.S. and China appeared to stall. If the current dispute between the two biggest contributors to global gross domestic product becomes a full‑scale trade war, it will adversely impact not just the U.S. and China, but the entire world economy. Trade wars do not produce any winners in the long term.

Tariffs directly affect economies in two main ways: first, because they function as simple taxes on goods and, second, because they cause uncertainty, which impacts household and corporate decision‑making. Let’s look at each of these in turn.

Tariffs as Taxes

Although taxes on goods increase the tax revenues of governments, they also lead to a misallocation of resources, which drives the overall economy into an inefficient equilibrium. In economics jargon, this is known as the “deadweight loss” of taxation. Because tariffs raise the price of consumption, the purchasing power of households is reduced and fewer goods are bought. At the same time, households and companies try to substitute away from the tariffed goods, thereby ending up consuming a basket of goods that has been distorted by the tax. This new basket of goods represents an inferior choice to the consumer.

When President Donald Trump tweets that the U.S. will win the tariff war, he assumes that U.S. households and companies will substitute toward a domestically produced basket of goods and that this will indirectly create new American jobs. I’m skeptical. 

Although taxes on goods increase tax revenues, they also lead to a misallocation of resources.

In my view, it is more likely that U.S. households and companies will shift their consumption to goods produced in Vietnam or Mexico rather than back to American‑produced goods and that U.S. jobs which have been outsourced to China will not be repatriated before the production process has become entirely automated. American‑produced goods would be a viable alternative if either the U.S. was the most cost‑efficient producer after China (which it is not) or if the U.S. harbored the production facilities required to produce electronic gizmos it currently imports from China. In an unsettled trade regime, U.S. companies are unlikely to build onshore production facilities to cater to this potential demand.

Tariff Uncertainty

The second way that tariffs reduce consumption is by creating uncertainty, which causes households to postpone consumption and companies to defer capital expenditures. The impact of uncertainty on an economy is akin to monetary tightening (which is clearly not part of President Trump’s agenda). As the U.S. and China are the two biggest economies in the world, any uncertainty created by a prolonged trade war between the two will affect the global economy. The few countries that might benefit are those, such as Vietnam and Mexico, that can deliver substitutes for tariffed Chinese goods in a cost‑efficient manner.

The impact of uncertainty on an economy is akin to monetary tightening.

Trade wars do not just hit consumption, they also impact inflation, central bank policies, and exchange rates. As tariffs function largely like consumption tax hikes they are likely to cause headline inflation to rise initially, but just like any other form of fiscal tightening, they will eventually cause growth to slow. This will lead to an increase in output gaps, which reduce core inflationary pressures. As U.S. households and consumers substitute away from goods produced in China, China is likely to respond by trying to export its excess capacity to the rest of the non‑U.S. world. This is how the disinflationary shock of tariffs is transmitted across the globe.

The impact of tariffs on central bank policies will differ by region. For a developed economy central bank, the monetary policy implications of tariffs are straightforward: Tariffs lead to slower growth and lower core inflation pressures, so the appropriate monetary policy response is dovish. In emerging markets, however, rising uncertainty is more likely to trigger capital outflows, putting downward pressure on growth and upward pressure on inflation. To keep capital onshore, emerging market central banks may be forced to respond with monetary tightening.

How tariffs affect exchange rates is a complex function of demand elasticities. Usually, the country whose output gap is most adversely affected by tariffs is likely to see its currency depreciate the most. In the current environment, this would mean that emerging market currencies would depreciate versus the U.S. dollar and the U.S. dollar would lose ground against other major currencies.

Given the negative overall impacts of tariffs, it is tempting to conclude that sanity will prevail and that the U.S. and China will step back from the brink and walk away from a situation that will only serve to harm the economies of both countries. However, President Trump seeks to be reelected next year and may decide that the political gains from an outright fight with China outweigh the political cost of slower economic growth. Indeed, support for populist parties across the world continues to grow on the back of rising inequality and concerns about the impact of globalization. Tariffs may not be a good idea economically, but it is politics, not economics, that wins elections. Consequently, we are unlikely to see the back of tariffs anytime soon.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of T. Rowe Price nor TEXPERS, and are subject to revision over time.

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