Inflation expectations in China are a great concern
The China A-share market, reserved for domestic investors and those with QFII quotas, has suffered huge losses so far this year after outperforming for two years in a row. AsianInvestor spoke with fund managers and analysts about their views on the market. This is part one of a four-part series.
James Cheng is the Singapore-based lead portfolio manager for Asian equities strategies at Morgan Stanley Investment Management. He manages the $900 million Morgan Stanley China A Share Fund, which was launched in September 2006. That fund is the first and thus far only US-listed portfolio that invests in the China A-share market.
According to Lipper data, the Morgan Stanley China A Share Fund posted a return of 174% in 2007 and was the top performing qualified foreign institutional investor (QFII) portfolio last year. Cheng spoke to AsianInvestor about his outlook for the China A-share market.
What is your outlook for the China A-share market?
Cheng: In the short-term, we are, like everybody else, concerned about inflationary pressures in the economy. The impact of the potential policy errors that the authorities can make when dealing with the inflationary pressures is something weÆre watching very closely. In our emerging markets experience, authorities tend to want to deal with inflationary pressures in different ways and henceforth sometimes that creates unintended consequences on the companies that we hold.
IÆm a little bit more sanguine than most people to the extent that I think the inflationary pressure that China faces is not specifically a Chinese problem. ItÆs much more of a global problem.
What would be the best way for China to deal with inflation?
I think they have to focus on the medium- to longer-term solutions. If you look at Chinese economic growth over the last 10 to 20 years, it has really been the result of a supply response. If you look at the last bouts of inflation in China, effectively the problems were resolved over a long period of time.
In the past, money supply growth was very high. Today, money supply growth is about 14% to 15% so it is about right smack in with nominal GDP growth. ItÆs not excessive when you compare it to the past. ItÆs not a worse-case scenario. In a way, I have been asking this question: what is the right level of inflation? In the west, you have an acceptable inflation level of around 2% to 3%, but the growth rate in the west is about 3% too. In a way, we should look at growth-to-inflation ratio.
What kind of solutions are you looking for?
The key issue here is really the supply response. What the Chinese have done in the last 10 to 20 years is build infrastructure across the country such as roads and ports. Now, I can do a day trip, start from central at 7:30 in the morning, drive all the way to Guangzhou, start my company visit there, and be back in Hong Kong at the end of the day and during the day, I could see four to five factories. ThatÆs the state of the infrastructure now in China.
When you look at emerging markets, a lot of the inflationary pressures are caused by infrastructure problems. If you go to India, for example, there is a high level of wastage in the retail business because by the time they ship the farm products out to the city, many of the farm products are already rotten. This is one of the problems that the Chinese have focused on and they have done a good job with that.
I am actually more concerned about inflation expectation. Inflation by itself at around 6% is not as scary as inflation expectation. Inflation by itself is just a number and over time, it will come down. But when inflation expectation starts building, it becomes a spiral.
What about the medium- to long term economic and stock market prospects in China?
On the medium- to longer-term, we are much more focused on companiesÆ profitability. We are seeing some hits and some of them are serious. I have been to factories in China, there have been some changes to ChinaÆs labour law and people are talking about that. In general, there has been some pressure on the low margin producers. There are a lot of factories that are being rumoured to be closed down. I think a lot of them are closing down to move inland, but some of them û such as the higher polluting ones û are closing down because they are being driven out. It is like an industrial upgrade for the coastal city.
In think what you are seeing in China today is a change in the export structure. The traditional exports of textiles and value-added items are rapidly giving way to the export of low-end capital equipment. This is very important because this is the key reason why emerging markets are growing a lot better-than-expected, given the rate of decline in the US. In the last GDP number that came out, the fourth quarter GDP in the US already contracted around 0.3% if you take out the trade impact. It flies in the face of people who donÆt believe in decoupling. I donÆt use the word decoupling. I use the word desensitization.
What kinds of companies are leading the way in China?
The key here is ChinaÆs growth is proving to be quite resilient despite the slowdown in US growth that we are already witnessing. The point here is that (several) days ago a company called Sonoma announced it got a contract for $1.6 billion from a Nigerian cement maker. And then it got another $0.6 billion from Lafarge to build six cement plants, three in China and three elsewhere. Combined, the contracts are valued at $2.2 billion. This is for ordering Chinese cement making equipment, and we are seeing a lot more of this around.
If IÆm not wrong, the Chinese companies like ZTE and Huawei, which is not listed, have about 20% to 30% of the global GSM telecommunications equipment market and they are coming at a much lower price. I think their per sub-capex for Chinese made telecommunications equipment is about below a US$100, maybe US$80. ItÆs very hard for equipment suppliers like Ericsson and Nokia to compete because the price performance is going down in ChinaÆs favour.
I completely take the argument that the Nokia and Ericsson equipment last longer, maybe 20 years, while the Chinese equipment may last 10 years. But in the face of technology thatÆs always changing, maybe extremely long-lasting products are not essential. If you have a product that will come in at $60-$80 per sub-capex, then you can justify a very low ARPU. It becomes economically justifiable.
On the other hand, you have the South African countries or Latin American countries that are exporting materials to China such as iron ore. The prices of raw materials are going up while the prices of capital equipment are going down. What happens with this combination? You can grow faster because you can develop faster. I think that is why the growth of global emerging markets has surprised on the upside. That to some extent is verified by the fact that CaterpillarÆs chairman just came out and said something about how they are witnessing the fastest growth in a very long time and this is something you can verify that on their website.
WhatÆs the percentage of your fund that is in China A-shares?
Almost all of it. The fund was specifically designed as an A-share fund. Less than 5% of the fund is in H-shares.
Is the China A-share market the best way to get exposure to ChinaÆs growth story? Or should investors have a mix of China A-shares, H-shares and red-chips?
ItÆs my view that you should ignore the alphabet soup. WhatÆs important is you get the right level of exposure. The good thing about the China A-share market is you do get a lot more exposure to the domestic sector of the economy. Not everything that is listed in the A-share market is in the H-share market.
The China A-share market is a much more diverse universe. You have companies such as the traditional Chinese wine maker Kweichow Moutai that you donÆt get in other markets. So what you have is a lot more leverage of the domestic market and a lot more leverage on specific sectors of the economy thatÆs doing well. Other examples include the machinery sector, which is not in the H-share universe.
What are the sectors that you favour at the moment?
Like everyone else, we like sectors that are exposed to the domestic area. Generally speaking, we tend to stay away from the export sector because of the renminbi pressure.
Are companies more transparent now and better researched?
I find investing in China A-shares more interesting. At this point in time, the level of analysis thatÆs available has become very generic so if you are able to dig deeper and develop different angles, it actually becomes much more interesting.
How many people are in your team?
There are about 20 people in the global emerging markets team. When we get highly convicted on certain sectors like coal, for example, itÆs not just a Chinese view. ItÆs a view that we are able to round up globally together with our Australian and Brazilian colleagues. We have a fairly concentrated portfolio.
What is the challenge that you are facing now when investing in the China A-share market?
The key challenge is to dig deep and find new companies that can do well despite challenging macro environment. I think in China there are a lot more chances of finding this, but we have to do a lot more work. If you look at the US, it has gone through recessions and booms but there are always companies that do well. I think that the Chinese economy is big and diverse enough that there should be companies that will do well even during an economic slowdown.
For an in-depth look at China's fund management industry and domestic stock market, see the April 2008 edition of AsianInvestor magazine.
According to Lipper data, the Morgan Stanley China A Share Fund posted a return of 174% in 2007 and was the top performing qualified foreign institutional investor (QFII) portfolio last year. Cheng spoke to AsianInvestor about his outlook for the China A-share market.
What is your outlook for the China A-share market?
Cheng: In the short-term, we are, like everybody else, concerned about inflationary pressures in the economy. The impact of the potential policy errors that the authorities can make when dealing with the inflationary pressures is something weÆre watching very closely. In our emerging markets experience, authorities tend to want to deal with inflationary pressures in different ways and henceforth sometimes that creates unintended consequences on the companies that we hold.
IÆm a little bit more sanguine than most people to the extent that I think the inflationary pressure that China faces is not specifically a Chinese problem. ItÆs much more of a global problem.
What would be the best way for China to deal with inflation?
I think they have to focus on the medium- to longer-term solutions. If you look at Chinese economic growth over the last 10 to 20 years, it has really been the result of a supply response. If you look at the last bouts of inflation in China, effectively the problems were resolved over a long period of time.
In the past, money supply growth was very high. Today, money supply growth is about 14% to 15% so it is about right smack in with nominal GDP growth. ItÆs not excessive when you compare it to the past. ItÆs not a worse-case scenario. In a way, I have been asking this question: what is the right level of inflation? In the west, you have an acceptable inflation level of around 2% to 3%, but the growth rate in the west is about 3% too. In a way, we should look at growth-to-inflation ratio.
What kind of solutions are you looking for?
The key issue here is really the supply response. What the Chinese have done in the last 10 to 20 years is build infrastructure across the country such as roads and ports. Now, I can do a day trip, start from central at 7:30 in the morning, drive all the way to Guangzhou, start my company visit there, and be back in Hong Kong at the end of the day and during the day, I could see four to five factories. ThatÆs the state of the infrastructure now in China.
When you look at emerging markets, a lot of the inflationary pressures are caused by infrastructure problems. If you go to India, for example, there is a high level of wastage in the retail business because by the time they ship the farm products out to the city, many of the farm products are already rotten. This is one of the problems that the Chinese have focused on and they have done a good job with that.
I am actually more concerned about inflation expectation. Inflation by itself at around 6% is not as scary as inflation expectation. Inflation by itself is just a number and over time, it will come down. But when inflation expectation starts building, it becomes a spiral.
What about the medium- to long term economic and stock market prospects in China?
On the medium- to longer-term, we are much more focused on companiesÆ profitability. We are seeing some hits and some of them are serious. I have been to factories in China, there have been some changes to ChinaÆs labour law and people are talking about that. In general, there has been some pressure on the low margin producers. There are a lot of factories that are being rumoured to be closed down. I think a lot of them are closing down to move inland, but some of them û such as the higher polluting ones û are closing down because they are being driven out. It is like an industrial upgrade for the coastal city.
In think what you are seeing in China today is a change in the export structure. The traditional exports of textiles and value-added items are rapidly giving way to the export of low-end capital equipment. This is very important because this is the key reason why emerging markets are growing a lot better-than-expected, given the rate of decline in the US. In the last GDP number that came out, the fourth quarter GDP in the US already contracted around 0.3% if you take out the trade impact. It flies in the face of people who donÆt believe in decoupling. I donÆt use the word decoupling. I use the word desensitization.
What kinds of companies are leading the way in China?
The key here is ChinaÆs growth is proving to be quite resilient despite the slowdown in US growth that we are already witnessing. The point here is that (several) days ago a company called Sonoma announced it got a contract for $1.6 billion from a Nigerian cement maker. And then it got another $0.6 billion from Lafarge to build six cement plants, three in China and three elsewhere. Combined, the contracts are valued at $2.2 billion. This is for ordering Chinese cement making equipment, and we are seeing a lot more of this around.
If IÆm not wrong, the Chinese companies like ZTE and Huawei, which is not listed, have about 20% to 30% of the global GSM telecommunications equipment market and they are coming at a much lower price. I think their per sub-capex for Chinese made telecommunications equipment is about below a US$100, maybe US$80. ItÆs very hard for equipment suppliers like Ericsson and Nokia to compete because the price performance is going down in ChinaÆs favour.
I completely take the argument that the Nokia and Ericsson equipment last longer, maybe 20 years, while the Chinese equipment may last 10 years. But in the face of technology thatÆs always changing, maybe extremely long-lasting products are not essential. If you have a product that will come in at $60-$80 per sub-capex, then you can justify a very low ARPU. It becomes economically justifiable.
On the other hand, you have the South African countries or Latin American countries that are exporting materials to China such as iron ore. The prices of raw materials are going up while the prices of capital equipment are going down. What happens with this combination? You can grow faster because you can develop faster. I think that is why the growth of global emerging markets has surprised on the upside. That to some extent is verified by the fact that CaterpillarÆs chairman just came out and said something about how they are witnessing the fastest growth in a very long time and this is something you can verify that on their website.
WhatÆs the percentage of your fund that is in China A-shares?
Almost all of it. The fund was specifically designed as an A-share fund. Less than 5% of the fund is in H-shares.
Is the China A-share market the best way to get exposure to ChinaÆs growth story? Or should investors have a mix of China A-shares, H-shares and red-chips?
ItÆs my view that you should ignore the alphabet soup. WhatÆs important is you get the right level of exposure. The good thing about the China A-share market is you do get a lot more exposure to the domestic sector of the economy. Not everything that is listed in the A-share market is in the H-share market.
The China A-share market is a much more diverse universe. You have companies such as the traditional Chinese wine maker Kweichow Moutai that you donÆt get in other markets. So what you have is a lot more leverage of the domestic market and a lot more leverage on specific sectors of the economy thatÆs doing well. Other examples include the machinery sector, which is not in the H-share universe.
What are the sectors that you favour at the moment?
Like everyone else, we like sectors that are exposed to the domestic area. Generally speaking, we tend to stay away from the export sector because of the renminbi pressure.
Are companies more transparent now and better researched?
I find investing in China A-shares more interesting. At this point in time, the level of analysis thatÆs available has become very generic so if you are able to dig deeper and develop different angles, it actually becomes much more interesting.
How many people are in your team?
There are about 20 people in the global emerging markets team. When we get highly convicted on certain sectors like coal, for example, itÆs not just a Chinese view. ItÆs a view that we are able to round up globally together with our Australian and Brazilian colleagues. We have a fairly concentrated portfolio.
What is the challenge that you are facing now when investing in the China A-share market?
The key challenge is to dig deep and find new companies that can do well despite challenging macro environment. I think in China there are a lot more chances of finding this, but we have to do a lot more work. If you look at the US, it has gone through recessions and booms but there are always companies that do well. I think that the Chinese economy is big and diverse enough that there should be companies that will do well even during an economic slowdown.
For an in-depth look at China's fund management industry and domestic stock market, see the April 2008 edition of AsianInvestor magazine.
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