Ben Buckler, Investment Specialist
Analysis published by Baillie Gifford*
Key Points:
Focusing on China’s risks could lead investors to miss out on plentiful growth opportunities in key industries.
The Chinese government is swinging back to supporting the private sector to achieve the growth the country needs.
Although geopolitical tensions are inevitable, the country’s world-beating growth companies are pioneering the disruptive trends of the future
Questions persist about the role of the Chinese state, the progress of its economic reforms and its perceived challenge to the geopolitical order. All have added to the fear factor.
But change and disruption bring opportunities as well as risks. The former can easily be overlooked by those making broad-brush statements in a short-term market.
There, the picture can be muddied by a host of factors more to do with politics, perspective and sentiment than economic fundamentals.
Look at it this way. China has proved itself far more innovative than many believed was possible. The size of its markets and the scale of its ambitions provide formidable advantages, and the combination of a dynamic entrepreneurial culture and bold top-down policies are helping to deliver a number of world-leading companies.
Add in low valuations, low correlations with global equities and inefficiencies that offer scope for alpha, and China’s fundamentals continue to excite. The question therefore is whether fear of China’s challenges should be balanced against ‘FOMO’: fear of missing out on the long-term opportunities it offers.
The story so far
With growth slowing, policy risks rising and geopolitical challenges likely to continue, the risk-adjusted return on investment in China has changed markedly in recent years.
But no other country presents us with such radical change on such a large scale. The world-leading companies forging that change give us a glimpse of what the future will look like.
The reasons why are worth recapping:
Now the number two economy in the world, China has contributed more to global growth in the last decade than the entire G7 combined.
China’s stock markets are the second largest in the world. There are over 6,000 listed companies with almost 3,000 new companies emerging on China’s A-share indices in the last decade.
According to the Australian Strategic Policy Institute, China’s global technological lead now extends to 37 out of 44 critical sectors, spanning robotics, energy, the environment, advanced materials and key quantum technologies.
China now has more 5G base stations than the rest of the world put together and more than 60 per cent of the world’s total 5G users.
Despite its carbon intensity, China has more renewable energy capacity than the next seven countries put together, leads global electric vehicle (EV), solar and wind supply chains, and is pioneering efficient energy use though rapidly expanding ‘smart city’ digital infrastructure.
A list of China’s achievements could go on. And yet its rapid growth in global economic and political importance hasn’t been matched by a similar shift in importance to investors.
So what are they afraid of?
Slowing the pace
After the fastest and most widespread economic transformation in global history, an inevitable change of gear is underway. China has grown GDP by an average of more than 9 per cent a year since 1978. It shouldn’t be a surprise that this has had to slow down. Its investment-led growth model is being increasingly challenged by the economic, social and environmental imbalances that accompanied its rise.
The previous solution to economic problems was to increase investment spending. But excessive investment spending is now the problem. China’s leaders must find new drivers of growth while addressing the negative legacies of the old ones. They need to boost domestic consumption – arguably the government’s biggest challenge yet.
For a smooth transition, serious structural and institutional reforms are needed. But these bring political challenges. The recent picture is blurred by the effects of the COVID-19 pandemic, but China’s economy is slowing on the back of declining labour force growth, diminishing returns to investment, and slowing productivity increases.
The dynamics of its domestic economy are critical to its next stage of development. But it also provides a tailwind of government support for cutting-edge industries, such as semiconductors, artificial intelligence (AI) and green technology: sectors that are critical to global challenges in coming decades.
Don’t get distracted
Chinese equity market returns have little historical correlation with China’s GDP growth trends. A focus on the big picture can distract investors from the specifics that matter to companies and returns over time.
We believe generating capital returns requires us to invest in disruptive and secular trends that play out over years or decades, not by trading share prices against other fund managers over months or quarters.
Thankfully, there are plenty of Chinese companies involved in long-term structural growth themes that are largely independent of what happens to the macro environment.
Take AI for example, which one think tank expects to account for 26 per cent of Chinese GDP by 2030 (it was 0.4 per cent in 2022). Access to oceans of data and the ingenuity of its companies, put China in a strong position to exploit AI’s business-boosting potential.
China is already the world’s top industrial robot manufacturer. In semiconductors it is producing 30 times more chips than it did 20 years ago. We also see companies making impressive strides in sectors such as smart manufacturing, the industrial internet and smart cities.
These kinds of industries serve to keep the country globally competitive and increasingly self-reliant. Their progress marches on, largely unaffected by China’s macroeconomic gear change. This is what continues to excite us.
What’s clear is that as aggregate growth slows to something more normal, investors will have to become more discerning about differences across Chinese provinces, themes, sectors and companies. Active management will matter more.
Regulation’s role
The view of increased regulation in China as a power grab against private companies has helped sour foreign investor sentiment. But to Beijing, a state-centric, mixed economic model avoids the periodic crises of a capital-dominated society, achieving sustainable growth and social stability.
Despite geopolitical tensions, we shouldn’t forget that economic prosperity remains the linchpin of the legitimacy of the Communist Party of China (CPC), and private enterprise is critical to this. Why? Because the private sector makes up 60 per cent of GDP, 70 per cent of tech innovation and 80 per cent of urban employment.
So, while regulatory uncertainty has provided an uncomfortable backdrop, and the backlash of recent years will take time for business and consumer confidence to recover from, the balance between innovation and regulation is returning. Recent years may have marked a tough cyclical downswing, not a structural shift.
The state and the market are both vital to China’s long-term development. But because of the country’s unique system, the two will sometimes get out of balance. We should expect periods of volatility as regulatory norms adjust. But we can also expect continued pragmatism and a willingness to roll back policies that don’t help China’s long-term goals.
Private pioneers
Opportunities flourish where top-down policymaking aligns with bottom-up innovation in a market as vast as China’s. Whether in digitisation, automation, climate solutions or elsewhere, China is producing an increasing number of world-leading companies.
To meet President Xi Jinping’s target of “moderately prosperous GDP per capita by 2035,” its economy must grow by up to 4.5 per cent a year. You can’t do that with a declining population and zero innovation.
For all the challenges and frustrations of recent years, well-executed government policy has created areas of excitement. Renewable energy is one. With China a net importer of oil and gas, national security concerns incentivise heavy investment in renewables. Decarbonisation is China’s strategic opportunity to deliver comprehensive industrial and technological leadership.
EVs became a priority in China’s Five-Year plan way back in 2001. Now China is the global leader. Ford’s CEO Jim Farley calls it “a new world order”: across China, 6.8 million EVs were sold last year alone. That’s over 60 per cent of the total sold globally, dwarfing the 980,000 sold in the US. If Chinese EV maker BYD is correct and EVs make up 90 per cent of all new cars sold in China in five years’ time, then China is on the path to being the first major economy to make the EV transition.
The speed of change is almost frightening. In 1990, China had just five million cars on the road. Today [2023] it has 320 million, and accounts for almost 50 per cent of the world’s EVs. Investors must ask themselves whether they can afford to ignore the shift to next-generation technologies that Chinese firms are spearheading in these vital industries of the future.
Geopolitics meets economics
While change in China provides investors with opportunities at company level, discussion of economic fundamentals has been drowned out by the noise of geopolitical arguments at times. The US-China relationship is critical, challenging, and one whose ebb and flow in coming decades will have wide-reaching implications.
To date, it is Chinese companies that have been discounted most on geopolitical concerns, though greater East-West ‘decoupling’ could have far wider ramifications for global portfolios. Any alienation that fractures global supply chains would likely deliver mutual stagflation. Accelerated global warming would be another obvious consequence given China’s leading role in clean energy.
Some of these strains arise from China’s new growth-related self-confidence. Flawed analogies between China and other countries persist.
China’s economy defies analogy. The past four decades of growth are unprecedented in human history. Now it must reconcile competing goals: accessing global markets while preventing creative destruction in its unique system. Xi’s ‘common prosperity’ will therefore be delivered in a uniquely Chinese way, harnessing the benefits of free market capitalism while seeking to mitigate its excesses and inequalities.
Recently we’ve seen government willingness to trade high growth for sustainable growth.
But government intervention is also about supporting sectors critical to future growth, prosperity and stability. A slowing economy will only remind the Party of the importance of an innovating private sector to its policy goals. The rebalancing of policy in support of private companies bodes well for businesses previously caught in the regulators’ crosshairs.
China in the world
Despite our Western perspectives on China’s geopolitical challenges, we must recognise that it is not on a track that terminates in our kind of politics or economics. This means that, for governments in Africa, Central Asia, Latin America and the Middle East, China’s rise gives them an alternative to either assimilation to the West or autarkic isolation.
Countries that need investment, technology and market access do not always want to absorb Western values. The coming decades will therefore see a more self-confident China reaching out and shaping the world. Whether it’s attempted interventions in the Middle East and growing payment for its oil in renminbi, Brazil’s President Luis Inácio Lula da Silva visiting China and talking up their relationship, or the assertive tone of the BRICS summit in South Africa in [2023], we need to understand China’s changing role in the world.
While many commentators are eager to depict these new global dynamics in black-and-white terms, such over-simplification risks distracting investors from assessing opportunities on their own merits in the day-to-day, complex and nuanced world in which Chinese companies – and investment managers – do business.
Looking ahead
Through all this uncertainty, we must recognise that change and disruption are important drivers of opportunity. Only China presents us with such radical change on such a large scale. It has nurtured some extraordinary companies, that help provide a lens into the future. We can’t ignore what they are showing us, as my colleague Qian Zhang has described in her article ‘Conversations with Shanghai: opportunities in the A-share market’ (bailliegifford.com/shanghai).
Yes, China has its long-term challenges: a declining population is unhelpful to growth. ‘Common prosperity’, Xi’s core idea, means that efforts to distribute wealth are needed to ensure greater equality. Regulation will come and go. Valid worries about the state’s role, as well as the wider geopolitical challenges, are unlikely to disappear. Macro discussions will continue to dominate short-term news bulletins.
Meanwhile, the forces unleashed by technological innovation will only accelerate. Renewable energy costs will continue to fall, battery chemistry will improve, factories will become more automated and Gen Z youth will become the main consumer cohort. In all these areas, China increasingly gives us a glimpse of what’s to come.
Long-term investors like to spend their time in the future, where the expanded global role of China is all but certain. Steering between fear and FOMO starts with a nuanced view of what China is trying to achieve. Wariness of unpredictable change in a rising nation is understandable. But it shouldn’t distract us from the opportunities we could miss if fear isn’t kept in check.
* A well-established investment management firm based in Edinburgh, Scotland, founded in 1908 as privately-owned partnership with a long-term investment approach, known for its growth-oriented, high-conviction investment strategies – DeepSeek
N.B. While this article was published in December 2023, it remains as topical now as when it was released. We have taken the liberty to publish an abridged and slightly revised version of it now because of its valuable insights into China’s economic development and the effectiveness of President Xi Jinping’s Economic Thought. We would like to thank Ben Buckler and Baillie Gifford for their efforts to clarify China’s often misunderstood economic development model.
The original article can be accessed on https://www.bailliegifford.com/en/uk/individual-investors/insights/ic-article/2023-q4-china-fear-or-fomo-10041220/
