“China is becoming a core asset class”
As trade tensions intensify, Julius Baer’s Chief Investment Officer Yves Bonzon discusses the advantages of investing in China.
China’s rise to global superpower
The change started a long time ago, in 1978, when the then leader of china Deng Xiaoping made a very important choice to shift the system of allocating scarce resources in the country away from communism and towards capitalism.
The execution was remarkable, extracting hundreds of millions of people out of poverty. During that entire transformation, the Western world was extremely supportive witnessing the rise of china but also taking advantage of a cheaper manufacturing base and a new market opening in a country of more than a billion inhabitants.
Increased prominence, increased controversy
The entire post-war Western system is one of countering communism by facilitating trade with countries willing to embrace a capitalist and very critically a democratic political system. That development has gone a long way. China is now challenging the United States geopolitically, especially in the Asian region, and we’ve come to a point where the tradeoff between the benefit of letting China develop further and the challenges to US supremacy have shifted toward the latter rather than the former.
Accordingly, the US has shifted strategy towards China and is pressuring them to better respect intellectual property rights and a number of other things. This has manifested itself first with tariff escalation, which has been going on by now for more than a year, and has actually shifted to a new dimension, potentially, as there have been suggestions in recent days that there might also be capital market restriction involved in U.S. tactics. We don’t think this is going away. Clearly, we’ve reached a point at which, yes, there might be some kind of a trade deal ahead of the US election next year but that challenge of the two superpowers vis-à-vis each other will continue.
Actually, we foresee a world in ten years’ time where we’re going to have one world but two systems. You know it’s a variation of the one country two systems of China and Hong Kong but at the global level this time. On the one hand we have China with its own economic and financial cycle and its own technology ecosystem, and on the other side the US with the economic and financial system that we know and we’re familiar with and it’s own technology ecosystem. It would be a sort of dual world, and for investors it’s a very interesting but challenging paradigm because that’s one that they’ve never been confronted with in the past but that’s one that they should embrace with optimism because that’s one which offers diversification benefits.
A few years ago, actually shortly after the great financial crisis at the end of the last decade, China shifted its growth models away from export led towards domestic demand led. That shift in and by itself leads to some slowdown in growth although in absolute terms China’s GDP growth today is as big or even bigger than it was at a lower base at higher growth rates years ago. So, that’s one important element. The second element is that growth has actually slowed globally. Interestingly, if you strip out China and India from emerging countries GDP growth rates, you realise emerging countries excluding China and India have seen growth converging toward G7 growth levels. So, the historical emerging market growth premia has actually vanished and the one country that is still growing faster than anyone else of a bigger base than anyone else remains China.
Julius Baer’s Chinese equity allocation
We’ve characterised this decade as a dollar secular bull market. When the gravity in the currency systems is towards a stronger dollar, capital flows in the world tend to go towards dollar producing balance sheets. In that market regime, dollar secular bull, emerging markets tend to underperform. So, our stance vis-à-vis emerging market equities has been a rather cautious one for quite some time now, actually most of the decade. Within emerging markets, though, we think China offers unique characteristics and we want to construct our asset allocation strategically in a way where we get the maximum benefit in terms of diversification for a portfolio by adding non-developed equities. To us, clearly, China is the one market that brings the most benefit by a margin in this respect.
Hopefully there are risks, because if there weren’t any risks there would be no opportunity whatsoever. We distinguish three broadly defined categories of risk. There is business risk, monetary debasement risk, and confiscation risk. We like China business risk, and we think diversifying a portfolio and exposing it to China business risk definitely brings value for investors over time. The second risk is in no way different from other countries with maybe the additional benefit in China that because China wants to play a bigger role globally, China has a vested interest to keep its currency reasonably stable, a decent store of value in monetary terms. Other countries might be more tempted by monetary debasement then China actually if you take a five to ten year view. The last risk is confiscation, financial repression, and that is clearly the one we are most concerned with. We don’t think it’s really more acute in China than it is in many other countries but that’s probably the one and biggest we would highlight in terms of those risks investors are exposed to in China.
China’s role in a diversified portfolio
Well, first of all I think over time, we’re not there yet, but over time the China allocation will be a standalone allocation. This means that you’re going to have developed market bonds and developed market equities, you’re going to have China equities and emerging markets excluding China equities. So, China is becoming a core asset class in and by itself and that will include also Chinese bonds, renminbi denominated bonds. It seems stretched today, but we tend to underestimate long-term changes, but they might be almost a quasi-equivalent to a Treasury bond in 2030 and beyond. So, let’s not forget about bonds. But when it comes to equities, I think they will provide investors with a nice total return mix, meaning both capital appreciation potential but also income potential.
Sectors to watch
For direct investments or more targeted sector investment, we would definitely concentrate on those sectors that give exposure on our Next Generation investment themes including healthcare, longevity, life sciences including urbanisation, for instance. These are the ones, mostly in the life science technology space, where we would emphasise a long-term overweight allocation. For the rest of the market we would rather go with a manager selection approach because managing Chinese equities requires local expertise and a local presence. It is probably a market that will provide active investors with opportunities for the foreseeable future that more developed, more matching markets no longer provide. So, I would definitely recommend to have an approach where you pick a good manager with a clearly defined investment hedge on the one hand, and then you can have some pockets of your portfolio where you’re more targeted in terms of sectors – and there I would really capitalise on long-term trends of the kind we describe in the Next Generation investment research.
Investing in China requires a long-term commitment. The one thing we should keep in mind is that the worse the trade war turned potential capital market war becomes, the more attractive the risk premium on Chinese assets in the short run. This means prices may actually decline short term because of these escalating tensions between the two but the more and the faster they escalate the greater the benefits over the long term of holding Chinese assets. This is because the Chinese markets and the Chinese economy will decouple from other more established markets faster as a result. We are already seeing evidence of this in technology for instance where the threat of banning Chinese operators from using Western developed and Western licensed technology is actually speeding up the process of developing Chinese equivalents to these technologies. So, this short-term pain will actually lead to greater long-term gains for investors and that’s the one thing to keep in mind as the negative news flow eventually hit the wires in the coming next months.