By Bryce Coward, CFA
Yesterday we gave three reasons why the stabilization seen in China over the last several weeks is just a cyclical pause before the next leg of the slowdown starts anew. Those reasons were that:
1) The current stabilization is almost entirely due to fiscal stimulus totaling about 2.8% of GDP, and that slower growth is in the offing as the fiscal stimulus turns turns into fiscal drag
2) The Chinese economy is in a structurally slowing pattern driven by the ongoing and inevitable slowdown, or even outright decline, in infrastructure investment – the driver of Chinese GDP growth for the last decade at least
3) Market driven prices for things hypersensitive to the level of Chines GDP growth (oil, copper, shipping rates) are all collapsing toward/have broken their cycle lows, indicating more slowing in China, not structural stabilization
The obvious question is then how one positions their portfolio in a world where China is on a structurally slowing growth trajectory. In an effort to not over-complicate things, let’s look at China from the 30,000 foot view. From this perspective we observe two things that will unfold over the next decade. First, investment as a share of GDP will fall from almost 50% of GDP to closer to 35% of GDP, if not lower. Second, consumption as a share of GDP will rise from 38% to around to 50%, if not higher. The first chart below depicts how this transition might play out. Mathematically, this implies growth in infrastructure investment will slow to the low single digits, if not turn outright negative, while growth in consumption continues at a rapid, if not accelerating pace. Now, having just described what in our view is the most likely outcome in terms of the Chinese rebalancing story, the investment implications are not all that difficult to discern. Companies that feed off of Chinese investment in infrastructure will likely struggle and companies that benefit from Chinese consumption will do ok, if not great. What if the Great Chinese Rabalance is not as graceful as we have show in our chart and the hard landing scenario comes to pass? In this case the investment implications are likely the same, except that first brand of companies may fall a lot more and the second brand may rise a lot less.
Ok then, specifically which are the companies, in and outside of China, that one should underweight and which are the companies that one should overweight? Keeping in mind that there are always companies in a given industry that buck the trend due to greater levels of innovation, less debt, different customers, etc, we can break down our bifurcated world along economic sector lines as as follows:
Now, we’re not saying that every industrial/materials company will underperform consistently for the next decade nor that every consumer discretionary or health care company will outperform, but the cards have been dealt and the odds are breaking in that direction. But here’s the catch: all the common benchmarks for diversified developed or emerging markets (MSCI, FTSE, Vanguard, etc) are around 50% (or more) allocated to the economic sectors with the largest headwinds in the decade ahead. That means that any diversified EM or DM investment products (mutual funds or ETFs) that look anything like the benchmark are by default leaning into the wind rather than letting it push them.
Putting it all together, the following, in our opinion, is the single most important thing investors should be thinking about as they consider core allocations to developed and emerging markets:
Do the products I’m invested in or considering look like the benchmark or do they look different from an allocation perspective? It goes without saying that products that are allocated like the benchmark will perform like the benchmark and investors need to decide if that situation is optimal, or not. In our opinion, the answer is clearly, “No”.