Some of us at KKR recently traveled for a week throughout Asia. The primary focus of our trip was issues relating to investment in China. In light of the recent devaluation of the yuan and the plunge on the Shanghai Stock Exchange, there were robust discussions to be had on both micro and macro trends. Here are some key takeaways:
China is in structural slowdown mode, as excess debt and capacity now weigh on profits, not just GDP. Slowing Chinese gross domestic product data seem to garner all the headlines these days, but we think the focus should be on trends in corporate profits. Indeed, increasingly weighed down by excess capacity and too much leverage, many corporations are now delivering significantly negative profit growth. Just consider that industrial profits declined by a sizable 8.8 percent year-over-year for the month of August, despite government reports that GDP is growing close to its 7 percent target. Traditional consumer businesses, too, are suffering from more mature penetration rates and the rise of e-commerce. If there is good news, our trip confirmed that there are still a lot of top- and bottom-line growth opportunities in high-value-added services parts of the economy. In particular, we left most impressed with what we saw unfolding in China’s food safety, environmental services and health care sectors.
Many emerging-markets Asia countries recently redirected their economies — potentially at just the wrong time — to take advantage of what they thought would be ongoing strength in China’s economy. With China’s growth now stalling amid lower commodity prices and weak inbound trade, however, many emerging markets in the region, including Indonesia, Thailand and Malaysia, are enduring weaker-than-expected growth, bigger deficits and resulting political tensions. We do not see this backdrop changing in the near term, and therefore we think high risk premiums are now warranted until more and bigger structural changes are embraced throughout the region.
If we are correct in our outlook for China and its emerging-markets trading partners, then there are two clear investment implications. First, more money is likely headed away from emerging markets and toward developed markets. We expect the U.S. to be a major beneficiary. By comparison, we actually think non-China emerging markets — particularly countries with levered corporates and low reserve balances — face significant macro risks. Second, with China slowing even more than consensus expectations have held, there is now significant potential for consumer and corporate debt unwind in many emerging markets.
Though we are seeing some signs of sequential improvement, China’s macro data remain generally weak. Factory orders, national holidays and weak commodity prices are all to blame for the sluggish data out of China. On the back of some stimulus measures targeted toward both residential property and public infrastructure, however, sequential economic data to be released over the next couple of weeks should show improvement. Regardless of whether the economy gyrates up or down in the short term, this economy now faces several large and structural headwinds — many that will manifest themselves further as the Chinese government is forced to bring nominal lending growth back below nominal GDP growth.
China’s so-called hard landing might be creeping across the economy. We have long argued that China is having a hard landing in fixed-asset investment. This is significant, as gross capital formation accounts for 46 percent of GDP and was the main driver of growth from 2000 to 2010. Somewhat more concerning is that many folks with whom we spoke now believe that the hard-landing aspect of the Chinese growth slowdown has extended itself to more traditional parts of the economy, including basic consumer purchases. A more accurate assessment, in our view, is that basic consumer purchases are now primarily linked to just periodic refresh and upgrade cycles, not to secular penetration stories as in the past.
There needs to be a new direction in credit creation. We estimate that corporate credit has ballooned to 180 to 190 percent of GDP. Significantly, this surge in fixed interest costs has helped to put further pressure on corporate earnings, which are already facing massive excess capacity headwinds. Interestingly, our discussions in China led us to conclude that despite waning demand in many sectors, many companies continue to run at or near full capacity. Moreover, we learned that frequently the banking system continues to lend, as annual credit creation and production targets often take precedence over return on capital decisions.
Recent initiatives to ease capital constraints on the banks are working. Almost every time we visit Beijing, we get pitched the bull case on Chinese banks: cheap valuations, 20 percent return on equity, robust dividends. Many banks state that nonperforming loan ratios are under 2 percent, yet we know that credit quality continues to deteriorate. At the moment, the sector appears to be discounting 14 percent nonperforming loans. That’s a big number, suggesting that a lot of bad news may be in the price of these securities. Moreover, given that local government financing vehicles are repaying local governments’ bank debt, swapping the risk into long-dated municipal bonds and allowing banks to reserve only 20 percent against municipal bonds, the banking sector is now enjoying a subtle — but noteworthy — rebalancing.
It will take time for Beijing to restore confidence in the economy. Although the government historically has had success influencing the Chinese economy by increasing or decreasing spending, recent interventions in the stock and currency markets suggest that a command-and-control approach does not always translate as well into investor-based markets. Not surprisingly, risk premiums across the capital markets have increased in recent weeks, a trend we expect to continue through the near term.
As for some good news, we left Beijing with the impression that there was not another imminent devaluation coming. If we are correct, then the investment implications are significant. First, many hard commodity prices are likely to suffer another leg down. Second, some form of currency hedging in emerging Asia — and all emerging markets, for that matter — has gone from optional to mandatory. Third, if China has to burn up more reserves to defend its currency after it devalues again, then the U.S. Treasury yields could rise as a consequence. Finally, China’s trading partners are likely at more risk than China, given that they have smaller reserves and, in many instances, less diversified economies.
Amid the bearishness we encountered, we used most of our time in China to learn more about growth-related bright spots. Not surprisingly, our focus was not on low-value-added exports or manufacturing. Rather, we spent time with executives well versed in dynamic areas such as wellness, sports, beauty and health care. The bottom line is, with 1.4 billion people and a rapidly changing social, political and economic backdrop, China still presents, we believe, many opportunities for double-digit growth in service sectors. They just look a lot different from how they appeared during the past five to ten years, and many are now focused in the high-value-added segment of the services market, not the traditional export or domestic retail markets.
Henry McVey is head of global macro and asset allocation, and Frances Lim is director of global macro and asset allocation; both at KKR in New York.
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