Positive reforms in China

Matthew Vaight, fund manager of the M&G Global Emerging Markets fund Despite ongoing concerns about China’s economy and debt levels, we are becoming more optimistic about China amid signs that the government’s recent reforms are taking effect. We are seeing the results of efforts to reduce overcapacity in a range of industries as well as stabilise the financial system. While we remain underweight the market as a whole, we have recently increased our exposure.

New vision for ‘Old China’

For the past few years, many investors in China have focused on the prospects of the so-called ‘new economy’. While we recognise that the shift towards a services-driven economy will create opportunities, we believe valuations of stocks related to popular themes such as the internet, social media and consumer spending are simply too high.

In contrast, we see attractive opportunities in the mainly state-owned manufacturing and industrial companies associated with ‘Old China’. These stocks have arguably been overlooked in the past few years as investors have concentrated on the consumer theme. However, profitability in sectors such as energy and industrials has risen recently but valuations have not (see Figure 1) which creates an interesting situation.

Figure 1: Old China delivering higher profits

As a result of the government’s supply side-reforms, production capacity in heavy industries such as cement and steel is being permanently cut. In addition, as part of its environmental protection campaign, many of the most polluting projects have been closed. Alongside this reduction in capacity, we are seeing consolidation into fewer, larger, more efficient operators. Importantly, there appears to be a new focus on profitability and cash flows rather than just revenues.

This represents an interesting shift and the potential improvement in performance of these companies does not yet seem to be fully appreciated.

Cleaning up the banking industry

We believe we are nearing an inflection in the Chinese banking industry. The level of bad debts in the system appears to be falling, partly as a result of the improving economic environment but also as a result of the banks’ writing off or selling bad loans.

Most significantly, however, is that the government has taken steps to improve the functioning of the financial system through reducing the amount of leverage in the system, tightening regulations around lending and clamping down on certain savings products.

There is now greater discipline around bank lending with the ability to lend dependent on a bank’s financial strength. In this environment, the better run, more disciplined banks with the strongest balance sheets should benefit. For arguably the first time ever, there will be real differentiation amongst the banks. Furthermore, there is a general shift in the sector towards more profitable, less risky retail lending.

Given these developments, we believe that the leading Chinese banks could potentially deliver sustainably decent levels of returns. However, they continue to trade at attractive valuations. For this reason, we have recently invested for the first time ever in a state-owned bank.

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