China, The Global Locomotive

Yesterday the third annual round of the Strategic and Economic Dialogue between the United States and China opened in Washington, D.C. It is difficult to over-state the importance of the US–China relationship. We will focus on the economic and financial perspective. Trade concerns, currency (progress toward a more flexible exchange rate for the yuan, the fiscal outlook in the US, QE 2 and what follows) and financial services (market access and financial-sector reform) are expected to be key subjects for discussion.

The global importance of the Chinese economy was underlined in 2010 when it overtook Japan as the second largest economy in the world, when measured in US dollars, according to the IMF. The US economy still had a commanding lead last year, some 2.5 time larger than that of China. However, this lead is diminishing and will disappear as the Chinese economy continues to advance at growth rates three times the estimated capacity growth rate of the US economy, a little less than 3% per annum.

At Cumberland Advisors we have developed a Scenario 2030 for the global economy and stock markets, with projections for some 47 countries. Under this scenario, the largest emerging-market countries are assumed to continue to have the strongest growth rates but to gradually slow over the projection period to more sustainable rates. In the case of China, its economic growth rate by 2030 is still a high 8% per annum. This implies the Chinese economy surpassing the US economy, in current dollar terms, by the end of the current decade and by 2030 rising to twice the size of the US economy.

There are, of course, a number of assumptions underlying such long-term projections. We also developed an alternative scenario in which the Chinese economy slows to 5% per annum by 2020 and remains at
that rate over the following decade. We also assumed that the process of appreciation of the yuan stops in 2020 and the yuan/US$ rate remains constant over that decade. While this set of projections incorporates a growth rate for China that we consider to be on the low side of likely outcomes, the Chinese economy still edges ahead of the US economy by 2021. By 2030 the Chinese economy is 23% larger than that of the US.  We conclude that China’s leading role in determining the course of the global economy, sustaining the bullish trend in commodity markets and the pattern of global investment flows, looks highly likely to continue for the foreseeable future. To give an example of the latter, a report published by the Asia Society projects that overseas investments by China’s businesses are poised to take off, reaching $1,000 billion by 2020.

Our projections have important implications for the relative sizes of US and Chinese stock markets over the next two decades. At the end of last year the market capitalisation of China’s stock markets in Shanghai and Shenzen together ranked fifth globally, following those of the United States, Japan, the United Kingdom, and India.

Looking forward to the middle and longer term, it is likely that the Hong Kongand Chinese markets will operate increasingly as a single market as current restrictions and barriers between the two continue to be lowered. Adding the Hong Kong Exchange’s market capitalisation to that of the Chinese markets catapults the combined China-Hong Kong market to second place, accounting for 10.5% of global market capitalisation, compared with 31.5% for the US market.  Our projections indicate that by 2024 the market capitalisation of the China-Hong Kong market will surpass that of the US. By 2030 it will be some 55% larger than the US market.  Should this projection be anywhere near close to the mark, Chinese stock market developments will have an increasingly dominant effect on global equity markets. Of course, we, like most investors, have considerably shorter time horizons. 

Even in the near term, it is evident that, as our friends in BCA Research have recently written, “Getting China right is probably one of the most important investment calls one will make over the next few years.”  Thus far this year the continued globe-leading growth of the Chinese economy has been accompanied by anemic equity market performance. The year-to-date (May 9) total return of the MSCI China equity market index is 2.85%, a bit better than the overall MSCI Emerging Market index’s gain of 1.74%. China equities, like those in many other emerging markets, suffered from bouts of risk aversion in the turbulent first quarter.  Investors also have been concerned about the possible effects of the monetary tightening moves of the Chinese central bank in response to rising inflationary pressures that have pushed Chinese inflation above 5% on a year-to-year basis. The headwinds have been particularly strong for Chinese banks.

Inflation pressures appear to peaking in China, but we do not expect Chinese equities to return to outperformance until there are clear indications that inflation definitely is ebbing.  We continue to be leery of Chinese banks and the questionable loans on their books. While the government will surely step in to prevent their failure, bank stocks could drop considerably before their rescue. That is one of the reasons why we prefer the SPDR S&P China ETF, GXC, over the popular iShares FTSE China 25 ETF, FXI.  Financials account for 51.4% of the FTSE China 25 index, while the financial sector share of the more diversified S&P China index is 32%. Thus far this year GXC is up 5% as compared with 1.8% for FXI.