Beijing or Basingstoke?
Earlier in the year we compared the vineyards – and equity markets – of France and California, coming down on the French (and Eurozone’s) side. So far we are glad to say that view has proven profitable – France’s CAC index is +16% year to date as we write compared to a 1% gain for the US S&P 500. This month we pick a much less glamorous comparison: Beijing vs Basingstoke. You wouldn’t, I think, have either at the top of your holiday vacation list. But how does China compare to the UK as an investment destination?
China is the world’s second largest economy and on current growth rates it is only a matter of time before it surpasses the United States (largely as its population is almost 3 times larger). It is also – depending on who you believe – growing at a rate of 4% to 7% a year. Wherever we are in this range this is still ahead of the UK and there is no reason to expect this to reverse any time soon: catch up growth is easier than productivity driven growth for any economy.
The UK is in many ways the opposite: a smaller economy (3.8% of global GDP) but with an equity market that is around 7.5% of the MSCI World Index (China has a zero weighting). In a straightforward world your typical China weighting would be far larger than your typical UK one. The world is, however, often far from straightforward. As a former communist country there is very little equity culture and ownership in China. This ultimately limits equity investment opportunities. That said a core allocation to Chinese equities makes sense to us.
If you are thinking the choice is bubbly, expensive China versus a more sober, sensible UK market you would be wrong. The boom and bust of the Chinese equity market has attracted much media attention but it is important to note that much of the boom was centred on the mainland equity markets which are not open to international investors. The main market for foreigners is the Hong Kong Index. Here the volatility has been more muted (though it has still had its fair share of excitement).
Our investments are therefore Hong Kong listed. The valuation comparison versus developed markets is interesting. Our Chinese equity fund has a weighted average trailing price earnings ratio (p/e) of 15.6x and a forward p/e of 14x (lower p/es generally imply better valuations). This compares well to an estimated 2015 p/e (calculated by Bloomberg) of 16.3x for the UK All-Share market. So to our eyes China offers a decent longer term growth opportunity at a cheaper price than you’d pay in the UK.
Part of the reason for this lower valuation is the clouds gathering over the Chinese economy as it tries to switch from an investment/infrastructure led growth model to a more balanced consumer-driven economy. This transition is depressing commodity prices and putting a strain on credit markets which have been used to fund some of the more dubious investment. The UK is in a much more stable place. The recovery from the 2008 crisis has been slow and likely still has further to run. Here it is definitely advantage UK.
Finally, we always like to separate the investment case from the currency story. In the last few days the Chinese authorities have (to the market’s surprise) relaxed the peg to the US dollar. The RMB has fallen almost 4% against the dollar in two days as a result. China has signalled that it is looking for more stability from here but how credible is this? A slowing economy has put downward pressure on the currency. This has finally led to a small, controlled devaluation. The temptation for the Chinese is surely now to get as much cash as you can out of the RMB. Why hold on to an asset that looks so likely to devalue? It looks hard for the RMB to avoid falling further.
Sterling looks to be in a much strong position. QE is over and rates look set to rise next year (and perhaps later this year). As with the dollar, a major currency with a positive yield should attract investment. Sustained weakness looks unlikely especially as so many regions (including most notably the Eurozone and Japan) are working hard to keep their currencies weak.
Putting this all together the verdict is not quite as clear as it was for Europe vs the US. The economic importance of China and its cheaper valuations for (you would hope) faster growing companies argue for a core strategic allocation. That said the slowdown is putting pressure on shorter term earnings growth for Chinese companies as well as the currency (which cannot easily be hedged). Longer term we feel optimistic our Chinese equities will make good money for clients but in the shorter term we expect plenty more volatility.
This volatility means that, for now, we think it’s prudent to limit the size of our Chinese equity positions. The market is simply too interesting an opportunity not to hold any exposure but the currency and short term outlook limit the size of the position we are prepared to take. Beijing is probably a more attractive destination than Basingstoke longer term but we’re not ready to fully commit just yet.