Also the challenges in terms of income inequality, an ageing population and environmental issues mean that structural reform is needed to bring growth to a more sustainable level in the medium term.
However, this does not mean that policymakers are looking at a significant slowdown in growth. In the previous five-year plan, the average GDP growth achieved was 11% versus a target of 7.5%. Going forward, growth will mainly be driven by investment and consumption instead of exports. Inflation is likely to stay at a higher level compared to the previous ten years due to a structural shift of the labour market and a rebalancing of the economic growth drivers. We think that a moderation of growth and higher inflation in the coming years will be the new norm.
Structural investment needed
Consumption growth, supported by rising wages, the wealth effect from asset inflation and demographic changes, have remained robust in spite of the external environment. The income gap between the urban and rural population will narrow and should continue to drive consumption upgrades and changes in consumer behaviour.
On the investment side, manufacturing, infrastructure and property investments are major components of fixed asset investment. Despite a weak external environment, manufacturing is running at full capacity to keep up with very robust domestic demand.
Currently in Beijing, car restrictions have to be implemented because the roads are not big enough. Technology upgrades and relocation of manufacturing facilities from coastal china to inner China also lends support to manufacturing capital investment. There is, therefore, plenty of scope for infrastructure investment such as building roads, railways and the like, which could bring about huge long-term economic benefits.
In terms of property investment, the government is building ten million low-cost housing units this year and another ten million units are in the pipeline for next year because of a shortage of affordable housing for Chinese households. This needs to be seen through to prevent housing from developing into a serious social problem.
Chinese equities have underperformed global markets this year even though the world’s second largest economy has continued to expand apace, while Western countries struggle with high levels of public and consumer debt. Concerns over inflation and monetary tightening appear to be the main drag on Chinese stocks.
However, there are signs that the economy is cooling and slower growth from the rest of the world is likely to lead to lower commodity prices and a moderate easing of inflation pressures.
Domestic focus
Monetary policy may become more accommodative as well: for instance, policies to support small and medium-sized enterprises sectors have improved investors’ sentiment towards China lately. Furthermore, China’s fiscal strength (its fiscal revenue is up 28% year-to-date) puts them in good stead to support economic growth through social housing and subsidies on selected consumer goods and services, among other initiatives, if the global slowdown becomes more apparent.
The outlook for Chinese equities remains cloudy as the correction has mainly been a result of the external environment. We still hold a constructively positive view on Chinese markets and a drop in inflation could bring some much needed cheer to Chinese equities.
October CPI inflation already came in at 5.5% year-on-year, significantly below September’s 6.1%. We think there could be a further drop in inflation in the final quarter of 2011 and early next year, although it will be difficult for policymakers to loosen monetary policy significantly at this point though because economic growth is still fairly resilient. However, from a valuation perspective, Chinese markets are already trading at a cheap level of current year price/earnings of nine times.
Given there is no easy solution to the debt issues in Europe and the US, global markets still remain susceptible to bouts of volatility.
We think that once the dust starts to settle and the situation stabilises in Europe and the US it should begin to be recognised that the impact of all this is not particularly severe for China.
As such, we favour domestic sectors such as insurance companies, property developers and consumer-facing companies, which are less vulnerable to a global shock.
We have reduced our exposure to commodities, energy and materials given the uncertainty of global growth and may pare it down further if required.
