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March 21, 2016 | Global Equity
China: An Enduring Story for Years to Come

Global Equity Strategist

Olga Bitel, partner, is a global strategist. She is responsible for economic research and analysis across all regions and sectors. She distills macroeconomic and geopolitical developments into actionable insights for global equity portfolios within a multifaceted strategic framework. In addition, she provides insights about cyclical turning points and structural trends as inputs into portfolio construction in predominantly bottom-up investment approaches. Before joining William Blair in 2009, Olga was a senior economist at the National Institute of Economic and Social Research in London, United Kingdom, where she produced macroeconomic forecasts for most Asian economies and led thematic research projects for some of the world’s best-known international organizations, including the Organization of the Petroleum Exporting Countries and the International Monetary Fund. Olga received a B.A. from the University of Chicago and an M.Sc. in economics from the London School of Economics and Political Science.

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We can debate whether China’s growth rate is moving from 10% to 7%, 5%, or 3%, but what is more interesting from our perspective is the nuance and complexity of that growth. We believe China is a tale of two economies. The first part of the story is the industrial sector, the old growth engine of China. This includes heavy, extractive industry and the industrials that supply it—for example coal, iron ore, steel production, and heavy machinery. We think this complex is growing at a rate of anywhere between 0% and 3% per year, as the chart below shows. This is much slower than anything we have seen in the recent past, feeding the headlines for a bear case on China.

There has been vast restructuring in China, and a lot of extra capacity still needs to be rationed away, but the industrial complex is not falling into the South China Sea anytime soon. There are hundreds of thousands, if not millions, of companies in China that are quietly but steadily moving up the value chain. We see it in the numbers and in observable changes in competitive behavior.

The auto industry is one of our favorite examples because it combines industrials and consumers, and everyone can associate with car ownership. In 2000 the quality of cars made by Chinese companies was so poor that almost no one wanted to own them. In that year, the number of complaints received in the first six months of ownership was so high that it did not matter how cheap these products were; they were just too bad to own.

Today the quality differential is almost gone, and it has disappeared at the lower end of the price spectrum. In other words, for the right price, Chinese consumers are willing to entertain the option of buying a locally made car. Many well-established American, European, and Japanese automakers grew accustomed to an underpenetrated or a completely unpenetrated Chinese market with very little competition and considerably outsized profit margins. Most had tremendously stronger profit margins in China than almost anywhere else in the world.

As Chinese automakers improve, the market dynamics are changing, and it is becoming harder to compete. We hear discussion of demand erosion and destruction, as well as decelerating growth in car sales among the multinationals. Among that rhetoric, there are real competitive threats because the local Chinese automakers are reporting considerably better numbers. Importantly, this force is occurring in a number of other industries and subsectors. The second part of the story is consumer services, at just over 50% of China’s GDP growth today and growing rapidly.

Headlines of decelerating retail sales growth in China were prevalent in 2015. The chart below shows that real retail sales (sales minus inflation) are growing by an average of 10% per year. This is the best consumption story on the planet by a very wide margin. In the United States and Europe, we are excited about retail sales growth picking up to 3% or 4%. In China, the discussion is about deceleration to 10% from a very large base.

Is the marked deceleration of same-store sales growth over the past couple of years due to demand destruction or low wage growth? In China, we believe neither is the case. We do not see demand destruction or tremendous deceleration in consumption in China. Consumption is well supported with solid wage growth. Instead, there is a phenomenon of moving up the value chain. Consumers are becoming more selective as local brands offer increasingly better values and opportunities.

We believe that this changing dynamic has more to do with the unexpected proliferation and rapid rise of e-commerce in China. E-commerce did not exist in China in 2008, in that it was not captured in the official retail sales statistics. As a result, no one has paid attention to it. Today, e-commerce is 10% of GDP and 14% of retail sales. Importantly, it is growing by more than 40% per year, which means that it is effectively doubling in size every two and a half years. The proliferation of e-commerce presents an opportunity for small- and micro-cap companies to have a presence in the retail market, reaching millions of people that they would never reach with a purely physical footprint. This is definitely an important and enduring force driving one of the world’s largest economies. The strength of the Chinese consumer is also increasingly manifesting itself abroad, increasing from $72 billion in 2011 to an estimated $230 billion in 2015.

Chinese tourism is picking up in earnest, and Chinese spending is growing quickly. This is the case not just in Asia but in Europe. Even if we assume modest 4% or 5% growth rates for the Chinese economy moving forward, within 10 years we will have at least another 200 million consumers in the middle class. This is a significant increase in consumers who will have the ability to travel abroad for holidays with their families. This anticipated growth will dwarf the tourism data shown above.

Lest anyone think that Chinese leaders are behind the times, the chart below summarizes the areas of growth they have identified in their long-term planning, consistent with their continued focus on rebalancing the economy. Amid the short-term financial market fluctuations, we believe it is important for investors to bear these priorities in mind as they think about longer-term opportunities.

Global Equity Strategist

Olga Bitel, partner, is a global strategist. She is responsible for economic research and analysis across all regions and sectors. She distills macroeconomic and geopolitical developments into actionable insights for global equity portfolios within a multifaceted strategic framework. In addition, she provides insights about cyclical turning points and structural trends as inputs into portfolio construction in predominantly bottom-up investment approaches. Before joining William Blair in 2009, Olga was a senior economist at the National Institute of Economic and Social Research in London, United Kingdom, where she produced macroeconomic forecasts for most Asian economies and led thematic research projects for some of the world’s best-known international organizations, including the Organization of the Petroleum Exporting Countries and the International Monetary Fund. Olga received a B.A. from the University of Chicago and an M.Sc. in economics from the London School of Economics and Political Science.

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