Those who follow our posts know that we see considerable secular growth potential in China. This view was again affirmed during my most recent trip to Hong Kong last month, where members of our team had the opportunity to meet with management teams throughout Asia that are benefiting from secular growth trends as they navigate near-term cyclical pressures. The country’s geopolitical aspirations (including its bid to internationalize the renminbi), as well as its commitment to transition its economy from public sector and investment-led growth to private sector and consumption-led growth are likely to provide many opportunities for long-term investors.
In addition to this longer-term lens, we also consider risk/reward from short- and intermediate-term perspectives. In the third quarter, our focus on managing near-term volatility contributed to our decision to underweight China. However, as we enter the fourth quarter, we are starting to see some of signs of stabilization in economic data that is contributing to a more constructive near-term view on China.
First, China’s primary measure of manufacturing PMI activity was 49.8 for September. While still hovering below an expansionary level of 50, the reading showed signs of stabilizing and came in ahead of the consensus of 49.7, which we view as positive. Moreover, we were expecting muted manufacturing data in September, due to the massive manufacturing shutdown mandated by the government to ensure blue skies for China’s commemoration of the 70th anniversary of the end of WWII. Our view has been that once the “Victory Blue” shutdown concluded, we would begin to see signs of recent stimulus working through to economic data. State-owned enterprises are likely to show the benefits of stimulus first, with a trickle down to small and medium enterprises in the coming months.
As we’ve noted in the past, China has many tools at its disposal to support its economy. In recent weeks, we’ve seen several fiscal policy moves that demonstrate the country’s commitment to avoid a hard landing while promoting the transition to a more consumption-driven economy. These include an auto tax cut and a reduction in requirements for property down payments. We’ve also seen a stabilization of the renminbi after a sharp depreciation, with additional capital controls being implemented to manage the flow of capital and reduce the volatility of this exchange rate. Over the medium-term, we should expect further depreciation of the renminbi relative to the dollar, as this currency adjusts to the weakness of other major trading currencies like the euro and yen, but the rate of this depreciation will be important as companies and governments adjust to this new environment.
To be clear, we still believe capital preservation remains paramount in the current environment. Nonetheless, we believe we are seeing encouraging signs that can improve investor perception about China by alleviating concerns about an imminent hard landing, while the correction we’ve seen in the equity markets seems to have more than discounted this risk. As a result, we are using this opportunity to gradually increase our exposure to China, both through equities that we believe have more than priced in this near-term risk and defensive convertibles that appear well positioned to participate in the eventual recovery of the Chinese equity markets.
Over the next weeks, there will be a great deal more data for us to evaluate, including foreign reserves data on October 6. Signs of stabilization in foreign reserves and savings deposits would point to a reduced risk of capital flight, which would give us more confidence in a gradual depreciation of the renminbi. We’ll also be watching for mid-month data on imports. As with many other data points coming out of China over the near term, we expect imports to be lower year-over-year, but here too we are looking for signs of stabilization in these next months.
If these green shoots begin to take hold and the markets can become comfortable that a hard landing is off the table for the near term, we wouldn’t rule out a fourth quarter rally in Chinese and global equity markets.