(August-2004) On the road to growth: The new China and its equity market

29 September 2005

| By External |

China is an awakening giant that is having and will continue to have a profound impact on the global economy.

This powerful structural shock to the global economy is unfolding and investors must keep this in the back of their minds when looking at longer term investment decisions. Steps by Chinese authorities to slow growth from a thumping 12 per cent in 2003 appear to be working and have seen investors fret about the short-term cyclical outlook.

Astute longer term investors know that over the last 20 years, the Chinese economy has grown at 9 per cent per annum and its share of world trade has risen from less than 1 per cent to almost 6 per cent. It is currently the sixth largest economy and fourth largest trader in the world. IMF modelling shows that if the pace of economic reforms continue, China’s economy will have absorbed 150 million additional workers from rural and agricultural areas by 2020. This is consistent with real GDP growth of 8 per cent a year through to 2020 and by then, its share of world trade and output will have more than doubled.

Unless Chinese authorities give up on reform, China’s integration into the world economy will continue and periods of excessive pessimism in the short term, provide longer term investors with opportunity. Rather than worry too much about the short term, effort should be put into how to make money out of the structural story. Active and astute stockpicking should see investors do well out of Chinese growth.

Australian equities

The China theme is all pervasive for our economy and our market. Certain businesses in Australia have a very direct link to the success of the Chinese economy and in recent times have seen their share prices reflect this. Perennial Growth believes that there are still significant opportunities for investors seeking exposure to this important driver.

In recent years Australian investors have seen the benefits of the strength of the Chinese economy. Evidence of this has been seen by those companies in the natural resources sectors. With current iron ore, coal and other metal prices trading at prices well above levels thought to be sustainable, the challenge for investors is to understand these changes in economic conditions and assess their sustainability.

The question on investors’ minds should be, are these changes in conditions cyclical or are they structural. If the changes are cyclical we would be reluctant to impute higher expectations than are already implied in current prices instead focusing on the longer-term sustainable price levels as a guide. If the assessment is that the changes are structural, whereby the demand for these commodities will continue to be driven by an economy experiencing a two-decade event, then the upside from here is significant for investors.

While difficult to predict, Perennial Growth believes that there is more credence in the structural viewpoint than the cyclical. As investors, this leaves us continuing to favour those primary commodity companies exposed to this phenomenon with preference for the large mining houses and the junior operators who have well capitalised businesses that can withstand short-term volatility.

In addition, the rewards will have benefits that reach beyond the primary industries, placing Australia and it’s companies in a very favourable position over the medium to long-term.

International equities

Short-term growth concerns from China, combined with a rising US interest rate cycle, have overshadowed the longer term potential displayed by Chinese growth. The benefits on offer are not just for Asia and Japan, where growth in the Chinese economy and its burgeoning middle class has underpinned the profit outlooks of regional companies. The Asian region has long been underrepresented, in our mind, in most diversified global equities portfolios — even though it serves to benefit the most from the potential upswing.

From an International, non-Pacific, perspective, China is also a key long-term consideration, both in terms of sales potential as well as manufacturing capability. An example from our own international equities portfolio, Philips, the Dutch consumer electronics giant, highlights this well. In the first half, China accounted for just over 10 per cent of global sales, showing growth of nearly 25 per cent against the same period last year and contributing strongly to its global growth rate.

Philips also uses China as a key manufacturing area — it has nearly 20,000 full-time employees in the China/ Hong Kong region (12 per cent of total), and makes, amongst other items, all of its Audio products and nearly 40 per cent of DVDs there. Philips has established thirteen research and technology centres to support both sales and production and demonstrates the importance that the company places on China as a core market in its growth strategy.

Having grown strongly for the past two decades, the impact of Chinese growth has reached a scale in its economies that can no longer be ignored by investors as peripheral. Indeed, it affects stockmarkets the world over, including our own.

— Adrian Mulcahy is a partner at Perennial Growth Management

— Harry Liem is portfolio manager at Perennial Investment Partners Asia