At the end of 2014, many headlines sourly declared that China’s economy had grown at its slowest annual rate in more than a quarter of a century—a mere 7.4%.
Only for China would such growth be considered a failure.
Yes, China’s white-hot expansion has slowed, and some investors have grown wary. But there are still good reasons to view the most populous country on earth as a growth opportunity, says Michelle Gibley, director of international research at the Schwab Center for Financial Research.
First, the Chinese economy is still the fastest-growing one in the world. Second, and even more important long term, the government reforms first laid out in 2013 are finally starting to gain traction. The reforms, meant to create a more balanced economy by increasing the share coming from Chinese consumer spending, “could create the next phase of growth in China and have a positive impact on Chinese stocks, even before any reforms are fully enacted,” Michelle says.
Many investors would welcome an improvement in the Chinese market. The average five-year annualized return for China-focused mutual funds slumped to 3.3% by December 31, 2014, according to Morningstar Inc. That’s less than a third of the 14.7% return for the S&P 500® Index over the same time period.
Three words: consumers, consumers, consumers
For years, the Chinese government helped boost economic activity by investing heavily in infrastructure projects. The old economic model worked for a time, but it began to lose steam and create a lot of investor uncertainty. So, more recently, the government has been trying to lay the groundwork for more sustainable domestic growth by enacting a number of reforms. Michelle notes two changes in particular:
- Proposed changes to the country’s household registration system, which will broaden migrant workers’ access to social services, such as education and health care, and could increase disposable income.
- Land ownership reforms, which could allow farmers to transfer and leverage land as collateral, and may eventually increase mobility and boost incomes in rural areas.
“These plans help China position its economy for more market-driven growth,” Michelle says.
China’s economy shifting away from manufacturing
And indeed, incomes are rising, the middle class is growing quickly, and even rural consumers have money to spend.
As you can see in the chart below, China’s transition from manufacturing (more export-driven) to services (more domestically driven), and from investment to consumption, is proving successful. In fact, the services sector became the largest segment of the economy in 2013—and it’s growing faster than the overall economy.
In 2014, services grew 8.1% and accounted for 48% of the economy, versus 43% of GDP for manufacturing and 9% for agriculture. The contribution from investment narrowed to 48.5% in 2014 from 54.4% in 2013, while consumption contributed 51.2% of growth, up from 50%.
It won’t happen overnight, but in the future Michelle believes that we could see higher multiples for Chinese stocks because investors will have more confidence in the long-term sustainability of the economy.
How to invest in China
China has two classes of publicly traded stocks. A-shares, traded on such Chinese exchanges, as the Shanghai Stock Exchange and the Shenzhen Stock Exchange, have tighter ownership restrictions, which makes it difficult for foreign investors to purchase them. H-shares, traded on the Hong Kong Exchange, are more widely available to foreign investors.
Multiple U.S. funds and exchange-traded funds (ETFs) invest in both types of shares. Prices of A-shares have already started rising likely due to hopes that the interest-rate cut by the People’s Bank of China (PBC) in November represents a shift in policy toward easing, as well as an increase in buying on margin by local individual investors in mainland China. H-share stocks appear attractive likely due to the disparity in performance and valuations between A-shares and H-shares, and the positive backdrop of potential monetary and fiscal stimulus in 2015.
What you can do next
- If you want to invest in China for the long term, consider overweighting China-focused mutual funds or ETFs within your emerging market allocation.
- Don’t expect China’s growth in the future to be quite as brisk as in the recent past.
- Be prepared for the volatility that comes with investing in emerging economies.