For decades, manufacturing was the backbone of China’s economy, to the extent that “made in China” became shorthand for inexpensively produced factory goods. But in recent years, China has begun a great restructuring project: It’s trying to shift its massive economy away from manufacturing and heavy industry, and toward consumer spending and services.
In the long run, this plan makes sense. China’s rise as a manufacturing powerhouse relied on having a surplus of laborers willing to work for lower wages than the competition overseas. But China’s working-age population—generally defined as those between ages 15 and 64—is peaking, and is expected to decline in coming years. China’s economy is also doing what economies typically do as they mature: Rapid growth inevitably slows, rising worker incomes support an expanding middle class, and future growth relies increasingly on consumer spending and business productivity.
What does this mean for U.S. investors? As with any major change, the transition could be bumpy. We’ve already seen the U.S. stock market swoon—more than once over the past year—amid fears about China’s slowing economic growth, its volatile stock market and the sinking value of its currency.
There are a lot of ways to look at the effects of China’s transition, but one that may be useful for investors is the potential impact on equity sector performance. Some sectors may suffer as demand wanes for commodities and products typically used in Chinese manufacturing. On the other hand, as Chinese workers move from rural areas and factory jobs to cities and white-collar careers, demand may grow for goods and services such as apparel, entertainment, travel and restaurants.
Let’s look more closely at some of the sectors that may be affected by China’s transition.
At risk: materials and energy
Six years ago, China’s official government-reported growth rate was more than 12%; today it’s less than 7%. Most of that decline has come at the expense of the two sectors most vulnerable to a slowdown in Chinese manufacturing: materials and energy.
China’s manufacturing slowdown has cut demand for industrial commodities such as copper, aluminum and iron ore. Technological advances and a buildout of production facilities are also allowing China to produce more of its own materials—for instance, it recently transitioned from being a net importer to a net exporter of steel. Global prices for those commodities have fallen, and this decline hurts the earnings of the companies that mine and sell them around the world.
It’s worth noting that companies feel the effect of lower prices even if they don’t sell directly to China—in a global market, reduced demand from one country can have a global effect on prices.
As China’s growth has slowed, its demand for crude oil has softened as well, contributing to the steep drop in global oil prices from mid-2014 to early 2016 and the subsequent drag on earnings for companies in the energy sector. Given that China is the world’s second-largest oil consumer (after the United States),1 slackening demand from China can have a big impact on oil prices. But keep in mind that demand is just one issue that affects oil prices—oversupply from oil-producing countries including Saudi Arabia, Russia, Iran, Libya and the United States can play a role too.
Potential opportunities: technology, consumer discretionary
China has major environmental problems, largely a result of its rapid manufacturing-fueled growth. It now leads the world in carbon emissions, and air pollution in its major cities poses a danger to public health.2 After years of paying lip service to its pollution problems, China has begun to invest in environmental improvement projects. In 2014, China reportedly spent $90 billion on solar power, wind power, and other renewable energy technology—a sum representing more than a quarter of total global spending in the renewable sector that year.3 This trend toward increased investment, if sustained, could provide opportunities for companies operating in the “green” space, which largely involves the energy and technology sectors.
Technology in general may benefit from China’s changing economy. China is extremely interested in keeping business within its borders, usually allowing Chinese companies to have the upper hand over foreign companies. However, Chinese companies often lack the know-how to create the technology they need to be globally competitive. They may reverse-engineer products from overseas, but given the rapid pace of technological change, by the time Chinese companies can copy foreign products, the tech world often has moved on. If they begin to buy more technology products from abroad, the greatest potential benefits will likely be enjoyed by hardware manufacturers. By its nature, hardware is less affected by cultural differences than software, and hardware is also more difficult for Chinese companies to replicate efficiently.
Consumer discretionary companies are also likely to benefit from China’s shift toward a consumer-based economy. China’s middle class is growing, especially in large cities such as Beijing and Shanghai. These increasingly affluent consumers are interested in luxury goods, dining, entertainment and travel. China’s government has taken steps to boost consumer spending; for instance, in June 2015, it slashed duties by an average of 50% on imports such as shoes, cosmetics and clothes, items that many Chinese consumers had been traveling abroad to buy. China also has become more open to foreign ownership, encouraging a growing footprint for foreign retailers, restaurants and e-commerce companies. Meanwhile, rising Chinese tourism benefits foreign hotels, restaurants, casinos and attractions even if they don’t have locations in mainland China.
Western companies’ dreams of tapping into a massive potential Chinese consumer base have not yet fully become reality. However, investors should be patient. While investment risk tends to be elevated in China—as in any state-run economy—there are opportunities to be found as the world’s second-largest economy shifts direction.
1 International Energy Agency, “Oil Market Report Table 2. Summary of Global Oil Demand,” 2/9/16.
2 Eleanor Albert and Beina Xu, “China’s Environmental Crisis,” CFR Backgrounder, 1/18/16.
3 Kenneth Rapoza, “China to Spend Trillions on ‘Green Technology,’” Forbes, 8/11/15.