Why investing in China is good while things look bad



Like London buses, political changes are all coming along at once this year.

While next week's headlines will be dominated by the US Presidential election, something equally significant will be getting underway in Beijing where a once-in-a-decade leadership transition begins on Thursday.

While the impact of Tuesday's US election will be felt almost immediately thanks to the ticking time-bomb of the fiscal cliff, the implications of the Chinese leadership change will be a slower burn, but no less important for that. Both countries face profound economic and social challenges but China's contribution to global growth and its still seriously unbalanced economy mean there is even more urgency about finding the right answers than there is in Washington.

As in the US, the economic backdrop in China has started to brighten at just the right time as far as the leadership is concerned. The latest manufacturing data show activity in the country's factories finally picking up in October after a slowdown which has now lasted for seven straight quarters.

Last week's figures suggest that the near two-year retreat from a growth rate of more than 12pc to 7.4pc may finally have stabilised and at a level that we can only dream of, mired as we are in Europe (Chicago Options: ^REURUSD - news) 's economic sclerosis. Amid all the soul-searching about whether China might be the new Japan (EUREX: FMJP.EX - news) on the cusp of a prolonged stagnation driven by anaemic consumption and a rapidly ageing population it is important to remember that, relatively speaking, China is still the humming engine of the global economy.

There is some speculation (and historical precedent) that the election of a new Central Committee next week could kick-start a renewed wave of government stimulus and this is a key component of the bullish argument for Chinese shares. I think the latest figures actually make this a bit less likely. They suggest that the modest monetary tweaks so far this year have been more effective than the outside world thinks. There may well be some modest pick-up in spending once the uncertainty caused by the very public infighting at the top of the Party dissipates, but China does not rush things and a detailed blueprint of the new leadership's plans will become clear only over the next 12 months or so.

That said, the direction of travel is obvious from the latest five-year plan. Its (Euronext: ALITS.NX - news) key focus, the rebalancing of the economy to domestic consumption, will continue. And it is essential that it does because an economy as dependent on investment spending as China's is around 50pc of total output is not sustainable.

The comparison with Japan 20 years ago is not as far-fetched as you might think because China has arguably become as addicted to building "bridges to nowhere" as Japan was. In 1990 consumer spending represented only half of Japanese GDP, compared with 70pc in the West, so when the investment boom ended the Japanese consumer was unable or unwilling to plug the gap. However, little more than a third of Chinese GDP is down to the consumer today and the savings rate is a staggering 25pc, so arguably the challenge is even more severe than Japan's was.

The key question for investors is the extent to which all this has been factored into Chinese share prices because on most measures they are historically very cheap. With both Shanghai-listed A shares and the H shares in Hong-Kong trading on only seven or eight times next year's expected earnings, a case can be made that much of the bad news is already baked in. Valuations stand at roughly a third of the peak level reached in 2007 at the height of enthusiasm for Chinese stocks.

The significant underperformance of the Chinese stock market, reflects indiscriminate selling of fundamentally sound companies and that continues to throw up a wealth of stock-picking opportunities, especially in the consumer-related companies which I continue to believe will be the main beneficiaries of a rebalancing of the economy, continued urbanisation and double-digit wage inflation.

Given the scale of the economic challenges facing China and the uncertainty that necessarily accompanies a once-in-a-decade change at the top, it would be a bold call to unequivocally signal the turn for Chinese shares. But investing when everyone else thinks it's a bad idea makes for better outcomes than jumping on a bandwagon.

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