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Global equities: How to invest in a slowing China

Want to understand the outlook for China? Look to Japan’s 1990s stagnation experience, says Pendal Asian equities manager SAMIR MEHTA

INVESTORS looking for clues as to how China’s economic future will pan out should examine Japan’s performance after the 1980s boom, says Pendal’s Samir Mehta.

China faces enormous uncertainty about its economic outlook after decades of faster-than-normal growth culminated in a slowdown on the back of Covid-lockdowns, a real estate crunch and regulatory tightening in tech and education.

As the rest of the world wrestles with supply constraints, runaway inflation and rising interest rates in 2022, China instead faces lacklustre growth, rising unemployment and the real prospect of deflation.

“It’s almost diametrically opposite to what the rest of the world is facing,” says Mehta, who manages Pendal’s Asian Share Fund.

“What we are seeing at the moment in China is reminiscent of what happened in the Japanese economy when their bubble burst in the 1990s — for the next three decades Japan’s economy was mostly hobbled.”

Samir Mehta on the China-Taiwan stand-off
“All of us are spell-bound watching a potential Thucydides Trap play out in action between China and the US,” says Pendal’s Samir Mehta on the recent geopolitical developments in the Taiwan Straits.
“Speaker Pelosi’s visit further heightened the risks as rising power China threatens the hegemony of the US.
“My opinion on whether events escalate or not does not matter. But we should not lose sight of what the underlying problems are in China.
“Even without geopolitics, investors looking for clues as to how China’s economic future will pan out should examine Japan’s performance after the 1980s boom,” says Mehta.

Mehta says the key to Japan’s long-term troubles lay in the fact that its banks refused to recognise non-performing loans (NPLs), take write-offs, recapitalise and move on to lubricate economic growth via taking on risks on new projects.

“There are parallels with what we are seeing in Chinese banks. They are unlikely to recognise or write off their NPLs and they are not changing old business models.

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“If you do not recognise the problem, then you risk a massive balance sheet recession and deflation.”

Another parallel to Japan is policy mistakes prolonging the downturn.

In the 1990s the Bank of Japan went too far with interest rate rises while increases in indirect taxes were poorly executed.

Similarly, Beijing seems to be making policy mistakes such as its strict zero COVID policy. Just last month authorities locked down a million people in Wuhan.

Mehta says an extended period of low growth should change the way investors approach China.

“Remember that in Japan’s case there were always some very good companies that were globally competitive — Toyota, Sony, Nintendo, some of their speciality chemical and semi-conductor companies.

“It’s not as if there weren’t good businesses but those businesses typically relied on export orientation because the domestic economy was going through a very challenging period of disinflation and deflation.

“I want to keep that precedent in mind for China and look for similar opportunities.”

Mehta cautions that the geopolitical environment is different. While Japan did cause resentment in the US in the 1980s because of its economic power, it was never a military threat.

“So be careful – the same export markets that were open to the Japanese might not be open to the Chinese.”

But the broad characteristics of companies that will thrive in a slow growth, deflationary domestic environment should be similar.

“The companies that stood out had shared characteristics.

“They were companies with high pricing power, they had an industry structure with few irrational competitors, and they were able to generate very strong cash flows.

“When you have a disinflationary or deflationary environment, cash is a fantastic asset to own.

“Inflation is the enemy of holding cash as value, whereas in a deflationary environment, cash is king.

“In my portfolio in China, I am gravitating towards these kinds of businesses – export-oriented champions or domestic champions with pricing power and cash flow.”


About Samir Mehta and Pendal Asian Share Fund

Samir manages Penda’s Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

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About Pendal Group

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

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