Effectively China is at the same point that Japan was at in 1968 or at a similar point to where South Korea and Taiwan were at in their industrialisation journeys in the early 1970s. The key point is that China has 1.3 billion people that are being taken on the industrialisation journey.

While the Chinese economy has slowed over the past year, low inflation leaves the door open for economic stimulus. Data out today showed the Chinese purchasing managers index at a 9-month low in August.

Attached is a chartpack, putting developments of the Chinese economy in perspective.

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• Inflation well contained. China’s annual inflation rate fell from 2.2 per cent to 1.8 per cent in July – a 30 month low. The July result was marginally higher than forecasts centred on a result near 1.7 per cent. Over the month inflation rose by 0.1 per cent after falling by 0.6 per cent in June.
• Business inflation (producer prices) fell by 0.8 per cent in July to stand 2.9 per cent lower than a year ago – a 33-month low.
• Scope to ease policy. The slower pace of growth combined with other data showing that inflation is in control gives the Chinese authorities’ scope to inject further stimulus if necessary in coming months.

What does it all mean?

• There is no doubt the Chinese economy has slowed down over the past year, however it has been a self-induced slowdown to get inflation in check. And that is exactly what has taken place; non-food inflation is barely growing, while food inflation has also slowed dramatically. In addition producer prices (or business inflation) is now going backwards, down by 0.8 per cent in July to stand 2.9 per cent lower than a year ago – a 33-month low.
• And while the latest retail sales and fixed asset investment figures (spending on infrastructure, roads, power plants etc) were below consensus it is really backward looking data (a view of the economic landscape before the policy was eased). In addition the forward looking manufacturing indices seem to suggest that activity levels have bottomed out in recent weeks.
• The latest results provide a strong base to launch a sustainable growth story. Chinese economic growth of around 7.5-8 per cent, pickup in lending, rising domestic income and consumption, robust business investment and inflation below 3 per cent sound like the ideal economic landscape for solid longer-term growth. And when coupled with news in recent weeks that local governments have been ramping up stimulatory measures – tax cuts, consumption subsidies and largely infrastructure investment being fast tracked, it does suggest that Chinese authorities have successfully engineered a “soft landing” for their economy.
• Interestingly it does look like the recent fall in the headline inflation rate is waning and will bottom out in coming months. As such it is likely that policymakers will be careful not to crank up growth too quickly. The focus will shift to judging the impact from the two interest rate cuts implemented over the past few months. However policymakers still have avenues to stimulate if they deem it is necessary.

What do the figures show?

• The annual rate of consumer price inflation eased from 2.2 per cent to 1.8 in July – a 30-month low. The June result was marginally higher than forecasts centered on a result near 1.7 per cent. Over the month inflation rose by 0.1 per cent in July after a 0.6 per cent slide in June.
• Food prices rose by 2.4 per cent over the year to July (3.8 per cent in June) while non-food prices rose by just 1.5 per cent in the year to July (1.4 per cent in June).
• Producer prices (business inflation) fell by 0.8 per cent in July to stand 2.9 per cent lower than a year ago – a 33-month low. The annual rate of producer price inflation peaked in July 2011 at 7.5 per cent and has been declining since.
• Industrial output expanded at a 9.2 per cent annual pace in July, down from 9.5 per cent in June and below forecasts centred on a result near 9.7 per cent. Production is well off the highs of 20.7 per cent annual growth in January/February 2010.
• China’s urban fixed asset investment, such as spending on roads and power plants, grew at a 20.4 per cent in 2012 to date (January – July), below forecasts (20.6 per cent) and in line from 20.4 per cent in June.
  Retail sales grew at a 13.1 per cent annual rate in July, down from 13.7 per cent in June and below forecasts, centred on 13.5 per cent annual growth.

What is the importance of the economic data?

• China’s National Bureau of Statistics releases its monthly economic statistics around the middle of each month. Quarterly GDP data is released around the 16th of January, April, July and October. China is Australia’s largest trading partner and changes in the Chinese economic have major implications for the Aussie economy.

What are the implications for interest rates and investors?

• Chinese policymakers spent the majority of the last year in tightening policy to get inflation in check; however the central bank underestimated was the escalating European debt crisis. The deeper recession in the Euro zone compounded the slowdown in Chinese exports. Importantly policymakers have been quick to shift to a more stimulatory stance in recent months.
• The latest Chinese economic data is encouraging for Australian businesses. China has successfully slowed its economy to a more sustainable growth rate. Now the challenge is to lift momentum, but not so far as to reignite inflation.
• China faces challenges – what country doesn’t. A key challenge is to rebalance growth in favour of household spending and the keep inflation under control. The Chinese economic data will alleviate global concerns that the world’s powerhouse economy was at risk of a hard landing.

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Market sentiment regarding China has become noticeably bearish, as the market fears growth in China will continue to slow.

They have been disappointed lately, with a range of Chinese economic indicators reporting on the downside and the country reported to be in its deepest slump since the 2008 global financial crisis.

A range of stimuli from the central government in Beijing also appears to have done little to boost the growth of the world’s second largest economy and its 1.3 billion people.

“But we are already seeing some signs that the growth slow-down is stabilising,” says David Urquhart, Portfolio Manager of the Fidelity Asia Fund, “at around the 7.5-8% GDP rate. 

“As GDP growth expectations have been revised down, the price to earnings (P/E) ratio of Chinese companies has also fallen to 8.3x [comparatively cheap versus its five year average of 12.1x and also versus the Australian market on 11.2x]. Yet earning per share (EPS) growth in China is expected to outpace that of Australia in both 2012 and 2013. As a result, Chinese shares that can deliver on current growth expectations are now looking attractive.”

Mr Urquhart notes “China is in the midst of rebalancing its economy, and GDP growth is shifting away from being heavily dependent on export growth and infrastructure spend, and towards domestic consumption. As this process of rebalancing continues growth rates will be lower than they have been over the past decade, but these changes will shift China to a more sustainable growth path.

“The composition of Chinese GDP growth has already begun to shift.  In the first half of this year, China’s GDP grew 7.8%, of which (a) investment growth added +3.9%; (b) consumption added +4.5% (so over 57% of GDP growth) while (c) net exports subtracted -0.6%. Only a few years ago growth was fairly evenly split between all three of these factors.
“Since the end of 2009 in the aftermath of the GFC, net exports have not contributed to GDP growth. Weak external demand from the US and Europe has removed this previously strong GDP growth driver.

“This also means that some micro data that was an indicator of growth in the past is now less relevant. For example, if one focuses on electricity generation growth, this has been growing at 1.48% year on year (YoY) in April and 3.25% in May.  However while this data is very relevant for growth in manufacturing/exports and infrastructure, it is not so meaningful in measuring consumption growth.  So by continuing to focus on this as an indicator of GDP growth could easily make one more bearish about China’s growth prospects than one should be. Consumption related data is now much more important an indicator of Chinese GDP growth.”

Mr Urquhart adds “in addition to rebalancing its economy, in 2011 China faced the challenge of high inflation. This saw the Chinese remove fiscal stimulus (eg infrastructure spend on high speed rail was frozen and restrictions on bank lending were put in place for key industries like cement, steel, real estate etc). In other words, monetary policy was very tight.  In 2012, with inflation now under control, we have seen some reversal of this tight monetary policy – RRR reductions, interest rate reductions and some easing in restrictions on bank lending.

“Unlike during the GFC, strong fiscal stimulus is seen as neither necessary nor desirable, particularly as we are starting to see some benefits of policy easing that should come through later this year.”

He suggests the latest HSBC PMI is one of a number of indicators demonstrating signs that China’s growth slow-down could be nearing an end. Other indicators also support this:

• China’s export trade grew 15.3% and 11.3% YoY in May and June after only 4.9% growth in April and shrinking in January 2012
• Industrial production growth has also accelerated from +3.8% YoY growth in Jan and Feb to +10.7% in June
• New loans by large banks doubled in the first half of July versus the first half of June
• Rail and highway investment rose by 34% month-on-month and 28% month-on-month in June versus 7% and 8% in May.

Mr Urquhart says “stable growth (rather than slowing growth) combined with attractive equity market valuations make China an interesting investment proposition. 

“Increased confidence that China can deliver GDP growth of better than 7% should see China’s flat equity market performance year to date in 2012, improve substantially. China’s growth concerns have been priced into the market at current valuations of 8.3x p/e and 1.5x book value.”

He notes “in other parts of Asia, we have also seen positive GDP growth surprises and/or positive earnings revisions – in countries like Singapore, the Philippines and Thailand – and have also seen strong equity market performance (each up between 15-24%).” 

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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