For a year marked by such historically low levels of volatility, there have been plenty of macro concerns to keep investors awake at night. Fears around Brexit, elections in Europe, growing populist sentiment in the West and the threat of nuclear war have been discussed at length, but there has been less spoken about the big risks posed by the world’s second largest economy – China.
This likely has something to do with the fact that 2017 has been another standout year for China and more importantly for investors in the region. The UK’s Investment Association China/Greater China category reigns supreme as the best performing sector year-to-date, producing returns comfortably above its peers.
As Stuart Parks, Invesco Perpetual’s head of Asian equities, points out, the growth of China’s middle class and domestic consumption has fuelled “stellar earnings growth”, including for its tech businesses, which have been a major draw for foreign investors.
China’s success story is “crucial for the prospects of the whole region”, he says. Gross domestic product growth has “remained stable at a respectable level” of 6.8% in the third quarter year-on-year, “helped by stimulatory government policies and continuing income growth”.
“Although the debt mountain has remained high — China’s debt-to-GDP ratio is still 270% — the continued liquidity of the banking system, aided by strong domestic saving rates, means that the economy is unlikely to topple over in the short term,” he adds.
Not all the winners of 2017 will continue to outshine in 2018, though many think there is reason to suspect China will be one of the exceptions to the rule.
The danger here is that investors have grown too complacent or are underestimating the force of the currently sleeping dragon that is China’s debt pile.
The region’s over-leveraged economy, problems with pollution and the banking sector still requiring reform have been clearly signposted risks for investors looking to get into the region for years.
Tightening tipping point
What hasn’t received nearly as much attention this year and is now coming back into focus, is the People’s Bank of China monetary tightening trajectory.
“The Fed’s tightening cycle has not yet begun but China’s has,” points out Société Générale’s analyst and permabear, Albert Edwards.
While “there is a sense in which the tightening has not really begun” at the Federal Reserve or at central banks in other developed markets, Edwards says the same is not true in China where after successfully “puffing up the economy with credit ahead of the October Party Congress, the policy brakes are very firmly being applied once again”.
But Edwards thinks the current period of “quiet and calm” in the Chinese market against this monetary tightening backdrop is precisely what “might catch investors off guard”.
Quoting Axiom Capital’s Gordon Johnson, who handles the firm’s stock picking in the alternative energy and metals and mining sectors, Edwards highlights the possibility that after years of diminishing returns, China’s credit multiplier might finally be “exhausted”.
Johnson points out China’s credit issuance growth of 101.7% year-to-date through to October “it seems the level of credit necessary to stimulate growth in China could prove elusive at this point”.
“We don’t recall any economist’s forecasts exiting 2016 pointing to China’s new credit issuance more than doubling year on year in 2017, yet that’s exactly what’s happened,” he continues. “Had this been our base case, we would have expected all economic indicators in China to be moving substantially higher at this point in the cycle.”
The International Monetary Fund reached a similar conclusion earlier this month, warning that “the credit-to-GDP ratio is now about 25% above the long-term trend, very high by international standards and consistent with a high probability of financial distress”.
Edwards continues: “Inevitably, it is impossible to predict what might be the trigger to crash the global markets, but given the nature of these things it is highly likely to be something that investors are not currently worrying about, and China certainly fits that bill.”