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Hermes’ Greenberg on the changing face of the Chinese economy

25 September 2017

FE Alpha Manager Gary Greenberg outlines why China remains a compelling investment case despite many of his peers underweighting the emerging markets giant.

By Jonathan Jones,

Reporter, FE Trustnet

Investors should reconsider their underweight positions in China despite concerns over debt levels and slowing growth, according to Hermes Investment Management’s Gary Greenberg.

The FE Alpha Manager (pictured) said he has an overweight position in the country, with a mixture of both ‘old’ and ‘new’ economy names in the portfolio of the £2bn, five FE Crown-rated Hermes Global Emerging Markets fund while many of his peers are underweight.

The main reason for optimism in China is the move in the economy from focusing on ‘tangible’ to ‘intangible’ assets, he said. In other words, the move from an ‘old’, commodities and manufacturing-focused economy to a ‘new’ technology-driven economy.

“In 1975, five-sixths of the market value of the S&P 500 was tangible assets – things like big factories and the infrastructure that was built around them,” Greenberg said.

“Over the next 40 years the intangibles became much more important through companies such as Microsoft, Apple and Facebook who don’t have much in the way of tangible assets.

“What’s interesting is that it is also happening in the emerging markets.”

He explained: “If you look at China ‘old economy’ versus ‘new economy’ back as recently as 2000 there wasn’t much to talk about [it].

“But what we have seen since is that the ‘old economy’ as a total percentage of market cap has shrunk a lot and the ‘new economy’ is becoming much more important.”

He added: “What this means is that intellectual property is becoming more important in emerging markets: they are turning from the low labour costs, factory of the world which is really a dead-end street into countries that innovate on their own.”

Indeed, a decade ago the MSCI Emerging Market benchmark was dominated by companies with tangible assets such as energy (15 per cent), materials (14 per cent) and telecoms (11 per cent).

Sector weights in the MSCI Emerging Market benchmark

  

Source: MSCI

Since then, the weighting to all these industries has halved, as the above chart shows, while technology has doubled with almost all of this innovation coming from China.

“Just 1 percentage point of the emerging market benchmark’s information technology weighting is domiciled outside of China,” the manager said.

“This means you can fund research and development and have a chance of becoming truly innovative on a global scale.”



He said countries in emerging markets that are stuck exporting commodities – traditionally China’s largest export – could be left behind.

“It is a well-known saying that if you are stuck exporting commodities you are never going to get rich,” said Greenberg. “China figured that out and are not exporting commodities, they are moving up to higher and higher values.”

However, the manager said new innovative technology firms were not yet large enough to become the primary engine of growth for the country.

As such, it is just as key for investors to understand what is happening in the ‘old China’ portion of the market, namely banks and other state-owned enterprises.

Many investors have become concerned about slowing growth rate in these company types, where growth has been kept artificially high by government borrowing.

While it is possible further rises in debt levels could exacerbate  misallocations of capital and precipitate an eventual crash, Greenberg does not believe this will happen and that China should continue to move higher.

“China has been growing on the back of debt and its debt to GDP has gone up a lot,” the manager said. “This has led false Cassandras to say it is all going to fall apart but so far it hasn’t happened."

Performance of MSCI China over 10yrs

 

Source: FE Analytics

He said while policy to gradually slow growth rates looks inevitable, investors are unwilling to believe the government will do this in the right way.

“We think the political will is there and the populace will ‘eat bitter’ – a Chinese colloquialism for enduring hardship – in the name of longer-term stability,” he said.

Key to this is the moves the government have been making to reduce the level of external debt, giving it less dependence on other countries.

“China has done a good job of reducing the external portion of the debt so that its external vulnerability is low,” he said.

“There effectively isn’t a credit stimulus going on. The credit impulse in China has dropped to slightly negative and, in fact, the latest figure […] on Chinese debt to GDP has come off slightly.



“So, we have basically a slightly slowing indebtedness and the money supply growth has also slowed down.”

While this means that growth will be lower, it bolsters confidence that the government is approaching its debt burden in the right way.

This confidence has allowed the manager to buy back into certain parts of the ‘old China’ with the most contrarian new addition to the Hermes Global Emerging Markets fund being the Industrial and Commercial Bank of China (ICBC).

“People are convinced that the Chinese banks are full of non-performing loans and it is just a matter of months if not weeks before they blow up,” Greenberg noted.

“We’ve been talking to people in China and we don’t think that is the case with the big four banks. We think some of the smaller banks are in trouble but we don’t think the 'big four' are in trouble and the non-performers, we think, are under control.”

He said that the volume of non-performing loans held by the banks is probably 5 per cent higher than reported levels but that these are expected to be digested over the next three-to-five years.

“They’re not growing that quickly but they are quite cheap and their capital levels and okay enough to continue to pay out dividends,” the manager noted.

 

Greenberg has run the Hermes Global Emerging Markets fund since 2011 and was joined by deputy manager Kunjal Gala last year.

Performance of fund vs sector and benchmark since manager start

 

Source: FE Analytics

Since Greenberg took over, the fund has been the best performing fund in the IA Global Emerging Markets sector, returning 71.05 per cent, compared with a 29.89 per cent gain for the average sector fund and a 30.4 per cent rise in the MSCI Emerging Markets benchmark.

The fund has a clean ongoing charges figure (OCF) of 1.13 per cent.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.