For investors outside China, whether they have holdings in Chinese shares or not, coming to a coherent investment view on the country has become imperative as it exerts an ever-increasing influence on global markets. In this paper, we discuss how we believe that China's economic riddle can only be explained as a once-in-a-century event — any shorter term perspective misses the wide-ranging and long-reaching implications. As Yngve Slyngstad, the CEO of the world's largest sovereign wealth fund, has stated: "Every time I come back, my perception of China has changed...The uncertainty among investors is partially due to the very simple fact that it's more difficult to know what's happening in that large economy than in any other1." In our view, it is crucial that investors take a balanced and comprehensive long-term investment view on China, including the significant implications of the country's current reform process.

Over the past few years, many investors have been concerned that deflation is taking hold in various regions of the globe (including China) and, as a result, that asset prices will fall. Although there is evidence that deflationary forces may be at work in Asia, investors should not conclude this will be negative for equity pricing. Such an environment can, in fact, be a positive for equity investing. We will present evidence for such an argument, drawing a parallel between the US's emergence as an industrial powerhouse in the late 19th century and the current decade as China undertakes significant reforms in its attempts to take the economic lead. Our advice to investors on how to harness the unprecedented rise of Asia, with China at the forefront, would be to think like an entrepreneur in that gilded age of US history. We believe that a well-researched high conviction equity portfolio containing quality companies in key growth sectors should provide the best way to profit in a supply-driven deflationary environment.

Is deflation necessarily negative for asset prices?

Deflation does not necessarily spell another Great Depression. According to a recent study by the Bank of International Settlements2,"it is misleading to draw inferences about the costs of deflation from the Great Depression, as if it was the archetypal example. The episode was an outlier in terms of output losses". According to their analysis, it depends on the driver of deflation. Deflation associated with a demand shortfall pushes down prices, incomes and output, whereas supply-driven deflations depress prices while raising incomes and output. The study notes that "in the postwar era, in which transitory deflations dominate, the growth rate has actually been higher during deflation years, at 3.2% versus 2.7%". Evidence from Great Britain and the US during the second half of the 19th century shows that deflation driven by rapid technological advances can co-exist with economic growth.

How does this link to Asia, and to China in particular? The answer is that China sits at the nexus of the deflationary argument. China's rise as an economic superpower brings unprecedented manufacturing capacity into production, along with technological advances in energy and food production, communications and information industries. Together, these factors are conspiring to cause an oversupply of goods and excess capacity in many sectors. This is similar to the situation for the US when it rose as an industrial power in the late 1800s. Despite this period seeing a deflationary growth environment (see chart 1), US productivity rose due to the effects of technology, reform and increased competition. Equity investing in the key sectors at that time was, in fact, quite profitable (see chart 2).

Chart 1: The US saw a sharp drop in inflation in the late 19th century
US CPI 1800-1900

Chart 1: The US saw a sharp drop in inflation in the late 19th century US CPI 1800-1900

Source: Mises Institute, "Deflating the Deflation Myth";

Chart 2: Despite deflationary environment, this was a favourable period for equity investing

Chart 2: Despite deflationary environment, this was a favourable period for equity investing

Source: with data from

As chart 2 shows, while the period of the Great Depression was extremely poor for US equity prices, the period of deflationary growth between 1870 and 1900 (the era Mark Twain called the gilded age) was very favourable to equity investing. Deflation during the Great Depression was driven by the destruction of capacity due to a sharp fall in asset prices, bankruptcies and risk avoidance. We would argue that, similar to the late 19th century gilded age in the US, the factors that are currently driving a deflationary environment in many parts of the globe, including Asia, are supply-driven due to new industry capacity from China, as well as increased digitalisation in many industries, including manufacturing processes. Another driver of the global over-supply problem is the mispricing of many economic factor costs, such as interest rates and environmental protection costs. Interest rates have long been distorted by central bank actions and environmental costs have been largely ignored in economic decision-making.

Asia case-study: growth slowdown can spark a positive equity investing environment

More recent examples of supply-driven deflation can be found in Asia and they highlight that deflationary price trends can be positive for equity investing depending on the driver. Japan, Korea, and Taiwan all enjoyed episodes of economic success in the mid to late-20th century despite a deflationary environment.

The industrialisation experience of many Asian nations, including Japan, Korea, and Taiwan, follows a similar story, which is well documented in Joe Studwell's book How Asia Works. Each of these countries, run by a strong government, pursues aggressive export-oriented economic policies, partially helped by a low exchange rate and fully exploiting its labour cost advantages. Successful industrialisation leads to years of extremely fast economic growth and high productivity gains. However, this success comes at the expense of subduing labour costs, interest rates, exchange rates and other industrial cost factors in favour of the exporting manufacturing sectors. The economic growth model, which encourages excess investment with a mercantilist mindset, becomes outdated as imbalances appear amid signs that economic growth is approaching an inflexion point. Factors pointing to a slowdown, or normalisation, of economic growth include higher wages, pollution factors, currency appreciation and increasing financial leverage from years of over-investing. To rebalance the economy, the government starts to liberalise the financial sectors by introducing free markets and lifting capital controls, while domestic consumption begins to pick up as industrial investment slows.

This scenario describes what occurred in Japan in the late 1970s to mid 1980s, and Korea and Taiwan in the late 1980s and early 1990s. It is also an accurate narrative of the economic environment in which Beijing has found itself in recent years. We can learn much about how to invest in China by analysing Japan, Korea and Taiwan in their transitional phases. While their best economic growth stories were written during a period of capital controls within a closed financial regime, all three countries actually saw some of their better equity market returns after GDP began to slow and financial reforms took hold as their governments worked to rebalance the economic model. The reform phase involves loosening capital controls, allowing exchange rates to free float and liberalising financial markets to enable more efficient allocation of capital. Despite headline GDP growth slowing considerably, it is during the second phase that equity performance improved substantially — in Japan during the 1980s (see chart 3), and Taiwan and Korea in the 1990s and 2000s.

Chart 3: Despite Japanese headline GDP slowing in 1980s, equity performance improved substantially
Decade-by-decade cumulative gains in Japan nominal GDP and the Nikkei Index

Chart 3: Despite Japanese headline GDP slowing in 1980s, equity performance improved substantially

Source:Bloomberg, and; Gavekal

Beijing has recently implemented a deposit insurance scheme and is about to liberalise interest rates to market forces. In addition, the Shanghai-Hong Kong Stock Connect (launched in November 2014) and talk of RMB full convertibility may be heralding a much more liberalised capital account. Domestically, we are seeing efforts to correct financial system vulnerabilities, promote market based risk-pricing and open up capital markets.

As we noted in a recent paper, "China's LGFV debt swap — Shining light on the Shadows" (by Senior Equity Analyst, Peter Monson), the introduction of the debt swap programme for local government financing vehicles is significant, representing one of the first steps in addressing more fundamental issues within China's fiscal framework. The debt swaps should eventually give rise to more market discipline and more effective risk pricing, as well as improving financial markets' perception of risk within the banking system. While the debt swap programme does not alter the trend for slower GDP growth, it should provide greater confidence in the country's ability to deal with other well-documented issues and provides further evidence that China is entering the second transitional phase.

China's long march towards global acceptance

At the end of 1999, China's GDP of USD 1 trillion was less than Italy's at USD 1.2 trillion. As of 2013, it ranked second-largest (behind the US) at USD 9.2 trillion, which was roughly equivalent to Germany (#4), France (#5), and the UK (#6) combined (see chart 4).

Chart 4: China has risen rapidly from the world's seventh-largest to second-largest economy
Top 7 Economies by GDP, 1999 vs. 2013

Chart 4: China has risen rapidly from the world’s seventh-largest to second-largest economy

Source: World Bank

Despite the fact that it is now the world's second-largest economy, China's representation in global equity indices is almost negligible because of these capital account controls. While China accounts for about 15% of world GDP, China comprises only about 2% of global equity indices. If these controls were to be relaxed, as they are starting to be, its weighting in the global equity markets should jump to around 5% of the MSCI All Countries World Index and around 38% of the MSCI Emerging Markets Index (see chart 5).

Chart 5: China is likely to represent a substantial weighting in global equity markets
Hypothetical weights of MSCI All Countries World Index and MSCI Emerging Markets Index

Chart 5: China is likely to represent a substantial weighting in global equity markets

Source: MSCI, The Conference Board Global Economic Outlook 2014, May 2014

In our view, broader inclusion of China stocks and ultimately Chinese currency and bonds is merely a matter of time. The recent volatility that erupted in the A-share markets led to strong interventionist policies by the Chinese government in an attempt to support the country's equity markets. However, this intervention has affected Beijing's credibility in terms of its intentions to further liberalise its financial markets. As a result, these events may delay the inclusion of China's domestic markets in global equity indices. However, our view on this topic remains that China's weight in global investors' equity allocation will gradually increase as China's financial reforms play out.

Investing in China: Buy great companies, not market indices

As you would expect from an evolutionary perspective, developed markets like the US and Europe have greater weights in the very large cap companies, while Asia has a higher representation in the mid cap companies (USD 1-4 billion market cap). In fact, according to chart 6, Asia has more mid cap listed companies than the US and Europe combined. In our view, this is the best place to pick tomorrow's winners, Asia's future super brands.

Chart 6: Asia has more mid cap listed companies than the US and Europe combined
Number of listed companies above USD 500 million market cap by country

Chart 6: Asia has more mid cap listed companies than the US and Europe combined

Source: Factset, Goldman Sachs Investment Research, 6 March 2015

As China slows down to a more normal growth rate, it offers a favourable window for equity investing. We believe the best opportunities are companies in sectors that will benefit from growth normalisation and a deflationary economy — companies that can maintain pricing power in a deflationary environment and continue to grow, while maintaining or expanding their profit margins due to product differentiation or innovation. We concentrate on industries which flourish despite slowing global growth and declining pricing power.

As a result, we think that through this transformational phase, it is most prudent to invest in China as a stock picker, rather than as a pure beta play since the major index, the Shanghai Stock Exchange, is populated with giant state-owned enterprises (SOEs) which have very large market capitalisations, but do not reflect where the new growth is coming from.

As with Japan, Korea and Taiwan before it, once GDP and GDP per capita cross the inflection point, the focus of China’s economy will shift to quality of living and enhancement of living standards. We have identified four sector themes to best capture the transformation that China and other Asian economies are undergoing right now: health care, tourism, insurance, and the environment. Companies well positioned in these sectors will be able to grow despite a deflationary growth environment, being able to maintain pricing power and even expand market share and profit margins. These sectors will capitalise on the natural aging trends in Asia and the fact that China is being forced to go up the economic value chain by becoming more high tech and less focused on low cost manufacturing.

Comments about recent volatilities in the China markets

China-related equity markets, particularly the onshore markets, suffered a sharp correction starting in late June/early July after a very strong run over the past year. During periods of this type of volatility, it is crucial to take a medium- to long-term view. Economic growth in China is likely to continue to slow and the authorities should continue to ease monetary policy and implement reforms. While these reforms are currently acting as short-term speed bumps, the medium and longer term prospects for China are much brighter since we expect Chinese companies to generate higher returns for shareholders, particularly in new economy companies and selected old-fashioned bricks and mortar businesses. China's future growth lies in the private sector companies, which are displaying the motivation and ideas to push China up the innovation curve to escape from the 'middle income trap’ and compete globally.

For further information on the recent share market volatility, please see "China: Now and tomorrow" and "Views on the China equity market selloff — from an Asian Fixed Income perspective" from Nikko Asset Management Asia's Singapore-based Asian equity and fixed income teams.

We are encouraged by China's ongoing anti-corruption and real financial reform efforts, which are beginning to allow for more efficient capital allocation and should be hugely beneficial to private sector companies. We view the recent devaluation of the RMB by the People's Bank of China (PBoC) as a positive and necessary step in the process towards comprehensive liberalisation of Chinese capital markets and a free floating currency. Our conclusion is that by making the price setting for the RMB more market-based, the PBoC has reinforced the global perception of China's resolve to implement far-reaching financial reforms, which will ultimately push the RMB exchange rate higher. For our analysis, please refer to "Why did China devalue the renminbi?" by Chia Woon Khien, Senior Portfolio Manager, Fixed Income, Asia.

Conclusion: Understanding China requires a very long view

For investors focused on the long term, we make the following broad conclusions:

  1. As with the US's gilded age, China's emergence as an economic superpower will distort many of the consensus economic conclusions drawn in recent decades. Particularly on the question of deflation, we think the outcome will be similar to America's impact on the world economy in the late 19th century. China has and will continue to exert significant deflationary forces on the global economy, as well as key industries on which China focuses its industrialisation policies.
  2. This deflationary scenario should not be interpreted as similar to the Great Depression, but as a positive backdrop to equity investing. To thrive in this environment, an entrepreneurial mindset (think of those industrial titans of the late 19th century US) of ruthlessly pursuing one's own competitive edge in a deflationary pricing environment is crucial to survival. Thus, we favour a concentrated stock-picking investment style, echoing the famous quote from Andrew Carnegie, "Concentrate your energies, your thoughts and your capital".
  3. China's current financial reforms echo the same efforts made by the Japanese, Korean and Taiwanese regimes in the late 20th century as they opened up their economy and financial markets to external participants. Their rebalancing acts occurred at a point when high growth normalised to a slower rate and the economic model badly needed a change. Historically, these types of financial reforms were
  4. On the debate of A-share inclusion and RMB reserve currency status, we believe that global institutions will, sooner or later, acknowledge China's significant economic role compared with its relatively small weighting in most investors' portfolios, including central banks. China is one of the largest creditor nations on the planet, able to finance its own growth from domestic savings and accumulated earnings without resorting to external borrowing or foreign capital.
  5. Just as the rise of the US was accompanied by frequent financial boom and bust cycles in the late 19th century, the future for global markets will see plenty of disruptive influences from China. We believe that looking at issues, balancing global viewpoints with local perspective rather than from a Western-centric point of view, and focusing on sectors which are aligned with the future path of China's industrialisation policy, will lead to more balanced views and profitable investment ideas.

1 Source:Bloomberg interview,
2 "The costs of deflations: a historical perspective", Bank of International Settlements Quarterly Review, March 2015. Authors: Claudio Borio, Magdalena Erdem, Andrew Filardo, and Boris Hofmann.