China may be undergoing a bumpy but managed landing but our operations suggest that the consumer remains on track.
The Chinese economy is not melting down. That notwithstanding, this shift has resulted in Asian market capital outflows that have driven valuations of certain key markets to levels not seen since the global financial crisis.
Deteriorating market sentiment is resulting from the realization that we are in the midst of a bumpy but managed landing. This is long-term better for the economy as it will lead to tougher reforms, but will also give rise to more volatility and events such as trust defaults and bankruptcies that in the past were shuffled aside. Moreover, with reform comes politics, and much of the indecision and confusion of late is a result of tension between entrenched interests and the current regime.
We believe that a slowdown has been underway for about six months, resulting from an intentional tightening of credit and exacerbated by political stasis due to the ongoing reforms under debate. This process may already be starting to bear fruit – money supply is being relaxed, and a better understanding of the tools at policy maker’s disposal is now clear. Events such as the recent military parade marking the defeat of Japan help provide political clarity – one look at the podium provides a good indicator of who remains in good favor and who, grudgingly or otherwise, has the mandate to act.
However, tension between reformers and the status quo is the primary reason for the slow pace at which reforms are progressing, and the generally sluggish pace of implementing the usual policies that, time and again, have kept growth on track. Market sentiment had not been pricing in this year’s political stasis, and has swung from believing Chinese policy makers are all-knowing gurus to “dangerous market Leninists”, fueled by the foreign press.
The most likely outcome is that China continues to muddle through reforming and effecting policy shifts, as it has for three decades. Often this means shooting first with ammunition in hand, and fine-tuning later. Further, as Justin Lin of the World Bank has noted, China’s retains an enormous advantage in that it remains a relatively poor and developing economy, with plenty of room for urbanization and wage inflation.
The insights we have from our businesses are consistent with slowing growth, but without signs of dramatic distress. Consumers have not stopped spending, although sales have slowed in first-tier cities, which are the most impacted by macroeconomic and market volatility. Sales and growth in second- and third-tier cities has offset this, tentatively providing validation of Lin’s “advantage in backwardness” thesis. Online sales have also helped all of our companies, due to changing consumer behavior and the present overabundance of e-commerce capacity.
Looking by sector, consumer discretionary remains strongest. Staples such as beverages are seeing a more marked slowdown in sales, as well as overcapacity. Snack foods are faring better, with niche players like Yonghong doing well, but having to contend with higher wage and input prices. Apparel is a brighter spot, with mass market premium brands like Yeehoo growing slower, but still steadily, and even higher priced luxury apparel brands like Pinco Pallino showing resilience.
Our operating data generally dovetails with public market observations. Consumer discretionary businesses continue to benefit from consumer’s upgrading tastes and a trend toward premiumization. These businesses have also tended to benefit from more attention to inventory management and costs. Staples are not as fortunate, reporting margin stress due to rising input costs and continued concerns about overcapacity. Other areas, like autos, are weak, due to the deferral of purchases by Chinese consumers who foresee falling prices.
Our outlook overall, therefore, remains cautiously optimistic. Consumer spending will rise, companies with room for operational improvements remain good targets, providers of niche discretionary products will outperform, and the key drivers of our thesis will remain wage growth and urbanization. Recent volatility is good for our pipeline and bargaining power, but may affect the timing of exits – neither in a dramatic fashion for businesses with strong underlying products, sales and earnings power.
Lunar | August 31, 2015