Published On: Mon, Oct 12th, 2015

KKR on China: A Shifting Landscape

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My colleague Frances Lim, now based in Sydney, and I recently traveled for a week throughout Asia, focusing primarily on key investment-related issues in China and Japan. Given recent events in China surrounding its currency and stock market as well as Prime Minister Abe’s rollout of his latest economic targets, the timing of our trip led to robust discussions on both micro and macro trends in the region. Our key takeaways, which we describe in more detail below, are as follows:

 

  • China is in structural slowdown mode, as excess debt and capacity now weigh on profits, not just GDP. Slowing Chinese GDP data seems to garner all the headlines these days, but after our most recent trip, we think the focus should be on trends in corporate profits. Indeed, increasingly weighed down by excess capacity and too much leverage, many corporations are now delivering significantly negative profit growth. Just consider that industrial profits declined by a sizeable 8.8% year-over-year for the month of August, despite government reports that the country’s GDP is growing close to its 7.0% target. Traditional consumer businesses too are suffering from more mature penetration rates and the rise of e-commerce. If there is good news, our trip confirmed that there are still a lot of top- and bottom-line growth opportunities in the higher value-added services parts of the economy. In particular, we left most impressed with what we saw unfolding in the food safety, environmental services, and healthcare sectors of the Chinese economy.

 

  • Japan is no longer just a macro story; focus on the micro too. In our humble opinion, the positive macro story in Japan is – on the margin – waning. To be sure, given sluggish GDP and inflation trends of late, we do expect more macro support from both the prime minister and the central bank in the months ahead; however, from what we can tell, the beta trade in Japan now seems to have run its course. As such, we think primarily just those companies that are actively shedding assets and/or returning cash to shareholders will outperform handily from current levels. We also see consolidators performing well, given the low cost of funding as well as the excess capacity. By comparison, inflexible players, particularly in the export sector of the economy, are likely to face stiff headwinds in 2016 and beyond.

 

  • Overall, Asia is in somewhat of a funk. See below for more details, but our trip reconfirmed our thesis that many EM Asia countries recently redirected their economies — potentially at just the wrong time — to take advantage of what they thought would be ongoing strength in China’s economy (Exhibit 2). However, with China’s growth now stalling amid lower commodity prices and weak inbound trade, many EM countries, including Indonesia, Thailand, and Malaysia, are now enduring weaker than expected growth, bigger deficits, and heightened political tensions. We do not see this backdrop changing in the near-term, and as such, we think higher risk premiums are now warranted until more and bigger structural changes are embraced throughout the region.

Looking at the big picture, our key conclusion from the trip is that the slowdown we are seeing in China is secular, not cyclical. Given that China is expected to account for at least one-third of global GDP growth this year, this insight has important implications for global trade, monetary policy, and inflation expectations, we believe, as we think ahead about 2016 and beyond (Exhibit 1). It also means that the recent surge in consumer and corporate credit across many emerging market countries could — ultimately — act as the primary catalyst for the next global economic downturn.

BY HENRY H. MCVEY, FRANCES B. LIM

 

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