KKR’s Henry McVey: China, A Visit to the Epicenter, a new macro Insights

Henry McVey, KKR’s Head of Global Macro and Asset Allocation (GMAA), and Frances Lim, who leads the team’s efforts in Asia, provide their outlook on China’s evolving role in the global economy.

“A recent trip to China reminded us why so many investors now consider China the ‘epicenter’ of global macro trends,” Henry McVey says. “In addition to accounting for nearly one-third of the global growth, the country is also in a heated trade dispute with the United States. Without question, it is not sitting idle, and we saw visible signs of change in both monetary and fiscal policies during our visit. Overall, we believe that the current trade wars will only accelerate China’s shift away from an export economy dependent on global trade towards a more self-reliant consumer services economy that is gaining prominence, particularly within Asia.”

In this latest report, Henry McVey and Frances Lim delve into the following four key areas of rapid change within the Chinese economy that they believe are potentially most important for investors to better understand:

The escalation of trade barriers between the U.S. and China and their undeniable attack on the traditional global supply chain.
Secular growth trends within the rising Asian millennial generation, the Chinese one in particular.
The evolution of e-commerce in China, which is dramatically more abrupt than what is occurring in other parts of the global economy.
Diverging macro data trends in China. While aggregate GDP statistics in China look fine, they are masking major disparities that can be uncovered in the underlying sector data.

From an investment standpoint, the report details how these macro themes factor into the GMAA team’s support of capital deployment in areas such as leisure, wellness, services (environmental, healthcare, and financial), healthy food and food safety. They also influence the team’s cautious view on branded consumer goods, global supply chains, and logistic plays that do not interface with the customer or can be disintermediated by the growing influence of Baidu, Alibaba, and Tencent. Finally, the GMAA team asserts now is the time to be thoughtful in terms of allocating to globally integrated industries such as autos as well as high-end technology.

“When written in Chinese, the word ‘crisis’ is composed of two characters. One represents danger and the other represents a point where things happen or change.”

1. The escalation of trade barriers between the U.S. and China is an undeniable attack on the traditional global supply chain, one that we now believe can no longer be easily repaired through rushed and/or reconciliatory negotiations on a go-forward basis. Without question, President Trump in the United States is ushering in a different era as it relates to global trade. As we detail below in the section where we trim our 2018 China Real GDP estimate, we think that the Trump administration will implement its $200 billion of retaliatory trade initiatives by early September, and we now believe that a global auto tariff is no longer out of the question. Hence, our view is that President Trump’s trade negotiations may just further intensify a global growth headwind that has actually been with us for some time (Exhibit 1), particularly as China insources production of more intermediate goods. It could also lead to further volatility in the currency market, as trade-affected countries attempt to potentially regain strategic advantage through competitive devaluations. These viewpoints are noteworthy, we believe, as many of the global business executives and investors with whom we met in China are currently forecasting more optimistic outcomes. So, if we are right, then investors should expect more earnings and market-based volatility beginning in the third quarter of 2018. Maybe of greater importance, though, is that the shift towards more nationalistic agendas represents a secular change that we believe has long-term implications for the way both business executives and allocators of capital think about the traditional benefits associated with ‘globalization’ compared to the past 30 years. In particular, we now expect a greater number of global multinational companies to begin to consider alternative supply chains, including more local production in both the U.S. and China. Technology, including semiconductors, and agriculture, including soybeans, are key areas of focus for us after our trip. We also expect a change of destination in global flows, as already evidenced by China’s significant slowdown in purchases of U.S. real estate in the second quarter of 2018.
2. Despite intensifying trade tensions, we are extremely bullish on secular growth trends within the Asian millennial generation, the Chinese one in particular. All told, there are now 828 million Asian millennials, compared to just 66 million in the U.S. Within China, which is the focus of this note, there are north of 300 million millennials. Not only do the numbers of Asian millennials in places like China dwarf those in the U.S. and Europe, they form the bulk of the labor force. They are also the cohort that is now entering middle income status in China, which suggests important shifts in buyer behavior patterns. As we detail below, we now look for these individuals to reshape many traditional consumer markets within China – and around the globe for that matter.
3. Our latest visit again reminded us that the evolution of e-commerce in China is unlike almost anything else we are seeing in any other part of the world. Specifically, consumers are bypassing conventional stages of online commerce development that have traditionally defined migratory patterns in key markets like the U.S. As a result, the power of Baidu, Alibaba, and Tencent (BAT) to decide which companies succeed or fail in China’s vast consumer and corporate markets has become both outsized and unprecedented. Indeed, by being part of the BAT network and infrastructure, several of the companies we met with in the healthy foods, data center, and logistics businesses are quickly emerging as almost preordained winners, often at the expense of incumbent companies in the more traditional consumer categories (many of which are multinational players). In our view, this shift in power is secular, not cyclical, and it has critical implications for return on capital in the Chinese corporate sector (both public and private), we believe.
4. The headline economic statistics in China look fine, but they are masking major sector disparities that we are uncovering in the underlying macro data [1]. For example, in terms of growth, China’s GDP ex-Financials grew 9.1% year-over-year during the March quarter, but the Financials component of the economy, which includes many parts of the shadow banking system, plodded along at a much more modest four percent. Even within the financial arena in China we found noteworthy divergences. For example, total consumer growth surged 18.8% year-over-year as of June 2018; by comparison, consumer credit growth reached just 9.7% over the same period, reflecting the government’s heavy focus on deleveraging its State Owned Enterprises (SOEs). Meanwhile, within Fixed Asset Investment (FAI), we note that year-to-date infrastructure investment growth declined to 3.3% year-over-year as of June 2018 versus 16.8% growth as of the same time last year. On the other hand, real estate investment, another important subcomponent of FAI, increased to 7.4% year-over-year as of June 2018 from 5.5% a year ago. See below for more details, but our punch line is that, while the aggregate numbers in China look fine, it is not business as usual. Key issues such as e-commerce, deleveraging, and now trade are all creating massive undercurrents to growth relative to the more benign generic headline level macro data that is currently being reported.

Overall, we believe that the current trade wars with the United States will only accelerate China’s shift away from an export economy dependent on global trade/flows towards a more self-reliant consumer services economy that is gaining prominence, particularly within Asia. No doubt, this transition will take time, and it will likely be complicated in the near term by the political agendas of both the East and the West. However, the long-term trends of the Chinese millennials helping to accelerate the transition of the nation towards more of a domestically focused, services-based economy with increasing technological advancements is undeniable. To this end, we think that, despite escalating trade tensions, there is a significant long-term opportunity for global investors to help fund this transition and receive potentially outsized returns along the way.

We also left China with the strong belief that recent uncertainty is creating opportunity for more corporate carve-outs, as a growing number of chief executives rethink what is really core to their Asian footprint, including distribution centers, supply chains, and capital equipment.

An important caveat is that, as we describe below in more detail, macro risks have definitely increased. In particular, both domestic and foreign policies are now creating significantly more cross-currents in the economy than in the past, influences that we believe can now materially enhance or diminish the merit of any investment thesis in key areas of today’s Chinese economy.

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