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Equity Outlook  |  Q1 2018

Can China avoid a hard landing?

Daniel J. Graña

Daniel J. Graña
Portfolio Manager of Putnam Emerging Markets Equity Fund

President Xi Jinping secured his second term in office at the culmination of the 19th Congress of the Communist Party in October. The Congress ended with the Politburo Standing Committee, the Party’s decision-making body, having no obvious successor to Xi. This points to the possibility that Xi may hold on to power for a third five-year term in 2022.

Picking up the pace of reforms

Xi has emerged as China’s most powerful ruler since Mao Zedong and Deng Xiaoping. He can pursue reforms that affect strong vested interests. For example, he has pledged to escalate economic and financial reforms, and we believe there will be an increased pace of change going forward. However, Xi is not a believer in unfettered free markets. China’s one-party state will continue to pursue a government-directed path of economic development.

Tech stocks remain a bright spot among many investment choices in the Chinese equity markets.

Among the challenges facing the government will be the frothy property market, the seemingly ever-rising financial leverage of the economy, and the capital inefficient state-owned enterprises (SOEs). The SOEs are critical for Xi’s vision of economic development, and policies that foster more efficient behemoths and less fragmented industries would benefit the economy.

Pivoting from growth-enhancing policies

We expect growth to decelerate in 2018 as China has pivoted from growth-enhancing policies to those that rein in credit expansion and encourage more environmentally friendly development that includes closures of polluting facilities. Over the long term, to avoid a hard landing, economic growth that is less dependent on credit is necessary.

The government has the incentives and policy tools to curb rising property prices and deal with debt risks to prevent an uncontrolled slowdown. The economy does not rely on foreign flows, the domestic savings rate is high, and credit underwriting standards that underpin the housing market do not concern us.

While the rapid buildup of financial leverage in the broader economy concerns us, debt is more sustainable in China because it is domestically funded. These factors reduce the risk of a sharp downturn in the economy. Should the government prove unwilling to accept the near-term pain of financial deleveraging, our concerns about the debt trajectory would rise.

The rise of the tech giants

Slower growth has not stopped investors from piling into Chinese technology companies, which have given Silicon Valley’s top tech stocks a run for their money. China’s tech boom is being fueled by the rapid growth of e-commerce, digital payment services, and innovations in financial technology. Millions of Chinese shoppers are using payment apps to make purchases using their smartphones instead of cash or bank cards.

Chinese tech companies are leading the way in financial technology to enable consumers to purchase investment products and secure consumer loans. The Chinese banking system is largely dominated by SOEs that are focused on corporate- and government-related lending. This facilitates the entry of Chinese tech companies into financial services for consumers.

We believe the growth of these Chinese tech stocks will last much longer than what has been priced in the markets. As a result, tech stocks remain a bright spot among many investment choices in the Chinese equity markets.

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