The seeds of discontent

Forty years ago today, in a hotel in west Beijing, the seeds of today’s US/China trade war were planted. It was on 18 December 1978, at a pivotal plenary session of the Chinese Communist Party, that the recently rehabilitated Deng Xiaoping buried Mao’s catastrophic Cultural Revolution and ushered in the economic reforms that would enable the Chinese miracle. This was the day that Donald Trump’s and Xi Jinping’s battle for supremacy really began.

You don’t hear much about Deng these days, the ‘great architect’ of China’s economic reforms. Under President Xi, the state is rolling back Deng’s reforming tide under cover of slogans that evoke the ‘self-reliant’, introspective Mao era. Companies are adjusting to a new reality characterised by the phrase ‘guo jin min tui’ -  roughly, the state advances as the private sector recedes. At the same time, exporters are facing headwinds overseas as the West led by President Trump hits back at what it sees as China’s unfair trade practices.

For investors today, reeling from the Chinese stock market’s fifth worst calendar year performance, stalling reforms are just one of many concerns. They sit alongside: continuing trade tensions, despite the recent ceasefire; a receding tide of credit as Beijing battles with borrowings that have grown by a third in ten years to 260pc of GDP; and a slowdown in the Chinese property market, one of the world’s biggest, and most important, asset classes.

Over the past 40 years, China’s economic development has been breath-taking. Deng’s reforms have transformed a $219bn economy in 1978 into today’s $12trn powerhouse, the world’s second largest. Over four decades, nominal GDP has grown by 14pc a year and by 13pc a year on a per capita basis thanks to China’s controversial one-child policy. China has been the world’s biggest car market for nine years now.

In 1978, almost 90pc of the population lived on less than $2 a day. Today you can’t move at Bicester’s factory outlets for Chinese tourists filling Samsonite cases with designer clothes. And don’t bother visiting Kyoto’s Kinkakuji Temple - with Chinese visitors to Japan quadrupling in just the past five years, you probably won’t be able to see it.

Breaks with the planned economy such as the end of agricultural collectives and the establishment of special economic zones, alongside the ‘one country, two systems’ policy that reunified the country in the 1980s, rank as one of the most successful and fastest economic revolutions ever attempted. As Deng said, it doesn’t matter if the cat is black or white so as long as it catches mice.

As China’s economy has grown to rival that of the United States, Beijing’s commitment to continuing those reforms has been called into question. The state is more active in the emerging and fast-growing industries that will be the front-line of China’s economic battle with America. Party committees have been set up in 70pc of private companies. New economy companies are being encouraged to employ party members to promote ‘correct social values’.

This marks a significant and dangerous break with the past 40 years because it has been the liberated private sector which has driven China’s miraculous growth. Goldman Sachs estimates that the value of the Chinese stock market would be 25pc lower than it was a decade ago without the contribution of privately-owned businesses, yet they fight an uneven battle with cossetted state-owned enterprises. China’s GDP was a tenth of America’s in 1978 but 63pc its size last year. Only a continuing Deng-style prioritisation of the economic over the political will see that trend continue, but it is far from guaranteed.

That is the backdrop to investing in China today, which thanks to the increasing integration of Chinese shares into global indices will be an ever-larger part of all of our financial futures. So, after a disastrous 2018, which has seen a 29pc fall from the market’s peak, what is the outlook for China in 2019?

The good news is that Beijing has begun to ease policy aggressively on various fronts since the middle of the year. On the fiscal front, wider budget deficits, VAT cuts and investment in infrastructure projects are expected to soften the impact of trade tensions and weakening consumer confidence. Monetary policy will remain loose in 2019 and the 10pc depreciation in the Chinese currency since its March peak could continue further, through the psychologically important level of 7 yuan to the dollar.

Acting with a lag, those measures should see steady growth next year in the economy (GDP growth of perhaps 6.2pc next year) and company profits rising at maybe 7pc, in line with earnings growth in most other markets in 2019, including the US. The difference between China and those other markets, however, is that Chinese shares are now cheaper than they have been at any point over the past five years. Costing just 10 times expected earnings on average, Chinese shares are cheaper even than the most out-of-favour Western markets, Britain and Japan.

That’s the optimistic view, and the contrarian view of the Chinese stock market today is that it is oversold and due a bounce. In the short-term that may be right. The less charitable conclusion is that the stock market is simply doing what’s it’s supposed to, forecasting a difficult 2019 in which an unsupportive outside world and a nervous Government at home conspires to undo Deng’s remarkable experiment. He famously said: ‘let some people get rich first and gradually all the people should get rich together.’ The first happened spectacularly, the second remains a work in progress.