[this is the translation of an article originally published in FundsSociety]
Some days ago, Bloomberg published an article featuring a comparison between the stock market valuations of the Shanghai Stock Exchange against the valuations of other major exchanges in the world. The key message of the article was that, despite falling 40% from the peak reached in June 2015, the index was still dear according to the median PER – in China, such a measure reached 60 times, in comparison to 20x and 13x in the US and Japan, respectively. To conclude, the article presented several opinions that stressed the low visibility for corporate profits in the short-run, given macroeconomic uncertainty and the difference in valuations and opportunities between the old economy (raw materials, industrials and real estate) and the new economy (technology, leisure, healthcare, etc.).
In fact, although making a one-year corporate profit forecast is a tough task, it is less hard if we make a ten-year forecast. Such a claim, although it may sound counterintuitive, is due to the macroeconomic dynamics that China will have to face in the medium-term. By this, we mean the rebalancing process, which implies reducing the investment share in GDP (and increasing the share of consumption) from roughly the current 50% down to 30% or less. That the rebalancing process implies moving resources from investment to consumption is already a well-known fact, and the investment community is starting to benefit from this insight recommending taking positions in consumption-related sectors and shying away from investment-intensive sectors – although, on the other hand, given analysts’ interpretations on the macroeconomic data published in May highlighting the supposedly ‘low growth’ of investment of around 9%, one wonders whether the analysts have yet understood even the basic concepts of the rebalancing process.
The Chinese rebalancing and the stock market: a simple numerical exercise
However, there is a second implicit consequence in the rebalancing process that has not received any attention so far, but as we have explained in the second issue of FundsSociety, is the key factor in understanding the future evolution of Chinese corporate profits, and therefore, the evolution of stock market prices. The key concept is the relationship at the macroeconomic level between total investment and corporate profits.
As we explained, whatever rebalancing process that reduces the share of investment in a substantial way (rising pari passu at the same time the share of consumption) implies, almost tautologically, a fall in the share of profits to GDP and an increase in the share of wages. Profits at the macroeconomic level are determined by the sum of investment, plus government deficit, plus the surplus in the current account, plus the dividends less households’ savings (this equation is an accounting identity, so it is always fulfilled). In an economy like China, where investment levels have not had any historical precedent, it means that the profits of the last few years have largely been a result of the enormous amount of investment carried out. In other words, the decline in the investment share that we will witness in the next few years will also produce a decline in the profit share. In our article for FundsSociety, we estimated that the profit share today is around 23%-25%, far from the share of 10% (or less) of the US and other developed economies like France, UK or Spain.
Can we use these concepts to put together a basic ‘baseline’ projection for the evolution of profits in the next few years? If we assume that the rebalancing process is completed in ten years (as Michael Pettis explains, longer time periods would imply higher debt accumulation and a more severe crisis eventually), and if we also assume (rounding the numbers) that the profit share falls from 25% to 12.5% from today to 2025, in line with other economies, then we just need to make an assumption about GDP growth. If we assume a nominal growth rate of 7% (excessively optimistic from our point of view, although achievable if Beijing can tolerate higher levels of inflation, but this will suffice for our simplification purposes), the Chinese GDP would double in ten years. But because the rebalancing process implies a decline in the profit share, in our baseline scenario the rise in profits due to GDP growth would be balanced by the fall in the profit share. In other words, we believe that the most likely scenario for Chinese corporate profits in the next ten years is essentially flat. Although such evolution will depend on how and how fast the rebalancing process is managed by Beijing (as far as it can do so), we believe that this scenario is reasonable, and it is in sharp contrast with other often-cited and very sweetened projections that show huge increases in profits because ‘Chinese people will consume more, and that’s good for companies’, but omit the crucial fact that the transition from an investment-led to a consumption-led economy cannot be accomplished if the profit and wage shares do not change too. The rebalancing does not only impose strict conditions on the GDP demand components, but also on the income components.
Although we have not discussed the change in stock market valuations and their impact on future equity returns, our analysis suggests that the Chinese stock market, according to its medium-term fundamentals (e.g. growth in profits), is not attractive. This does not mean that, although the market is going to deliver a poor performance as an asset class, there are not going to be any managers that will find value in very specific niches, thus generating high returns. Over this decade we will witness the rise of many companies operating in high-growth sectors: many of these companies will be the leaders of tomorrow. But the overall prospects for Chinese profits will be, to say the least, very challenging.