China's Rebalancing Effort: Will it Be Enough? - Henry McVey, KKR

Henry McVey, Head of Global Macro and Asset Allocation at KKR, provides a fascinating insight into the structural shifts occurring in China across the economic, political and social spectra of the region. Please follow this link for a detailed analysis and review of the potential opportunities and inevitable challenges that face the discerning investor as KKR's McVey reports on some of the highlights of his recent visit to China.

Over the past 10 years, China has been the fastest growing major economy in the world. It has also had among the worst stock market returns as capital was mis-allocated badly to drive growth and employment in areas of the economy that either lacked competitive advantage and/or did not create productive returns on capital. Today, we envision a different outlook for China. We see a slower growth economy with the potential for a better stock market in the near-term. Key to our thinking is that China now has a fast growing services economy that is larger than its combined construction and export sectors. We also see an e-commerce initiative that is driving both convenience and efficiency, and lower inflation that 1) makes real estate less interesting; and 2) gives the PBOC more flexibility to ease. The bad news is that China remains a country undergoing a massive transition across many parts of its economy, fixed investment and export activity in particular. Our bottom line: The upside for being in the right as well as the downside for being in the wrong sectors has never been higher in China, particularly given our view that the current re-balancing effort is likely to accelerate even more in the quarters ahead. - Henry McVey, Head of Global Macro and Asset Allocation at KKR.

The services sector has now become the largest part of the Chinese economy, outpacing manufacturing and construction for the first time.

For investors, there is somewhat of a double-edged sword. On the one hand, by providing important growth platforms to local Chinese companies in global sectors such as healthcare, technology, and industrial goods, we believe China is finally building a diverse set of industry “champions” that are much better suited to compete on the world stage. On the other hand, these new competitors are likely to dent margins through increased global competition both inside and outside China. As such, finding companies with sustainable pricing power will likely become even more important in the years ahead.

What are the implications for investors? China still faces a number of significant hurdles that investors need to consider. For example, even with higher leverage ratios, return on equity is now lower in China than it was in 2011. Meanwhile, corporate balance sheets are now more unproductive as evidenced by decreasing asset turnover.

China has also suffered negative Producer Price Inflation (PPI) for the past 36 months and low Consumer Price Inflation (CPI), which have resulted in an increase in real interest rates, raising the cost of capital and restricting liquidity in the process. As a result, McVey anticipates further interest rate cuts in 2015.

McVey concludes with a recommendation that equity investors should allocate capital towards areas that represent growth, including environmental remediation, healthcare services, robotics and logistics: "High yielding companies with even modest growth should also do well in an environment of low inflation and more liquidity".