Positioning Portfolios for Political Shifts and a Changing China

Neil Dwane | 23/01/2017
China Hong Kong Harbor

Summary

In his roundup of our latest Investment Forum, Neil Dwane highlights the top themes driving markets and economies – including China’s growing role in global indices, Trump’s ability to disrupt the status quo, Europe’s super-election cycle and the “hunt for income” going global.

Key takeaways

  • Reasons for optimism: Post-Trump reflation, rising yields and a higher oil price. Causes for concern: Dull global growth, rising debt, political risks and NIRP.
  • China is on the path to becoming its own asset class, disruption is more than a tech trend, and populism and protectionism are powering the new politics.
  • We continue to urge our clients to take risk to earn returns. Much-needed yield potential can be found in US and Asia high-yields, EM debt and European equities.

Our first Investment Forum of 2017 was held in the vibrant city of Hong Kong – a fitting location for an event with China as the lead agenda topic. Politics and disruption were the other big topics of the day, and all three themes converged in our recurring discussions about Donald Trump’s ability to disrupt the political status quo – particularly US-China relations.

The state of the global economy

Although global economic growth has remained somewhat dull, it accelerated slightly in the second half of 2016 – and the markets responded. Reflation hopes soared after Trump’s victory, despite uncertainty about his priorities. If Trump successfully lowers taxes, reduces regulations and increases infrastructure spending, the US should be able to extend its late-cycle growth. Globally, rising bond yields and a higher oil price are also cause for optimism. Of course, there are also legitimate reasons to be cautious. As the memory of the Great Financial Crisis recedes, global debt levels are rising. Moreover, euro-zone banks continue to appear risky, and we expect the central banks of both Europe and Japan to row back on their negative-interest-rate policy errors.

China: An asset class in its own right

Although not without its issues, China is making the necessary changes to succeed in the long term. Consider how China battled deflation and a commodities collapse: Their aggressive monetary-policy changes successfully restored profits, inflation and the profitability of state-owned enterprises. Moreover, China is at least confronting key structural issues by “rebalancing”, and while high debt and slower growth are problematic, China acknowledges the need to reform and has the will to do so – unlike Europe. Still, Trump presents a wild card: His policies could hurt trade relations, China’s “One Belt, One Road” policy and China’s longer-term regional ambitions.

In the end, however, China’s overall trajectory is clear: It boasts the second-largest economy in the world and has more listed companies than the US does, giving the country 18 per cent of total global equity-market capitalization. Yet China currently makes up a mere fraction of the world’s leading market indices, which don’t include China’s onshore markets. As China’s rebalancing and reforms continue, this should change. In turn, more investors will join us in considering China to be its own asset class.

Disruption is more than a tech trend

Artificial intelligence has been an enticing tech story since 2012, when machine learning, new algorithms and processor advances aligned with deep storage capacity. Although AI is in the early adoption stages, it is contributing to faster automation of previously manual work. This disruption could lead to efficiency gains, but it could also exacerbate income inequality, prompting governments and regulators to step in. Companies that thrive off disruption could also shift the investment trend away from indexing: With the top 20 per cent of companies accounting for all of the US market’s gain in 2016, actively picking stocks looks like a much more attractive proposition. For our part, our research team is adapting to this theme by implementing new “disruption ratings” on the companies we cover. We may find that future success in any industry requires embracing a new mindset: You will be disrupted, so get busy disrupting!

Populism and protectionism power new politics

As part of the changing political trend that is moving away from globalization and free trade toward populism and protectionism, European politics will take centre stage in 2017: Brexit negotiations should begin in earnest and a “super election cycle” will roll through the Netherlands, France, Germany and possibly Italy. Regardless of Brexit’s ultimate shape, the European Union may be keen to help the UK make its exit before the EU’s Parliamentary elections in May 2019. Another factor pressuring the region is that many feel the EU has too many members and therefore must “shrink to grow”. So while it is possible for Europe to muddle through 2017, the EU needs to build a vision and roadmap that is sustainable – and the clock is ticking. In the US, politics could play a major role in the future course of monetary policy: Trump may have an opportunity to appoint six out of seven members of the Fed’s Board of Governors.

Key considerations for investors

Here are five of the more significant opportunities and risks for investors to consider:

  • As China assumes a larger role in major global indices, it should play a larger role in investors’ portfolios.
  • Europe may remain mired in a depressing political cycle, and European financials appear risky.
  • Although still expensive, US equities may have room to run if Trump’s fiscal stimulus and tax cuts come to pass.
  • As the “hunt for income” goes global, much-needed yield potential can be found in high-yield bonds in the US and Asia, as well as in emerging-market debt and European equities.
  • Overall, we continue to urge our clients to take risk to earn returns – a stance that has been validated time and again by the market’s results.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Investments in smaller companies may be more volatile and less liquid than investments in larger companies. Investments in emerging markets may be more volatile than investments in more developed markets. Dividends are not guaranteed. Bonds are subject to interest rate risk and the credit risk of the issuer. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

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Expert-Image

Neil Dwane

linkedIn
Global Strategist
Neil Dwane is a portfolio manager and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook through articles and press appearances. Neil is a member of AllianzGI’s Equity Investment Management Group. He previously worked at JP Morgan Investment Management as a UK and European specialist portfolio manager; at Fleming Investment Management; and at Kleinwort Benson Investment Management as an analyst and a fund manager. He has a B.A. in classics from Durham University and is a member of the Institute of Chartered Accountants.

Will China's Next 'Four Modernizations' Bring Good Fortune?

Neil Dwane | 24/02/2017
Year of the Rooster

Summary

While China celebrates its Lunar New Year, the reform-minded President Xi Jinping is likely polishing up his next Five Year Plan. Perhaps he will put his own twist on a predecessor’s strategy and look to strengthen China in four key areas: agriculture, industry, defence and science & technology.

Key takeaways
  • President Xi Jinping is determined to fashion a more modern, dynamic and economically prosperous China than his predecessors did.
  • China wants to transition away from agriculture, focus on innovation and retool its industrial capabilities – but its maritime expansion and increased defense spending could raise tensions.
  • We view China as the big investment story of 2017; it is the biggest contributor to global growth and should continue playing a larger role in investors’ portfolios.

China’s Year of the Rooster officially began on 28 January 2017, and investors should be happy to hear this proud creature crow out a new dawn – especially given China’s tough start to the Year of the Monkey in 2016. Fortunately, determined policy makers at the time were able to focus their efforts on continuing reforms and restoring economic growth, which boosted commodities prices globally in the second half.

We believe President Xi Jinping will use 2017 to keep up his reform efforts and project stability as he readies his Five Year Plan for the Communist Party congress in November – but we also wouldn’t be surprised to see a little rooster-like showmanship on China’s "One Belt, One Road" initiative and other prestige projects. President Xi, who is already the most powerful Chinese leader for a generation, is determined to fashion a more modern, dynamic and economically prosperous China than his predecessors did – albeit one that is still under party control.

Four Modernizations 2.0

In fact, Xi’s ambitions for the next five to 10 years could be called the “Four Modernizations 2.0,” after the efforts of former Premier Zhou Enlai to reform China in four key areas: agriculture, industry, defence and science and technology. Today, these same economic lenses can show us where President Xi may focus China’s efforts in the coming years.

Agriculture

China’s agriculture industry is woefully undeveloped, and it still employs too many people compared with more prosperous nations: China’s agriculture employment share has come down significantly but is still around 30 per cent, compared with the US at 3 per cent. China must continue moving along this path as it focuses on urbanization, industrialization and higher consumption. Despite its significant economic progress over the last 25 years, China still suffers from huge wealth inequality between its developed coastal provinces and its rural interior regions. Improving water quality and reducing pollution should help China improve farming productivity, and its recent acquisition of a farming chemicals and seeds giant could wring more food from less land.

This strategic transition away from agriculture could also force China to substantially reform its "hukou" system, which markedly limits the ability of China’s people to migrate to where the economic opportunities lie. With noticeable differences in living standards and property prices, China will need to share its future economic success with both urbanites and the rural hukou citizens who have contributed to building the provincial economies.

Industry

China already has some of the world's most significant industrial capabilities, although it does need to reduce its emphasis on past successes such as coal and steel. The country is rapidly moving up the value chain with its expertise in robotics, automation and new technologies such as electric vehicles and EV and hydrogen buses – which are underpinning its “One Belt, One Road” plans. With strong franchises and more engineers being trained than the rest of the world combined, China is seeking to leap several decades of industrial progress in a single bound; along the way, China hopes it can rectify the enormous environmental damage it has wrought over the last 25 years and become more of an innovator than a fast follower. The corporate confidence of the BATs and new mobile- computing technology from Chinese firms should help form a base of accelerated consumption and services, which should help China rebalance even further away from exports and cheap, low-value-added manufacturing.

Defence

China has always had a significant army defending the walls to its north, the deserts to its west and the jungles to its south, but for several centuries it has not devoted enough attention to its naval powers. China is now treating its air and sea defences more earnestly – fortifying disputed island territories and expanding its aircraft carrier and submarine fleets – but this is raising geopolitical temperatures in the South China Sea. Many nations – particularly the US – are concerned about China’s maritime expansion, yet it is not without precedent. After the Civil War, the US expanded its maritime boundaries from the Philippines to Bermuda, which went relatively unremarked at the time, but which now helps China justify its efforts to reclaim its former hegemony.

China’s geopolitical relationships with other nations could also change in other significant ways. The diplomatic myopia of the new US president may enable China to pursue its current geographical expansion undeterred, and to use its "One Belt, One Road" initiative to fill the economic void left by the US. At the same time, an irrational North Korea could create the kind of tension that might force China to respond to external pressures and change its approach to controlling its sea routes. It is also possible that China’s ever-closer relationship with the Philippines could pave the way for the US to withdraw its forces from those islands, which would help China feel less boxed-in on its Pacific side.

Science and Technology

China became a great manufacturing economy in the last 25 years, but it has lagged somewhat in innovation and in research and development (R&D). That is beginning to change, however, as China breaks new ground with social media and the consumerization of its economy. China’s BATs (Baidu, Alibaba and Tencent) are as fast-paced – although arguably not as innovative – as Google, Amazon and Facebook, driving China toward greater economic integration within the region with new financial services such as Alipay. China is also filing more patents than any other nation, creating new global forces in telecommunications and technology, boosting defense R&D and tackling new initiatives in space—although the gap between China and the “best of the west” remains wide for now. Of course, China must invest more in its health-care system and focus on building related skills, since the country still offers lower standards of health care than many others. Nevertheless, Chinese companies are moving away from commodity investments toward higher-tech and R&D-intensive acquisitions – particularly in the agriculture sector.

Key considerations for investors

As we wrote late last year in our annual outlook, we see China as the big investment story of 2017, and our overall optimism continues as China enters the Year of the Rooster. Here are some important factors for investors to keep in mind as they consider investing in this dynamic region:

  • As China urbanizes rapidly, it may require fewer industrial commodities and more oil and softs, which may shift the outlook for commodities.

  • With China rebalancing toward a consumption-based economy, and with reform movements converging in India and Indonesia, this may be the dawn of a new consumer market with 4 billion people.

  • Valid concerns remain over China’s capital position, and President Trump presents a wild card: His policies could hurt trade relations and China’s “One Belt, One Road” policy.

  • Overall, however, China is the biggest contributor to global growth and boasts 18% of global stock market capitalization.

  • As China assumes a larger role in major global indices, it should play a larger role in investors’ portfolios.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Investments in smaller companies may be more volatile and less liquid than investments in larger companies. Investments in emerging markets may be more volatile than investments in more developed markets. Dividends are not guaranteed. Bonds are subject to interest rate risk and the credit risk of the issuer. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

116087

Expert-Image

Neil Dwane

linkedIn
Global Strategist
Neil Dwane is a portfolio manager and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook through articles and press appearances. Neil is a member of AllianzGI’s Equity Investment Management Group. He previously worked at JP Morgan Investment Management as a UK and European specialist portfolio manager; at Fleming Investment Management; and at Kleinwort Benson Investment Management as an analyst and a fund manager. He has a B.A. in classics from Durham University and is a member of the Institute of Chartered Accountants.
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