Here’s where China’s headed over the next five years

Every five years, China holds a big Congress where all the bigwigs of the Communist party gather and debate policy directions for the coming years.

(Though to call it a debate is technically incorrect. It is more of a forum for the leadership to dictate what it thinks, and what everyone else must do to follow along.)

This is also when the party makes major reshuffles to the highest-level decision-making bodies, like the Politburo Standing Committee. This is the top of the political leadership pyramid in China.

Last month, the 19th China Communist Party Congress (CPC) took place… laying out the blueprint for the next five years.

As investors, we can use this blueprint to know where to focus our attention – and cash.

You see, what happens in China today is increasingly affecting what happens in markets all around the world…

Why it matters: China is BIG and getting bigger

With a GDP of US$11.2 trillion, China is already the world’s second-largest economy (it will soon be the largest), and the second-largest stock market. The country will also soon have the world’s largest middle class with over 550 million people by 2022. To put this in perspective: That’s 1.7 times the entire population of the U.S.

China is also becoming a leader in globalisation as the U.S. turns inward. Through its One Belt One Road (OBOR) initiative, China is developing infrastructure across 60 countries. So China will soon have strategic interests across a huge swathe of Africa, Central Asia and Eastern Europe.

So what happens in China matters – a lot – to the global economy, and to investors everywhere.

Xi and his “thoughts”

As expected, one key result of the CPC is that President Xi Jinping and Premier Li Keqiang will remain in power for their second terms.

The all-important Politburo Standing Committee was also totally revamped. Out of its seven members, only President Xi and Premier Li remain. The other five members have retired and a new bench has been drafted in. This is very unusual, and of course has led to huge speculation about the background credentials and leanings of the new incumbents.

But probably the most glaring aspect of this congress has been what many observers see as a very obvious power grab by President Xi to create himself in the image of Mao Zedong and Deng Xiaoping – China’s previous mega leaders – by enshrining “Xi Jinping Thought on Socialism with Chinese characteristics for a New Era” into the Chinese constitution.

We should not underestimate the significance of this. The use of the term “thought” is designed to give Xi’s “thoughts” similar weight to those of Mao Zedong and Deng Xiaoping. More importantly, by incorporating his “thoughts” into China’s constitution, Xi is giving himself even more political and moral authority.

The western media seems almost awestruck by Xi’s “thoughts”. Xi is being compared with great world leaders, and has been described as the most powerful person in the world. He has also been touted as providing grand leadership for China, with an iron grip on power, and he’s been described as defining China’s ambitions in the world and its own domestic path to the future.

The main message of this year’s event: Stability

The central message was continuation – to maintain stability (in the economy, finances and most importantly socially/politically), to maintain and enhance the control of the Communist party and its leadership (that is, Xi), to stick to the reform path put in place so far, to continue opening up to the outside world (in a measured, calculated way) and to take evolutionary, not revolutionary steps.

In short, it was not a message of radical change in direction from what Xi has put in place over the past five years.

Growth will slow

Following 30 years of around 10 percent GDP growth, a new reality has set in over recent years. As China becomes more of a middle-income country, it can’t possibly sustain those kinds of growth rates.

On Xi’s watch that growth has inevitably slowed to around 6 percent to 7 percent recently. And even now, growth targets are not as emphatically stated and applied as they were in the past.

We all know the overall China policy story of recent years – reduce the reliance on exports, increase the role of domestic consumption and boost job creation in service industries. And this is certainly happening. Domestic economic output is now substantially higher than export-led manufacturing output today.

The slower growth reality was a shock to the system three to five years ago. It is now generally accepted as the most likely outcome for the coming few years.

But we can expect to see the consumption side of the economy continue to grow in importance. China’s massively high savings ratio of around 45 percent of GDP will be drawn down slowly, fueling domestic consumption in all sorts of areas – basic consumer goods, housing, education, healthcare, technology, travel and tourism.

So our investment focus on China’s consumers remains very much intact.

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Excess capacity and supply side reforms

In recent years, there have been efforts to reform many aspects of China’s economy. Cutting excess capacity in traditional “smokestack” industries (like coal, steel, aluminum and cement) has been high on the agenda. This has been happening, but much more slowly than many observers and experts on the ground expected. Recent rises in coal and steel prices, for example, seemed to discourage marginal producers from closing up shop, hence slowing the reform process.

Other core reforms have included slowing money supply growth and aggregate lending. Controlling asset price inflation is part of this policy mix to avoid real estate and stock bubbles.

The commitments to reform and restructuring efforts have been less than wholehearted. They have not produced the big, rapid results that many expected.

The question now is whether such supply side reforms will be accelerated in the next five years of Xi’s reign. The message from the congress suggests that they will be.

Environmental policies are high on the priority list

Environmental controls and improvement have become core policy initiatives – phasing out internal combustion vehicles, boosting production of electric cars and trucks and focusing on clean water, green energy (wind, solar and water), air pollution controls, waste treatment, food safety and security. This party congress cemented these policy objectives firmly into place as part of Xi’s “thoughts”.

We can expect to see continuing regulations imposed on manufacturing and other smokestack industries, chemicals and power to reduce pollution levels. There will likely be changes in the regulatory incentive-based structure to “go green”.

There are numerous investment opportunities that will benefit from these policies. (We’ve recommended a few in The Churchouse Letter.)

And the fact that these policies are now enshrined in the constitution as part of “Xi Thought” means they’re not just lofty, well-intentioned blurbs with little actual substance.

More open to foreign investment?

Xi claims to be opening the economy further to the outside world. But policy actions of late don’t seem to reflect that claim.

Increasingly, foreign businesses have complained of discriminatory treatment. For example, the U.S. recently launched an investigation into China’s intellectual property rules and practices. This discriminatory treatment is very evident in the technology, telecoms, consumer goods and services and of course strategic manufacturing areas.

So foreign consumer companies hoping to benefit from China’s move to a more consumer-driven economy will likely also find discriminatory practices aimed at protecting incumbent players.

Where certain domestic industries have excess leverage, or serious lack of competitiveness, even in the domestic market, there will likely be less discriminatory policy.

Also, policy has recently slowed the pace of outward investment in foreign assets via mergers and acquisitions (M&As). Many of these were being viewed as random, non-strategic vanity projects and investments.

Offshore bound M&A deals and investment are not going to dry up, but the pace will slow and the targets may be rather more strategic than seems to have been the case with much recent investment out of China.

However, China has made progress in opening its capital markets to more foreign involvement through various “connect” schemes that allow foreign investors to buy Chinese stocks and bonds through the Shenzhen and Shanghai exchanges.

To sum up, China’s main focus over the next five years will be to maintain stability… control pollution and slowly open up to the rest of the world.

Good investing,

Peter Churchouse

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Source: Stansberry