Rumble in the jungle: Insights on the Chinese economy

There has been much debate about whether the China “super cycle” can continue at the same pace. For good reason. With the US economy slowing sharply – most likely going into recession – strong growth in China is vital to underpin the global economy.

After spending time in China, I’m convinced its super cycle is firmly intact, but expect a moderation in economic growth from around 12% to 10% this year – maybe even 8% if the US goes into recession. This is still strong in anybody’s language.

My sense is rising inflation in China could become a bigger problem than many expect in the short term, and with that comes higher interest rates to cool an overheating economy.

And I am especially concerned about the China Class A stock market, which looks extremely overvalued. Some Chinese stocks I analysed are trading on price earnings multiples of more than 50. The average PE multiple in China in 2007 was 20.1, according to Morgan Stanley figures, making it the second most expensive major stock market in the Asian region after India, which had an average PE of 23.3.

The chart below of the Shanghai Composite Index shows the bubble in China Class A shares.

I strongly caution against investors buying shares directly in the China stock market. The best way to play China is to invest in other countries in the region such as Hong Kong, Singapore, South Korea and Taiwan that are linked to, and benefiting from, China’s growth.

This is one of the reasons we are launching Alpha POWER Shares – 'Asian Lions' , which focuses on the key Asian economies, excluding the overheated China A share market (although investors will be directly exposed to the Chinese economy through Hong Kong stocks).

Despite the short-term valuation issues, the long-term trend in China is extremely compelling. The massive construction in its cities, driven largely by the aggregation of millions of small rural plots, which is seeing rural workers head to urban centres, will drive growth.

Politically, the Communist Party is determined to maintain political and economic stability in order to drive China’s growth (and clearly – to retain its position of power).

As we saw firsthand on our visit to China, this is driving the emergence of an urban middle class with rising affluence and economic freedom. This, in turn, is linked to a massive semi-privatisation of leading Chinese State Owned Enterprises (across all key sectors of the Chinese economy; these look very similar to our own Telstra – hard-nosed, market-based commercialism within a part public/part private ownership model).

UBS estimates the urban population in China will rise from 560 million in 2006 to 660 million in 2015. To put that into perspective, China will need new accommodation in its cities for roughly five times the Australian population over nine years!