Chinese consumption healthy as they finally spend like the US
Chinese consumer sales remain healthy while prices are being driven up further by strong demand as healthy jobs and income gains result in high consumer spending power. Property sales increased by 60% in April while outbound tourism from China grew by a third last year, leading to a growth in property, tourism, and overseas investment. In the effort to spur growth China has been expanding its credit, increasing concerns of potential financial fallout due to an escalation of non-performing loans leading to the possible deterioration of Chinese credit quality.

Chinese retail sales, industrial production and capital investment were weaker than economists had expected, emboldening the gloom-and-doom crowd.

But investors largely shrugged off the news, as other reports late last week served as a foreshadowing. The big picture is that Chinese consumers are in good shape, and this bodes well for China, say analysts.

“Underlying consumption demand remains healthy,” says Britney Lam, investment strategist with Macquarie Investment Management, which runs the Delaware Asia Select Fund US:DMAAX.

Chinese consumer prices are being driven up by strong demand, she says. And property sales grew 60% from January through April, by value.

“This reflects price and volume growth that is demand-driven and has been broad-based across 40 key cities,” she says.

The bottom line: “We continue to favor domestic demand and local consumption and services in China and Asia markets,” says Lam.

In short, there’s a key megatrend in Asia that often gets lost amid all the China naysaying. Thanks to regular, healthy jobs and income gains, Chinese consumers have lots of spending power, and they use it.

Chinese wanderlust

One way to play this megatrend is to buy shares of China-based retailers, of course. But increasingly, Chinese consumers love to travel and spend money abroad. So that sets up another approach: Buy shares of companies in countries near China, the ones that get a boost from spending by Chinese tourists.

Outbound tourism from China grew by almost a third last year. “It’s a real growth phenomenon,” says Sam Le Cornu, who also helps manage the Delaware Asia Select Fund. Chinese tourists regularly jam airports in nearby countries during peak travel season.

Then once they get out and about, they readily open up their wallets. On average, Chinese tourists spend $2,000 per trip, says Lam. Big picture, Chinese travelers spent $215 billion last year, an increase of 53% compared with 2014, according to the World Travel & Tourism Council.

Le Cornu and Lam think Chinese spending abroad will grow rapidly over the next several years for the following reasons.

1. Wage growth in China is quite healthy. After inflation, wages have been growing about 10% a year for the past 10 years, says Lam.

2. Next, state pension reform is on the way, which should see the government build out its social security system. Why does this matter? The Chinese are great savers. They have about $10 trillion worth of savings in bank accounts, says Le Cornu. “That, for us, is very interesting. What if consumers go out and start spending that $10 trillion?”

They just might, and here’s why: One of the reasons they save so much is that China’s social security system is pretty limited. But Le Cornu expects China will beef it up. “If there is pension reform, consumers will have the confidence to spend that money,” he says.

3. The fund managers also expect a big increase in the number of people with passports over the next several years as China aligns with global trends. The number of Chinese with passports is still relatively low at about 4%, compared with almost 40% in the U.S.

Reverse China plays

The fund managers prefer to tap into Chinese consumer strength and wanderlust via what they call “reverse China plays.” This means companies outside of China that benefit. Key destinations of Chinese tourists include South Korea, Japan and Thailand, so that’s where you find these companies.

Le Cornu and Lam like to focus on relatively easy-to-understand businesses with strong cash flow, in areas like retail, food, cosmetics and infrastructure. This way, there’s no need to make a call on Chinese banks or property companies, or have a view on commodity prices. “Simple businesses with good cash flow, earnings, and strong corporate governance are key,” says Lam.

The fund owns several Asian consumer-facing companies that are unlisted on U.S. exchanges, or thinly traded over-the-counter issues here. For example, top holdings include Hyundai Department Store in Seoul; Korea Kolmar, which sells cosmetics that are popular among Chinese consumers; and Airports of Thailand. Unless you have a brokerage account that gives you access to Asian exchanges, you’ll have to buy the fund to get exposure to those names.

But the fund also owns several names you can readily buy here as domestic consumer plays inside China. The fund counts China Mobile US:CHL and Tencent Holdings TCEHY, +0.84% , which offers games, messaging and online advertising services among top holdings.

And while Coach US:COH doesn’t appear as a fund holding, its products are popular in China and among Chinese tourists travelling outside of China. So much so that Coach hires Mandarin-speaking sales staff in stores outside China.

Risks

Of course, buying stocks that benefit from Chinese tourism and consumer strength has its risks.

Successful investors like Stanley Druckenmiller have raised a red flag about debt levels in China for years. He repeated the theme at this year’s Sohn Investment Conference in early May.

“Credit has expanded too fast and non-performing loans will increase a lot,” agrees a native Chinese fund manager based in Philadelphia — who asked to remain anonymous because of concerns about possible fallout, when he goes back on trips, for speaking negatively about his homeland. China has been expanding credit even more, recently, to try to spur growth. “To increase debt just makes the longer-term problem worse,” he says.

And Jim Chanos of Kynikos Associates even cites looming problems in China as one of the reasons he is betting on a decline in a South Africa-based telecom company called MTN Group MTNOY, +2.98% . In other words, things are going to get so bad in China, it will have reverberations elsewhere, he says. That’s pretty bad. Chanos predicts African economies will suffer as further economic weakness in China reduces Chinese investments in African natural-resource development. “China is pulling back from Africa,” says Chanos.

Lam acknowledges there are risks in the potential deterioration of credit quality in China. This explains why her fund is underweight its Asian market benchmark, which happens to be full of Chinese banks, state-owned businesses and companies in steel, cement and manufacturing.

“We are cautious about the over-leverage on this side of the economy. We are the most underweight in eight years,” she says. “But we are very optimistic on the other side of the economy, which is the consumer. Our focus is on the consumer.”

Lam thinks the government still has enough policy tools to solve problems that arise, and that low interest rates after a series of rate cuts last year should help with growth.

Lam thinks India is a greater risk for investors because valuations are so rich there.

“India looks expensive while earnings estimates are getting revised down. It is difficult to find a lot of value in India at the moment. We have been patient for prices to come down, and we are still being patient.”

One exception is HDFC Bank HDB, -1.82% , which trades in the U.S. as an ADR. HDFC is one of the largest banks in India that is not owned by the government.

At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter, Brush Up on Stocks. Brush has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.