By HENRY MCVEY Aug 07, 2018

A recent trip to China again reminded my colleague Frances Lim and me why so many investors now consider China the ‘epicenter’ of global macro trends. In addition to accounting for nearly one-third of the global growth, the country is also in a heated trade dispute with the United States. Without question, it is not sitting idle, and we saw visible signs of change in both monetary and fiscal policies during our visit. China is also facing a massive societal change, as its millennial population, which represents the largest in the world, is becoming increasingly influential in terms of what, how, and where to buy. Third, technology is also having a profound impact across a wide swath of Chinese industries — more so than any other country where KKR does business, we believe. Finally, while economic growth appears reasonable, we see major macro divergences occurring at the sector level that could profoundly impact which companies prosper and which ones wither during the next 12-24 months. From an investment standpoint, our trip and our macro research lead us to remain supportive of capital deployment in areas such as leisure, wellness, services (environmental, healthcare and financial), healthy food, and food safety. On the other hand, we left China quite cautious on branded consumer goods, global supply chains, and logistic plays that do not interface with the customer and/or can be disintermediated by the growing influence of Baidu, Alibaba, and Tencent. Finally, we believe now is the time to be thoughtful in terms of allocating to globally integrated industries such as autos as well as high-end technology.

“When written in Chinese, the word ‘crisis’ is composed of two characters. One represents danger and the other represents a point where things happen or change.”

Anonymous

My colleague Frances Lim, who heads our Global Macro & Asset Allocation effort in Asia, and I recently traveled through China and met with a variety of business executives across multiple segments of the economy. To cast the widest macro ‘net’ possible this trip, we focused not only on Chinese corporate executives but also leaders from many large publicly traded U.S. companies that operate significant businesses in China. In addition, we caught up with several large asset allocators and macroeconomic experts, many of whom we have maintained regular dialogue with throughout the years.

As one might expect these days, the conversations were robust, and we were able to cover a variety of topical issues, including trade, politics, currency, growth expectations, etc. However, for this report, we have focused our attention on four areas that we believe are potentially the most important for investors to better understand as China’s role in the global economy continues to evolve. They are as follows:

When written in Chinese, the word ‘crisis’ is composed of two characters. One represents danger and the other represents a point where things happen or change.

Anonymous

  1. The escalation of trade barriers between the U.S. and China is an undeniable attack on the traditional global supply chain, one that we now believe can no longer be easily repaired through rushed and/or reconciliatory negotiations on a go-forward basis. Without question, President Trump in the United States is ushering in a different era as it relates to global trade. As we detail below in the section where we trim our 2018 China Real GDP estimate, we think that the Trump administration will implement its $200 billion of retaliatory trade initiatives by early September, and we now believe that a global auto tariff is no longer out of the question. Hence, our view is that President Trump’s trade negotiations may just further intensify a global growth headwind that has actually been with us for some time (Exhibit 1), particularly as China insources production of more intermediate goods. It could also lead to further volatility in the currency market, as trade-affected countries attempt to potentially regain strategic advantage through competitive devaluations. These viewpoints are noteworthy, we believe, as many of the global business executives and investors with whom we met in China are currently forecasting more optimistic outcomes. So, if we are right, then investors should expect more earnings and market-based volatility beginning in the third quarter of 2018. Maybe of greater importance, though, is that the shift towards more nationalistic agendas represents a secular change that we believe has long-term implications for the way both business executives and allocators of capital think about the traditional benefits associated with ‘globalization’ compared to the past 30 years. In particular, we now expect a greater number of global multinational companies to begin to consider alternative supply chains, including more local production in both the U.S. and China. Technology, including semiconductors, and agriculture, including soybeans, are key areas of focus for us after our trip. We also expect a change of destination in global flows, as already evidenced by China’s significant slowdown in purchases of U.S. real estate in the second quarter of 2018.
  2. Despite intensifying trade tensions, we are extremely bullish on secular growth trends within the Asian millennial generation, the Chinese one in particular. All told, there are now 828 million Asian millennials, compared to just 66 million in the U.S. Within China, which is the focus of this note, there are north of 300 million millennials. Not only do the numbers of Asian millennials in places like China dwarf those in the U.S. and Europe, they form the bulk of the labor force. They are also the cohort that is now entering middle income status in China, which suggests important shifts in buyer behavior patterns. As we detail below, we now look for these individuals to reshape many traditional consumer markets within China – and around the globe for that matter.
  3. Our latest visit again reminded us that the evolution of e-commerce in China is unlike almost anything else we are seeing in any other part of the world. Specifically, consumers are bypassing conventional stages of online commerce development that have traditionally defined migratory patterns in key markets like the U.S. As a result, the power of Baidu, Alibaba, and Tencent (BAT) to decide which companies succeed or fail in China’s vast consumer and corporate markets has become both outsized and unprecedented. Indeed, by being part of the BAT network and infrastructure, several of the companies we met with in the healthy foods, data center, and logistics businesses are quickly emerging as almost preordained winners, often at the expense of incumbent companies in the more traditional consumer categories (many of which are multinational players). In our view, this shift in power is secular, not cyclical, and it has critical implications for return on capital in the Chinese corporate sector (both public and private), we believe.
  4. The headline economic statistics in China look fine, but they are masking major sector disparities that we are uncovering in the underlying macro data1. For example, in terms of growth, China’s GDP ex-Financials grew 9.1% year-over-year during the March quarter, but the Financials component of the economy, which includes many parts of the shadow banking system, plodded along at a much more modest four percent. Even within the financial arena in China we found noteworthy divergences. For example, total consumer growth surged 18.8% year-over-year as of June 2018; by comparison, consumer credit growth reached just 9.7% over the same period, reflecting the government’s heavy focus on deleveraging its State Owned Enterprises (SOEs). Meanwhile, within Fixed Asset Investment (FAI), we note that year-to-date infrastructure investment growth declined to 3.3% year-over-year as of June 2018 versus 16.8% growth as of the same time last year. On the other hand, real estate investment, another important subcomponent of FAI, increased to 7.4% year-over-year as of June 2018 from 5.5% a year ago. See below for more details, but our punch line is that, while the aggregate numbers in China look fine, it is not business as usual. Key issues such as e-commerce, deleveraging, and now trade are all creating massive undercurrents to growth relative to the more benign generic headline level macro data that is currently being reported.

Overall, we believe that the current trade wars with the United States will only accelerate China’s shift away from an export economy dependent on global trade/flows towards a more self-reliant consumer services economy that is gaining prominence, particularly within Asia. No doubt, this transition will take time, and it will likely be complicated in the near term by the political agendas of both the East and the West. However, the long-term trends of the Chinese millennials helping to accelerate the transition of the nation towards more of a domestically focused, services-based economy with increasing technological advancements is undeniable. To this end, we think that, despite escalating trade tensions, there is a significant long-term opportunity for global investors to help fund this transition and receive potentially outsized returns along the way.

We also left China with the strong belief that recent uncertainty is creating opportunity for more corporate carve-outs, as a growing number of chief executives rethink what is really core to their Asian footprint, including distribution centers, supply chains, and capital equipment.

An important caveat is that, as we describe below in more detail, macro risks have definitely increased. In particular, both domestic and foreign policies are now creating significantly more cross-currents in the economy than in the past, influences that we believe can now materially enhance or diminish the merit of any investment thesis in key areas of today’s Chinese economy.

DETAILS

In the following section we drill down on what we believe are four key insights from our trip.

#1: We Are Likely More Cautious on Global Trade Tensions than the Consensus. While we covered a range of issues during our most recent visit to China, the most engaging topic was – not surprisingly – trends in global trade. To review, our base case remains that global trade actually peaked in 2008, as one can see in Exhibit 1. The second key part of our thesis is that analyzing trade requires more focus on the signal and less on the noise. For example, as Exhibit 2 shows, over 100% of the U.S. – Mexico trade deficit can be explained by Transportation (i.e., autos) in Mexico, while nearly 60% of the China deficit with the U.S. is linked to the Apparel and Computer (i.e., Technology) sectors. Without question, our travels and research suggest that autos and high-end technology remain the real battlegrounds that the Trump administration will continue to pursue under almost any scenario. If we are right, then there is not likely to be a quick trade ‘fix’ that many investors now champion (or at least are hoping for).

Exhibit 1

We Believe Global Trade Actually Peaked in 2008

Data as at July 31, 2018. Source: IMF, Haver Analytics.

Exhibit 2

Much of the U.S. Trade Deficit Can Be Explained by China and Mexico

Note: Limited to top 30 trading partner of each country. Data as at December 31, 2017. Source: Goldman Sachs.

Exhibit 3

Successive Rounds of U.S. Tariffs on China Will Increasingly Hit Goods With Fewer Sourcing Alternatives and More Direct Consumer Impacts

Data as at July 11, 2018. Source: U.S. International Trade Commission Dataweb, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

Exhibit 4

There Are Several Key Product Categories Included in the Second Round ($200 Billion) of Tariffs Announced July 10th

Data as at July 11, 2018. Source: U.S. International Trade Commission Dataweb, Have Analytics, KKR Global Macro & Asset Allocation analysis.

So, what insights did we learn from our most recent visit that investors might value? For starters, overall business trends related to trade still do feel stable; major capex plans have not been halted, and hiring proposals remain encouraging. That’s the good news. The offset, however, is that we did learn of a few cases where U.S. firms felt that they were being potentially burdened through non-tariff initiatives, including more frequent inspections and/or more difficult positioning on potential M&A situations. Also, while momentum has not yet visibly slowed in the industrial economy, forward-looking orders appear to have peaked ― even before what we believe will be intensifying headwinds from trade tensions. One can see the downward trajectory of ordering patterns below in Exhibit 6. Finally, we learned of some slowdown in consumption patterns in Tier 2 and Tier 3 cities, though we were not able to quantify if this moderation in activity was directly linked to trade concerns.

Exhibit 5

Both Imports and Exports Have Peaked, But Overall Business Trends Have Generally Held Up Well Despite Trade Tensions…

Data as at June 30, 2018. Source: China Customs, Haver Analytics.

Exhibit 6

...Though Forward Looking Export PMI Data Does Suggest a Dip in Coming Quarters

Data as at July 31, 2018. Source: China Federation of Logistics & Purchasing/CNBS, Haver Analytics.

At the moment, our current base case is that the additional $200 billion of retaliatory trade initiatives do go into effect in September. This view assumes that the pace of dialogue with China increases, but it’s not enough to prevent President Trump from turning up the heat on the Chinese government. Consistent with this view, we also expect China to respond with $60 billion of its own retaliatory tariffs. Interestingly, though, very few executives with whom we spoke are currently planning for the scenario that we now view as the most likely. In our view, this is a missed opportunity and could lead to some supply chain headwinds and/or margin squeezes if not addressed rather quickly.

In terms of specifics for the economy, my colleague Frances Lim estimates that the first tranche of 25% tariffs on $50 billion of goods will impact China’s real GDP growth by 10-20 basis points.  An incremental 25% tariff on $200 billion of goods could have an additional 40-60 basis points impact, though we actually believe the true effect will likely not make its way into the real economy until 2019.  So, at the moment, we are currently lowering our real GDP estimate for 2018 by 10 basis points to 6.5%. This implies a deceleration of 45 basis points to 6.3% in the second half of 2018 versus the first half of this year, with the possibility of additional downside if trade tensions escalate further beyond the $200 billion we now have incorporated into our model.

Of particular concern to us is the indirect impact of escalating trade tensions, which could deter business investment as well as dampen consumer spending in 2019. In our view, any material slowdown in investment would be far more meaningful to long-term growth and productivity than the tariffs in isolation. There is also potential for an increase in trade tensions to incite a greater sense of nationalism against the U.S., encouraging consumers to buy Chinese (or even European and Japanese) products versus those from the U.S.

Importantly, though, we are not forecasting that trade tensions fully derail growth. In fact, our on-the-ground conversations in China give us confidence that, under almost any scenario except for a full-blown trade war that extends into the global auto arena (which is not our base case), the Chinese government just won’t allow the economy to slip below the six percent growth threshold. To this end, we note that the weekly State Council meeting reported on July 24th that the government would “make preemptive policy fine-tuning, depending on the situation change, to deal with external uncertainties and keep the economy growing at a reasonable zone”. In addition, we note that the PBOC has allowed the currency to weaken a full nine percent since the end of March, which obviously helps exports. Weaker commodity prices are also keeping inflation lower than expected, which gives the government more flexibility to be accommodative.

We also think that there will be moderate easing of policy to offset downside risks to growth in the second half of 2018. Specifically, we now expect some modest reacceleration of fiscal spending on additional infrastructure projects and at least two more RRR cuts this year. A consumer tax cut will also be implemented in the second half of 2018, and this effort should also help to boost consumption, we believe. Importantly, these consumer benefits are being added to the system at a time, when, as we detail below in Exhibit 8, the Chinese consumer is still in good shape. In fact, the job market in China remains quite tight, wage growth is steady, and consumer confidence remains at all-time highs (Exhibit 7).

Exhibit 7

The Job Market in China Is Tight and Consumer Confidence High, A Backdrop That Should Provide Some Ballast in the Event of A Downturn...

Data as at May 31, 2018. Source: Ministry of Human Resources and Social Security of China, China National Bureau of Statistics, Haver Analytics.

Exhibit 8

We Take Some Comfort That Disposable Income and Wages Are Not Only Headed in the Right Direction but Are Also Running Well Above Inflation

Data as at March 31, 2018. Source: China National Bureau of Statistics, Haver Analytics.

Our trip gave us insight into the fundamental differences between the U.S. and China on what defines the current trade imbalance. See details in Exhibits 9 and 10, respectively, but many China executives and politicians believe that the ‘true’ trade deficit is actually close to zero, not the nearly $400 billion that President Trump cites. True, as we show in Exhibit 9, the pure gross trade deficit of goods, on which the current U.S. administration is focused, is around $396 billion. However, the pure trade deficit of goods does not capture trade of U.S. subsidiaries based in China selling to China or U.S. services sold to China. This broader definition is an important consideration; one can see this in Exhibit 10. All told, Frances estimates that U.S. firms currently sell $448 billion of net goods and services to China, while China sells $428 billion of net good and services to the U.S.

The big difference in views from China relative to the consensus in the United States is that most of goods sold by U.S. firms to China are from U.S. companies with an onshore presence in China. Just consider that Apple sold $40 billion worth of iPhones to China in 2017, while General Motors sold more cars in China than in the U.S. last year (four million versus three million, respectively). Neither of these products is included in the reported goods trade balance statistics. Moreover, China is actually a net importer of U.S. services. So, after adjusting for sales of U.S. subsidiaries to China as well as U.S. services sold to China, the aggregate sales deficit in 2017 actually appears to be a $20 billion surplus (i.e., $448 billion less $428 billion) rather than the $374 billion goods export deficit many folks in Washington, D.C. now quote.

Our bottom line: We left China thinking that investors, business executives, and politicians should not underestimate the growing risks of selling into China’s large-end growth markets if the U.S. does impose the next $200 billion in tariffs. Without question, China has some very powerful tools in its toolkit, including clamping down on U.S. firms selling into China’s burgeoning consumer market as a retaliatory measure, should the U.S. decide to implement further tariffs on Chinese imports.

Exhibit 9

From China’s Perspective, Its Trade Deficit With the U.S. Is Actually Much More Balanced

*China goods sold to U.S. from China net of goods sold from non-Chinese affliates operating in China. Likewise, U.S. goods sold to China is net of goods sold to China by other countries affiliates operating in the US. Data as at June 11, 2018. Source: Deutsche Bank, China Macro: U.S. Economic Balances With Partners.

Exhibit 10

Goods and Services Sold to China Through Subsidiaries Is Actually Key to Understanding U.S.-China Trade Relations

*China goods sold to U.S. from China net of goods sold from non-Chinese affliates operating in China. Likewise, U.S. goods sold to China is net of goods sold to China by other countries affiliates operating in the U.S. Data as at June 11, 2018. Source: Deutsche Bank, China Macro: U.S. Economic Balances With Partners.

Our bigger picture conclusion from our deep-dive in China is the that recent escalation in barriers to free trade is an undeniable attack on the traditional global supply chain, one that we now believe can no longer be easily repaired through rushed and/or reconciliatory negotiations on a go-forward basis. Hence, almost regardless of what President Trump now does around trade and tariffs, we expect more corporations around the world to begin to create local supply chains. This insight is important for global real estate as well as many global manufacturing industries, particularly the Technology and Auto sectors. To be sure, global supply chains that emphasize required local specialization will continue to survive, but large companies will increasingly seek alternative sourcing options during what appears to be a sustained period of heightened nationalist agendas, we believe. As we show below in Exhibit 11, a reshuffling of global supply chains will have far reaching implications beyond just China and the United States.

We also believe that profit margins have most likely peaked in many of the countries where we forecast macro trends. As such, we now see tariffs as an additional input cost to consider beyond rising rates, higher wages, and increasing oil prices.

Exhibit 11

Small, Open Economies Could Be Most Exposed to a Global Trade Conflict

Data as at July 2018. Source: World Trade Organization, WSJ.

In sum, we fully acknowledge that predicting how trade negotiations will play out, particularly when it involves many different political and economic variables, remains an extremely difficult task for investors. What we do know, however, is that we have entered what we believe is something akin to ‘trench warfare’ when it comes to US.-China relations. So, while negotiations may produce some ‘deals’, we believe the new normal is a world where China’s continued focus on higher value-added goods and services will inevitably produce more systematic and consistent trade tensions. Without question, it is one of the key reasons that we do not believe China just buying more U.S. goods will ever satisfy the current U.S. administration.

Another important conclusion from our trip is that the ‘old model’ of globalization, which was largely founded on the premise of the U.S. buying low value-added Chinese goods at the same time that China used its capital account surplus to buy assets such as real estate and U.S. Treasuries is now over. Already, for the first time since 2008, China was a sizeable net seller of U.S. real estate in 2Q18 (it sold $1.29 billion of real estate and bought just $126 million). On the other hand, China’s burgeoning millennial population is rebalancing China’s economy and reshaping the global consumer market.

Exhibit 12

For Years the Chinese Government Has Been Committed to Making Trade a Smaller Part of Its Economy

Data as at June 30, 2018. Source: China Customs, Haver Analytics.

Exhibit 13

China Has Continued to Migrate Its Export Economy Towards Higher Value-Added Offerings

Data as at June 30, 2018. Source: China Customs, Haver Analytics.

Hence, as we turn towards 2019 and beyond (and almost irrespective of near-term outcomes), we believe that China will aggressively insource more of its goods and services. Already, we note that exports as a percentage of GDP in China have fallen to 18% from 36% at the peak in 2007 (Exhibit 12). Meanwhile, during our trip we learned that the government is raising a RMB 300 billion (US$47 billion) fund to boost its semiconductor industry. This public-private partnership is noteworthy because it allows China to shift its supply chain in size by creating alternatives to production located in the West. Given these trends, we stick to our thesis that global trade actually peaked in 2008, something the consensus believes has not actually happened yet. This viewpoint is significant, as it has ongoing implications for shipping, logistics, and supply chain management.

Exhibit 14

China’s Share of Global Mobile Phone Manufacturing Has Increased Dramatically in Recent Years...

Data as at July 24, 2018. Chinese brands include Xiaomi, Huawei, ZTE, OPPO, Vivo, Lenovo (HK-based), Coolpad, Gionee, Hisense and K-Touch. Source: Morgan Stanley Global Smartphone Model.

Exhibit 15

…However, It Is Still Not the Owner of Critical Upstream Technology: Looking Ahead, However, We Expect This to Change

Data as at December 31, 2015. Source: WSTS, ITA, ANZ Research.

Second, recent activity by both the Trump administration and the Authorities in China underscore KKR Global Head of Public Affairs Ken Mehlman’s view that the Technology sector is now a national security concern, and as such, all investors will now need to approach investments in this area using a different underwriting lens (e.g., more stringent CFIUS reforms). Indeed, we may all look back on the ZTE incident as somewhat of an inflection point on U.S.-China relations regarding technological dependence/connectivity.

Exhibit 16

We Believe China Will Aggressively Move Into the Design of Memory Chips and Compound Semiconductors After the ZTE Issue

Data as at November 15, 2017. Source: PWC China’s Semiconductor Industry.

Exhibit 17

There Have Been Winners and Losers Amongst Public Equities So Far in the Trade Dispute

Data as at July 26, 2018. Source: Bloomberg.

Third, there are likely to be some significant opportunities for investors to make outsized returns in the coming months. For example, our on-the-ground conversations with CEOs across a broad range of industries suggest that, given the uptick in nationalist agendas, more and more multinational companies will reassess their global footprints in the near-term, which is bullish for our Deconglomeratization thesis. We also believe that a growing percentage of equity securities in Asia is being sold indiscriminately, which may lead to opportunities in the public equity markets that were previously not available. One can see this in Exhibit 17.

Finally, heightened trade tensions could ultimately put pressure on our call that the Federal Reserve will raise rates by a cumulative six times in 2018 and 2019. To be sure, we do believe that both wages and input costs are rising to levels where the Fed will feel compelled to act. However, if we get into September and President Trump does actually implement $200 billion of additional tariffs (and remember as Exhibit 3 above shows, the percentage of goods dependent on China for sourcing increases as the tariff pool grows), then both the Fed and the KKR Global Macro & Asset Allocation team may be forced to consider revising down our short-term rate forecasts. The offset to this premise (and one we will also be watching closely), is that tariffs could push the Federal Reserve to further increase its inflation forecast. This viewpoint is significant because the Fed is already forecasting cyclical inflation that is in excess of its long-term projected rate of two percent.

#2: Invest Behind the Rise of the Asian Millennials, Chinese Ones in Particular. There are times when our team does macro analysis on a particular topic while working with a deal team on an investment, and an on-the-ground visit to a certain country and/or company helps to confirm that the micro and the macro are totally in sync, which is what we are usually searching for when we deploy capital on behalf of our limited partners. Our recent trip to China was one of those times, as Frances and I had several corporate meetings that confirmed her bullish thesis about the massive opportunity set linked to the burgeoning Chinese millennial population.

By way of background, of the total 828 million millennials in Asia, Frances estimates that fully 40%, or 330 million, are today in China. To put the 330 million in perspective, we would note that there are ‘just’ 66 million millennials in the U.S. One can see this in Exhibit 19. Said differently, China’s millennial population alone is now roughly the same size as the entire population of the United States. Also, as we show below, millennials are now a sizeable proportion of the overall Chinese population; moreover given this heft and growth, they will unequivocally dominate the labor force and consumer markets over the next two decades.

Exhibit 18

China Is One of the Larger EM Countries with a Millennial Population That Is Well Above Those of the U.S. and Europe in Terms of Size and Representation

Asia includes China, India, Japan, Hong Kong, Korea, and ASEAN (Indonesia, Malaysia, Philippines, Thailand, Singapore, Vietnam). Data as at June 24, 2017. Source: United Nations World Population Prospects, Haver Analytics.

Exhibit 19

Asia’s Milennial Population Is Now Likely the Most Influential Demographic Cohort in the World

Asia includes China, India, Japan, Hong Kong, Korea, and ASEAN (Indonesia, Malaysia, Philippines, Thailand, Singapore, Vietnam). Data as at June 24, 2017. Source: United Nations World Population Prospects, Haver Analytics.

Exhibit 20

Chinese Millennials Save Less and Allocate Three Times More of Their Income to Leisure

Data as at December 31, 2016. Source: Goldman Sachs Global Investment Research.

Exhibit 21

The Millennial Population Is the Highest Percentage of the Labor Force Within ASEAN, India, and China

Data as at June 24, 2017. Source: United Nations World Population Prospects, Haver Analytics.

Exhibit 22

While Many Asian Consumers Still Earn Less Than Their Counterparts in Developed Economies, Asian Millennials Have Higher Incomes Compared to Their Parents

Source: Morgan Stanley research The Millennial Series Unique Insights into the Future of Indian Consumption dated March 23, 2017.

Beyond the sheer size in population differential, we also estimate that there is also a huge income disparity between U.S. and Asia millennials in regard to attaining more wealth than their parents. Indeed, proprietary research from a group led by Stanford’s Raj Chetty as well as leading economists and sociologists from Harvard and the University of California at Berkeley now suggest that only half the U.S. children born in the 1980s, after adjusting for inflation, earn more than their parents ― a drop from 92% of children born in 19402. By comparison, most millennials in Asia are rich compared to their parents and grandparents in Asia. These diverging paths have huge implications for politics, public policy and populism on both ends of the spectrum. One can see this in Exhibit 22. In our view, this dichotomy in wealth is significant, and both our quantitative research as well as our qualitative research in China suggest that it does shape psychology about consumer behavior patterns for these cohorts of individuals.

Against this backdrop, we have come to appreciate that Chinese millennials have developed distinct consumption preferences in recent years. As we show in Exhibit 20, they spend about one-third more on leisure. They value fresher and healthier food and product alternatives than their parents, and they price comparison shop much more than their elders and many of their global peers. We link many of these traits to their tech-savvy ways – and it is not just goods purchased. Just consider that it only took Didi, China’s ride hailing leader, three years to reach 50% penetration, while Uber has yet to reach 50% penetration after seven years in the U.S. Meanwhile, AliPay has only taken four years to hit a penetration rate of 50%, while ApplePay has yet to reach the 50% milestone in the United States. To be sure, some of this accelerated migration in China is linked to the country’s desire to use technology to accommodate its population of 1.4 billion as well as to create national champions, but it also speaks to the rapid adoption of technology throughout the country. We attribute this to the favorable logistics in the country where courier costs are low and population density high, as well as the emergence of the growing middle class which is unencumbered by traditional channels. As a result, China’s Internet economy as a percent of GDP is larger than that of the U.S. According to a recent BCG study (Exhibit 24), China’s Internet economy was 6.9% of GDP in 2016 (latest data available), a full 150 basis points larger than the 5.4% of GDP in the U.S. We think that number is even larger today given the trends we see in online shopping, particularly when you consider that China’s Internet penetration is just 53% versus 76% for the U.S.

Exhibit 23

China’s Pace of Adoption Across Various Technology Platforms Is Unprecedented

Note: User penetration is defined as the ratio of app’s registered users to the total number of Internet users of the year. Taobao (淘宝) is the e-commerce platform under Alibaba; Alipay (支付宝) is the #1 online payment service provider in China owned by Ant Financial; Wechat (微信) is the mobile message app launched by Tencent; Didi (滴滴) is the #1 car hailing app in China, acquired Uber China in 2016; Iqiyi (爱奇艺) is an online video platform in China and just got listed in US. Source: BCG white paper on China’s Internet economy dated September 2017.

Exhibit 24

China’s Internet-Related Activities Contribute More to GDP Than the U.S. or Europe

Source: BCG white paper on China’s Internet economy dated September 2017.

Exhibit 25

China Has Made Significantly More Progress in e-commerce and Online Finance Than the U.S.

Source: BCG white paper on China’s Internet economy dated September 2017.

Exhibit 26

China Has Overtaken the U.S. in Online Sales Penetration

Data as at December 31, 2017. Source: iResearch, China National Bureau of Statistics, U.S. Census Bureau, Bloomberg.

Exhibit 27

Favorable Logistics and a Supportive Policy Backdrop Have Helped to Facilitate China’s Rapid Ascent in e-Commerce

Source: BCG white paper on China’s Internet economy dated September 2017.

So, what does this all mean for investment opportunities? Without question, all our quantitative – and maybe more importantly, our qualitative – research of late shows the secular trend towards Experiences Over Things in China has inflected upward in what feels like an exponential fashion. In fact, we had several interesting conversations with parents whose kids are paying up to ‘experience’ a concert with friends at the same time that they are cutting back on purchases of fashion clothing. Amusement parks, travel, and theatre all appear to be gaining momentum as a share of consumers’ wallets.

Personal financial services, healthcare services, wellness/beauty, healthier foods, and food safety should also be major beneficiaries of the environment we are envisioning. We also anticipate continued demand for China to tackle air, water and soil pollution, likely creating opportunities for companies that address these issues. Importantly, though, the Chinese consumer is becoming increasingly sophisticated, which is leading to a more demanding customer who uses technology more often to drive value, select aspirational brands over standardized ones, and comparison shops more often than in the past.

On the other hand, we left China quite concerned about traditional goods, food items in particular, offered by many multinationals. Their brands appear to be losing appeal at the same time their distribution networks are being squeezed by higher costs and increased competition.

#3: The Significant Impact of the Internet on the Chinese Economy. We have been highlighting for some time that e-commerce growth in China would ‘leap frog’ that of the U.S. Key to our thinking is that China’s e-commerce giants have not had to contend with the same degree of competition, infrastructure expenditure, and deep pockets of global competitors that U.S. companies have faced. They also have had more government backing than many of the e-commerce giants we see in other parts of the global economy.

Despite our optimism about these companies’ prospects to reshape the nature of commerce in China, it is still happening faster than what we thought. All told, Alibaba’s various online market places now count more than 550 million active customers, while Tencent’s WeChat messaging service survey recently surpassed one billion (yes, one billion) accounts. Given such heft, we were not surprised to learn that in 2017, China processed $15.4 trillion worth of mobile payment transactions, which was greater than the combined $12.5 trillion volume of credit card transactions of Visa and Mastercard.

Moreover, all three companies are acquiring expertise in new verticals at an outstanding rate, which argues for even further convergence between their offerings in the coming quarters. All told, OppenheimerFunds technology analyst Bhavtosh Vajpayee estimates that there have been 280 Tencent deals over the past three years and 174 for Alibaba over the same period. By blending social, e-commerce and payment functions into single apps, customers can manage their finances at the same time as managing their social lives. Collectively, China’s Tech sector has created an interlocking network of offerings that complement each other, fueling a powerful network effect that we believe may be hard to replicate as sharply in other e-commerce networks that we have studied. Importantly, as part of this initiative, ‘distributors’ like Tencent and Alibaba are now increasingly leveraging data and their pricing power to force traditional manufacturers to pay more for advertising and infrastructure costs than we previously thought ahead of our trip. Unfortunately for manufacturers of traditional consumer products, these pricing headwinds from the BAT community are occurring at a time when consumers want more add-on services and customized offerings at little to no additional cost.

Exhibit 28

China Is a Global Leader in the Adoption of Financial Technology

Note: The figures show the average percentage of respondents in each market who reported using one or more FinTech service in that category. Data as at 2017. Source: EY FinTech Adoption Index 2017.

Exhibit 29

When It Comes to Mobile Payments, China’s Activity Dwarfs That of the U.S.

Source: iResearch, Forrester, Alibaba and Tencent Set Fast Pace in Mobile-Payments Race, WSJ, September 22, 2017.

As one might guess, mobile devices have already dwarfed fixed Internet connectivity, including the traditional desktop; maybe more important, though, is the dawning reality that e-commerce trends in China are occurring in a radically different pattern than in the United States (i.e., large incumbents such as Target.com and Walmart.com poured billions of dollars into trying to protect their historical franchises against online start-ups, including Amazon). In China, by comparison, the shift towards online has been much more rapid and much more concentrated, as there were only a few dominant e-commerce interfaces, as only a limited number of major publicly traded competitors had the wherewithal to invest in a sophisticated online strategy. However, we do want to underscore that there is still room for a small number innovative new competitors to emerge. For example, creative offerings by companies like Pinduoduo (who recently filed for a public listing in the U.S.), which is using social networks to create ‘shopping teams’ to get further discounts and scale via bulk buying, are making their impact known as well.

Against this backdrop, the overall e-commerce market has just exploded. All told, China’s Internet giants have already helped to create a $15 trillion mobile payments market (and one that is likely to grow meaningfully larger), up sharply from just $2 trillion in 2011, according to iResearch. The U.S. mobile payments market, which is not nearly as widespread in practice by comparison, only reached $377 billion in 2017, up from $8.3 billion in 2011. One can see this in Exhibit 29.

What would disrupt the current momentum in China’s e-commerce space, we believe, is not increased competition. We think it is likely too late for that threat to play out. Rather, we think it would be the growing concern by the government that these private sector players have gotten too powerful. Without question, a high profile executive like Jack Ma is walking the razor’s edge. On the one hand, he represents an executive who has helped to create a national champion that puts China’s technology effort on par with that of the U.S. In addition, he has helped to make the economy not only more efficient but also more productive. These attributes are necessary for China’s massive population to continue its transition from rural to urban.

On the other hand, Alibaba is on track to dominate large swaths of the infrastructure food chain across transportation, media, communication, and financial services. As such, it has become a credible threat to the government in terms of the information and data analytics that it now holds on the Chinese consumer. However, given our view that the government is inclined to be more accommodative than less during this period of uncertainty surrounding trade, we believe that the potential for the government to intervene in a detrimental fashion has been vastly diminished for the next six to 28 months.

So what’s our bottom line? Without question, our trip re-affirmed our strong belief that the infrastructure of Baidu, Alibaba, and Tencent are increasingly dictating if and when businesses succeed across a growing band of industries within China’s domestic economy. Importantly, in today’s unsettled environment the government may have more patience to allow these companies to pursue oligopolistic business practices. From a business standpoint, this backdrop only gives us additional conviction that marginal businesses, particularly on the consumer goods side of the Chinese economy, will wither quickly. Key to our thinking is that these companies are increasingly facing pricing pressure from both the consumers that buy their products as well as the service providers (i.e., the BATs) that allow for the distribution of their products online.

Exhibit 30

WeChat Is Becoming a Digital Operating System for the Entire Chinese Economy

Data as at 2017. Source: iResearch Global, Fortune.

Exhibit 31

China’s Mobile Payment Market Accounted for $15 Trillion Worth of Transactions in 2017

Source: iResearch, Forrester, Alibaba and Tencent Set Fast Pace in Mobile-Payments Race WSJ, September 22, 2017.

Importantly, we left China thinking that public growth companies such as Baidu, Alibaba, and Tencent may represent better value than some of the private investment opportunities that we learned about during our trip. Valuations appear more reasonable, and growth remains strong. All told, the BAT companies are expected to grow earnings per share by an average of 101%, or a CAGR of 26% per year during the next three years.

#4: The Aggregate GDP Statistics Do Not Tell the Whole Story in China. During a series of meetings post our most recent journey to China, Frances and I have been consistently asked about how the Chinese economy is performing3. At the aggregate level, we stick to our view that we feel pretty good about current trends. Key to our thinking is that China has already crashed as an economy as nominal GDP actually fell 67% from 2011 to 2015. Subsequently, with the country’s producer price index (PPI) jumping back into positive territory, nominal GDP has actually rebounded more than 50% to around 10%. One can see this in Exhibit 32. Moreover, in trying to extricate the country from deflationary pressures, the government has forced capacity to come out of many ‘old economy’ sectors. This decision has been instrumental in returning profitability to not only China’s major industrial producers, but we also heard similar sighs of relief from commodity producers in other markets such as India too. Finally, as we mentioned earlier, there is enough stimulus in the system to ride out many of the known risks that are emerging from heightened trade tensions.

Exhibit 32

Nominal GDP in China Fell 67% from 2011 to 2015; As Such, We Think that China’s Economy Has Already Crashed

Data as at June 30, 2018. Source: China National Bureau of Statistics, Haver Analytics.

Exhibit 33

With Supply Being Rationalized, Chinese Industrial Profits Appear to Have Bottomed

Data as at June 30, 2018. Source: China National Bureau of Statistics, Haver Analytics.

However, our strong opinion is that the headline statistics do not tell the real story of the significant rebalancing that is actually occurring under the surface – a story that investors may not fully appreciate. For starters, we believe that the composition of GDP is changing faster and more dramatically than many investors and executives with whom we speak may fully comprehend. Indeed, as we show below in Exhibit 35, the portion of GDP of the Chinese economy linked to Financials has been under considerable pressure in recent quarters, as the government looks to wring excesses out of the system. In particular, there has been a massive attack on the shadow banking system, which has put notable downward pressure on the growth of the Financials component of Chinese GDP. All told, this sector of the economy, which is now just 16.0% of Chinese GDP, is growing at just 4.0% (Exhibit 35). On the other hand, non-Financials GDP, which is a sizeable 86.0% of the economy, is growing quite nicely. As we described earlier, Chinese millennials – amongst others – are spending more and saving less than their predecessors.

Exhibit 34

Services, Not Manufacturing, Now Drive Growth in China

Data as at 1Q2018. Source: China Household Survey, China National Bureau of Statistics, Haver Analytics.

Exhibit 35

While China’s GDP Appears Stable, There Have Been Some Substantial Changes Occurring as the Deleveraging Happens

Data as at 1Q2018. Source: Ministry of Finance of China, China National Bureau of Statistics, Haver Analytics.

Interestingly, even with the credit story, there is a notable divergence in patterns. Within the consumer segment of the market, loan growth has been strong. Autos and mortgages, in particular, have certainly become more influential drivers of credit growth. At the same time, however, the government has been clamping down more on corporate loan growth. As a result, consumer credit growth across China has increased to 18.8% year-over-year as of June 2018; by comparison, corporate credit growth has slowed to just 9.7% during the same period, reflecting the government’s heavy focus on deleveraging its State Owned Enterprises (SOEs). One can see the dichotomy in growth rates in Exhibit 37.

Exhibit 36

Consumer Credit Penetration Is Rising…

Data as at 2016. Source: Auto Media on Uptrend and Finance in Early Stages, Citi Research, Frost & Sullivan.

Exhibit 37

...Making Consumer Credit More of an Engine of Growth Than Corporate Credit

Data as at June 30, 2018. Source: Bank for International Settlements, Haver.

We also note that Fixed Asset Investment, or FAI, is enduring some major bifurcations. For example, growth in traditional infrastructure investment appears to have plummeted in recent quarters, as the government has looked to wring certain excesses out of the system. Yet, when one looks at Exhibit 39, one can see that fixed investment designated for Environmental Management has actually accelerated sharply in recent quarters. Our conversations on the ground support this notable pick-up, given the government’s view that the environment may now actually be as important as job growth.

Exhibit 38

Infrastructure Spending Is Slowing

Data as at June 30, 2018. Source: China National Bureau of Statistics, Haver Analytics.

Exhibit 39

…But Spending on Environmental Management Has Increased

Data as at April 30, 2018. Source: Ministry of Finance of China, China National Bureau of Statistics, Haver Analytics.

Finally, we see a similar divergence occurring across the China Retail Sales data. Indeed, on the one hand, autos sales have fallen off significantly ahead of China’s changing tariff policy on imported cars. On the other, furniture sales have hooked up sharply, rising 15.0% year-over-year in June 2018. One can see the divergence in sales patterns below in Exhibit 40.

Exhibit 40

Chinese Auto Sales Have Been Weak Ahead of the Auto Tariff Cut. At the Same Time, Furniture Sales Have Ticked Up

Data as at June 30, 2018. Source: China National Bureau of Statistics, Haver Analytics.

So, our punch line is that there is a lot more churn underneath the surface than recent headline statistics in China might suggest. For instance, key areas such as consumer credit, environmental fixed investment, and technology are all growing nicely. Yet, our top-down work shows that investors need to be cautious in key areas where government deleveraging is not only impacting growth but also return profiles. As we look ahead, we expect more of the same, which means that investors will now have to spend more time on understanding the investable nuances of China’s GDP growth versus simply relying on companies to meet stated budgets on GDP growth and returns.

Conclusion: Our Trip to the Epicenter Reveals a Country in Transition

Given China’s influential role in the global economy (i.e., one-third of total global growth in 2018), we spend a lot of waking hours trying to better understand what is going on there.  Our strong view, as we have detailed in this report, is that it is not business as usual in China. The country is facing extraordinary pressure to resolve heightened trade tensions with the United States, and it is also facing a massive societal change, as its millennial population, which is the largest in the world, is becoming increasingly influential.  This cohort in China has different aspirations from their parents, and as a result, their spending habits are notably different than their predecessors. 

Exhibit 41

China Remains the ‘Swing Factor’ in Global Growth Again This Year. As Such, Trade Tariffs Now Require Significant Investor Attention

Data as at April 17, 2018. Source: IMFWEO, Haver Analytics.

Exhibit 42

There Are Still Many Key Products That Are Not Yet Flagged for U.S. Tariffs on Imports from China

Data as at July 11, 2018. Source: U.S. International Trade Commission Dataweb, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

Technology is also having a profound impact across a wide swath of Chinese industries more so than ever before.  We actually left the mainland with the view that this ‘winner takes all’ mentality in e-commerce is likely to accelerate during the next 12 to 24 months.  Given this view, the upside and downside risk for many companies is as large as we have seen since we began visiting China for investment purposes in 1995.

Finally, given all these cross-currents, we think that it is imperative that macro investors and asset allocators do not rely solely on headline data out of China to make investment decisions.  Now is the time to dig deeper, particularly as the government intensifies its focus on deleveraging, services, and trade policies. Indeed, as we show in Exhibit 42, there are still many important areas of the economy that have not yet been flagged by the Trump administration for tariff penalties (though they could be).

Exhibit 43

The Recent Decline in the Yuan Represents One of the Most Dramatic Moves in History

Data as at August 2, 2018. Source: Bloomberg.

From an investment standpoint, these macro themes lead us to remain supportive of capital deployment in areas such as leisure, wellness, services (healthcare, environmental, and financial), and food safety. We are also bullish on our corporate carve-out thesis in China, as increasing numbers of multinationals re-assess where they want to lean in and out by business line. However, as we show in Exhibit 43, all investors should invest with the mindset of a much more dynamic currency environment going forward in the new regime that we are envisioning.

Importantly, we are quite cautious on branded consumer goods, global supply chains, and logistic plays that do not interface with the customer and/or can be disintermediated by the growing influence of Baidu, Alibaba, and Tencent.  Finally, as we have mentioned in this note, we believe now is the time to be prudent in terms of allocating to globally integrated industries such as Autos as well as high-end Technology, both areas that we believe could continue to face longer-term headwinds as cross-border flows and trade both face intensifying scrutiny.


1 Data in this section as at July 31, 2018. Source: China Bureau of National Statistics.

2 Data as at December 8, 2016. Source: American Dream Collapsing For Young Adults, Study Says, As Odds Plunge That Children Will Earn More Than Their Parents, Washington Post.

3 All data this paragraph is Ibid.1.