- China’s income problem
- What President Xi is really saying
- Future opportunity for investors
As long-term investors, we often look through shorter-term noise to take advantage of opportunities. For example, we recently wrote about Evergrande, a large Chinese property developer that’s fallen on hard times. We believe this has created an opportunity in Chinese bank stocks. Another recent development in China has caught investor attention.
China’s income problem
In an August speech, President Xi called for “adjusting” excessive incomes and for high-income individuals and companies to contribute more to society. The catchphrase “common prosperity”, like many Communist Party slogans, appears everywhere now but details on the policy remain vague.
Investors have taken it to simply mean that China will now “take from the rich and give to the poor” to make everyone equal, thereby stifling economic innovation and setting the Chinese economy back 50 years or so. The reaction from global investors to issues in China has been swift and brutal, with the Chinese stock market underperforming the S&P 500 by a staggering 30% this year!
Price return, year to date
One of the most often asked questions is why now? It’s hard to know, but what is undisputable is that China, like many countries around the world, has an income distribution problem. Economic development has now reached a critical juncture. Per capita income has continued to move higher, but the distribution of household incomes has become markedly uneven as China’s richest now earn more than 10x that of China’s poorest – which is higher than most western nations.
Today, the most pressing need to address is income inequality, and to raise the share of wages as a percentage of GDP in order to support the long-standing goal of rebalancing the economy towards consumption. Compared to countries like Canada, Chinese consumers have a high level of precautionary savings due to the lack of a broad social safety net.
Spending flows to healthcare, education and housing (especially for migrant workers), leaving less money for private consumption. Raising the share of household incomes in GDP and reducing inequality while tackling the ‘three big mountains’ – escalating healthcare, education and housing costs – should support a higher share of private consumption.
To narrow the income gap, China could gradually introduce:
- Wealth taxes on capital gains, inheritance and property
- Wage adjustments linked to economic growth and inflation
- Centralization of local land revenues for fiscal transfer to less-developed regions
- Enhanced basic social security programs
- Incentives for firms and high-income individuals to perform charitable activities via tax benefits
Regardless of what policies are enacted, we believe the ultimate goal is to increase the income and share of middle-income earners.
What President Xi is really saying
On October 15, a fuller transcript of those mid-August remarks made by President Xi was released and piqued investor interest. In the publication, the language seemed more reassuring to investors with discussions like “rationally adjusting” excessive income. He also addresses entrepreneurship near the top of the document, saying that “common prosperity depends on hard work” and innovation and law-abiding entrepreneurs should be particularly encouraged.
The newly-released remarks also warn about the dangers of “welfarism” and government dependence—language that was absent from the original text. We believe there’s a fair amount to like here. Most importantly, it shows that President Xi understands the importance of incentives, and that the rapidly escalating regulatory campaign over the past year risks damaging entrepreneurship.
Simply stated, common prosperity does not reflect absolute equality, and differentiated levels of income/wealth would still be a reality to preserve market incentives.
Chinese Disposable Income:
Mean quintile urban disposable income (US$)
Source: CEIC, Morgan Stanley Research
Future opportunity for investors
China has already shown improvement in this area as disposable income for middle-income earners has increased dramatically since 2000. Further, focus on improving this in the future will have major implications for companies and investors globally as they battle for the buying attention of this burgeoning Chinese consumer. We continue to see opportunities in luxury companies to take advantage of this common prosperity goal. Research done by Bain and McKinsey noted:
Chinese consumers contribute to around 30% of the global luxury consumption, and domestically, the middle-class consumers account for 70% of the luxury market. Moreover, driven by the growth of the middle class in low-tier cities, foreign luxury brands are expected to gain a considerable number of new consumers in the following years.
Luxury sector - Sales exposure in ML China and to the Chinese consumer worldwide pre COVID-19
Source: Morgan Stanley
Looking at the international portfolio and our core luxury holdings, we believe LVMH, Prada and Richemont (all listed in Europe) are poised to benefit from their respective positioning, and that sales to Chinese consumers (both on the mainland and abroad) will take more wallet share as common prosperity makes middle-income earning Chinese wallets bigger.
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