Why Are We Hitching A Ride On China’s Broken Engine?

“You know, I think back to those black and white photos of German parades before World War 2, and I wonder if we’re going regret this.”
So said a friend of mine earlier this week, as we gazed down The Mall towards Buckingham Palace, each side of the famous road festooned with huge flags of the People’s Republic of China that fluttered in partnership with equally massive Union Jacks.
It was all in honour of the state visit of Chinese Premier Xi Jinping – an event that Prime Minister David Cameron heralded as a sign of a “golden era” of co-operation between the UK and China.
We were there to see what the fuss was about.
And I was especially curious because all the volatility in the markets we’ve seen this year seems to lead back to China.
It is certainly a golden moment of political posturing – for good or ill.
But what could closer ties with China mean for us as investors?

Modern world: made in China

You can, of course, argue the financial payoff of this rapprochement is hardly the most important question to ask in the face of a Britain suddenly intent on being China’s chief sidekick among the G7.
And I did feel some of the same doubts my friend had, even if it did seem churlish to point out that she’d proven Godwin’s Law – that all arguments lead to an invocation of Nazism – in record time.
Many of us despair of China’s human rights record, such as the 500,000 of its own citizens who, are according to Amnesty International, being detained without charge or trial.
China is the world’s leading applier of the death sentence for good measure, too.
Yet it seems a little late for Britain or the other Western powers – or us as citizens – to protest too much about state visits, while we all spend freely on Chinese goods in our shops.
Most of our ubiquitous gadgets are made in China, for instance.
The fortunes of FTSE giants like BHP Billiton (LSE: BLT) and Rio Tinto (LSE: RIO) were made on the back of China’s vast appetite for natural resources, too.
The fact is that we – like the rest of the world – already do business with China on a grand scale.
Every time you play an angry Rage Against The Machine track on your Apple iPhone, you’re using a device assembled in China.

Given all the Chinese products in our lives (the facts on the ground, in military parlance), you can understand the political calculation that says ‘in for a penny, in for a trillion more pounds’!

Slow down a minute

Let’s then park the difficult moral questions for now. They are above my pay grade really, and outside of the scope of The Collective.
Instead, the issue for us as investors is whether we’re hitching our wagon to China’s growth locomotive just as its wheels are coming off.
On Monday, for example, we learned China’s GDP growth has slowed to 6.9%. Better than forecast, but below the Chinese government’s own target.
Many economists don’t believe the official figures anyway. They point to a steeper slowdown showing up in commodity prices, which have been crashing for years now.
We’re also seeing signs of headwinds in individual company results.
Luxury firms like Burberry and Paris-based LVMH blamed their recent poor results on unexpected weakness in China.
Then there’s the huge crash in the Chinese stock market – the second largest in the world as of last year – that’s been blamed for at least contributing to the bumpy ride we’ve endured since late July.
It’s all a bit ominous.
Are we doubling down on China’s economy just as it falls a cliff?
Time will tell, but I doubt it.

China 2.0

Whereas I find the moral ambiguities of our leaders trying to secure closer links with China hard to navigate – not to mention the strategic wisdom of China being deeply involved in our next-generation nuclear reactors, which is another item on the table – the economic argument is compelling.
Until proven otherwise, I believe the slowdown in China we’ve seen so far represents the fallout of a well-flagged attempt by the Chinese government to try to move their economy from relying on exports towards a more mature one based on consumption and services.
And that shift could eventually mean a far bigger market for the higher value goods and services that British companies can provide.
China is already the biggest iPhone market in the world for Apple – even larger than the US!

They don’t just build our products. They buy them, too.
Equally, I think recent hiccups for the likes of Burberry and Diageo when it comes to China can clearly be laid at the foot of the anti-corruption and bribery drive that China’s leaders have embarked upon.
While I don’t doubt this is at least partly to do with securing a power base and settling scores, it also seems to be about reforming the Chinese Communist Party in order to push through the reforms required to make that economic transition stick.
It’s hard to ask for a more modern, Western-style China, and then complain we’re losing some of the good old profits of bribery.

Better than bungs

So just how big could the prize be – for China and for us – if it pulls off this great transformation?
My fellow Share Advisor analyst Mark Rogers quotes a great statistic that truly paints a picture.
According to The Economist, while one million households today earn over $75,000 a year in China, within 15 years there should be 74 million households boasting such an income.
That is extraordinary, and it puts the present-day travails of Burberry and Diageo into perspective.

Sure, it might be tough that sales of Johnnie Walker Black Label or Burberry handbags are down in China because they’re not being ‘gifted’ in shady business deals.
But how much more alluring a market are tens of millions of extra households who can buy these luxuries under their own steam?

Bull in a China shop

New research by Credit Suisse already claims China has a bigger middle class than America.
It’s getting richer quicker, too.
The optimist in me hopes that these wealthier Chinese consumers will eventually demand and win the political freedoms we in the West take for granted, just as they want our phones and trench coats.
The investor in me sees a future we cannot afford to ignore, nor be scared out of by a few bumps in economic growth along the way.

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Owain Bennallack owns shares in Burberry and Diageo. The Motley Fool UK has recommended Burberry. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.