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Can China's Economy Bounce Back?

U.S. Trust's DeAnne Steele weighs in on the depreciation of the yuan, the changing focus of the Chinese economy, and what it all means for investors

AT THE BEGINNING OF 2016, global markets were falling as concerns about China's growth rate and currency were on the rise. And the country's future continues to be a concern for some investors. In this interview, DeAnne Steele, investment executive for the western United States at U.S. Trust, discusses the outlook for China, its importance to the global economy, and what it all could mean for U.S. investors.

Merrill Lynch: Is China headed for an economic hard landing?

DEANNE STEELE: The annual growth rate of China's gross domestic product (GDP) is certainly slowing — from 6.9% in 2015 toward 6.0% over the coming years1 — but we don't expect a hard landing. One reason is that although the growth rate is slower today than a decade ago, the GDP base is larger. So, in a rough comparison of the two periods, GDP of $10 trillion and an annual growth of 5% could add $500 billion to GDP; by contrast, a $3 trillion GDP base and a 10% growth rate added far less—some $300 billion—to GDP.2 Four years ago, Beijing initiated its plan to transition from an economy driven by manufacturing to an economy driven by consumption, a move that appears to be working. The services sector, which includes consumption, may be under 50% of GDP in China versus almost 80% of GDP in the United States; still the sector recently overtook industry as the largest share of GDP.3 (For more, see "Services Sector Gains Traction in China," below.)

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There's evidence of this in other areas, as well. For example, China's retail sales were up 10.5% year over year in March 2016.4 As more and more rural Chinese people move to urban centers, "ghost cities" appear to be filling up. Wages are rising, according to some estimates, and high-end manufacturing is increasing. Yes, the Chinese face challenges, but we believe they have the tools to make the transition work. Those tools include foreign currency reserves—about $3.2 trillion as of March 2016—that China can use to trade for yuan and help stem its depreciation; and an annual current account surplus in 2015 of some $300 billion.5, 6

"We think the U.S. economy is strong enough to withstand CHINA's slowing growth rate." — DeAnne Steele
Investment Executive for the Western United States at U.S. Trust

ML: Explain the yuan's depreciation.

DS: The Chinese currency was pegged to the U.S. dollar, which recently strengthened by over 20%, making the yuan stronger than it otherwise would have been, especially relative to the currencies of trading partners such as Europe. Assuming China's economic growth rate slows, its currency should weaken. In addition, to better align itself with its trading partners, Beijing is moving to peg the yuan to a basket of currencies. This is likely to lead to gradual depreciation of the yuan versus the dollar over the next several years.

In general, the Chinese government did a lackluster job of communicating its plan to depreciate the currency. As a consequence, nervous investors questioned the nation's growth rate and wondered how much the currency would need to weaken further before depreciation was complete. This led to capital outflows at a time when China needed domestic investment to help support the transition, which is one reason why the government now appears to be using foreign currency reserves and other tools to help slow the depreciation.

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ML: Does a slowdown in China mean a slowdown in the U.S.?

DS: We think the U.S. economy is strong enough to withstand China's slowing growth rate. That said, there's little question that the slowdown will affect U.S. company earnings, as well as our stock market and economy. This is why we look beyond Chinese government data to company surveys and other sources of insight, to help refine our estimates of China's growth rate, and to support our view that their economy will not face a hard landing. This is important in an environment where global growth is only 3% or so. There isn't a very large margin for error, which is one reason we expect more volatility in the U.S. stock market during China's transition. Policy and communication missteps are likely, which can lead to volatility.

ML: What does this mean for those wanting to invest in China?

DS: We recommend focusing on investing in companies that are based in developed countries and that supply goods and services to Chinese consumers. We would consider travel, healthcare, pharmaceuticals, consumer goods, and health and fitness. As China transitions toward a more consumer-based economy, and as rural Chinese move into cities and gradually become wealthier, these key areas should benefit.

3 Questions to Ask Your Advisor

  1. Would investments in Chinese companies be in keeping with my portfolio's desired risk profile?
  2. Is my portfolio in a position to benefit from potential growth in the Chinese consumer economy?
  3. Are there other opportunities internationally that I should consider for my investments?

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