Is China a bubble?

Published by on 15 June 2010.
Last updated on 15 June 2010

temple of heaven in Chinese flag

What do you get when you squirt washing-up liquid into running water? Bubbles - thousands upon thousands of them.

Thankfully for investors, the creation of a bubble in stockmarkets is a little more complex, and despite the amount the word is bandied around, it happens less often than you might think.

Most recently, the buzzword has been used in reference to China, as people question whether the extraordinary economic expansion in the region can continue.

But Mark Dampier, head of research at online broker Hargreaves Lansdown, says he has only seen one true bubble in his lifetime - in the technology sector during the late 1990s.

"I think it's an over-used term," he says. "I don't think China is any kind of bubble. When your friends start asking you which Chinese fund to invest in and how to do it, that's when you know it's gone too far."

Rise of the economy

Following a rapid recovery in the second quarter of last year, the Shanghai Composite index peaked in August 2009 at 3471.44. Since then, the index has been hovering between the 2500 and 2700 mark (May-June).

"The Chinese economy is unlikely to overheat because the government has shown it's prepared to manage it. And because of its different form of governance it can implement controls quickly," says Andrew Merricks, head of investments at Skerritt Consultants.

Certainly, most commentators recognise the authoritarian nature of Chinese governance makes a difference, although this is not necessarily a good thing.

Andrew Wilson, head of investment at Towry Law, says we should remember that China is a command economy, which means the government regulates the market.

When someone claims certainty on a China-related issue, you should ask how well they understand the government policies and leadership of the country, he adds.

Other elements to consider are: how do you feel about property rights, the rule of law and corporate governance in China? But, assuming you take these issues on board, there are some great opportunities to be had in the region.

According to Jennifer Storrow, managing director of Gee & Co financial advisers, emerging markets in general tend to be volatile and will most likely continue to have periodic setbacks.

However, she says they also have significant periods of growth, which it would be a shame to miss out on.

"The key point here is to take a long-term view - over 10 to 20 years and beyond. I have no doubt the short-term picture will continue to be relatively turbulent," she says.

Darius McDermott, managing director of Chelsea Financial Services, is concerned about China valuations in the short term, and over the medium-to-long term, he points to protectionist measures, an inflating real-estate bubble and potential currency manipulations as issues to be wary of.

Despite this, he still feels there's a strong case for investment in the area, since the economic shift from West to East is undeniable. As Angus Tulloch, manager of First State Asia Pacific Leaders Fund, says: "The age of American Dominance is over."

Western beneficiaries

So what's the best way to make the most of the changing world order? The key is to mitigate risk, and one way to do this is to stick to what you know. Merricks thinks investing in beneficiaries of the China story is the best way forward.

Many FTSE 100 companies have exposure to China and are benefiting from growth there, so you could benefit along with them.

To invest in China as a trend rather than a region, Merricks suggests investing in a consumer trends fund, such as the JP Morgan Consumer Trends fund managed by Peter Kirkman.

Wilson also backs this approach: he says many big names serving the growing consumerism in China are listed in developed markets and this makes them more transparent, liquid and arguably cheaper.

If you want to invest directly in China, it's worth taking time to consider your attitude to risk. Could you handle it if a correction in the market cut the value of your investment by 25%?

If the answer is no, then you should back away. But if the answer is yes, then you need to think about how much of your portfolio you're willing to place in the region.

Traditionally, 5-10% of exposure to emerging markets as a whole was seen as plenty. Now, in line with the economic shift to the East, many advisers recommend more.

"I wouldn't invest 45% in emerging markets, but I think investing in countries with very little debt, which are on the upward curve, is nowhere near as high-risk as it traditionally would have been," says Merrick.

Wilson recommends emerging markets exposure should be between 20-30% of a portfolio's overall equity exposure, with China a key component of its make-up. He adds that a proportion of this could be through Western beneficiaries.

Others maintain a more conservative attitude to emerging markets: both Storrow and McDermott advise between 5-10% as a blend with other emerging markets, and Storrow adds that investing in China might not suit a low-risk investor at all.

But with the Chinese GDP set to achieve 10% growth this year, according to the International Monetary Fund forecasts, as long as you are in it for the long haul, investing in China need not be something to fear.

"The most suitable route for most investors is via some sort of collective investment vehicle such as a unit trust or an investment trust," says Storrow. "There is now a huge variety of choice, from very specialist funds to more general global funds with exposure to the area."

The beauty of China as an investment opportunity lies in the long-term potential of the area, so those unsure of how or when to enter the market have plenty of time to mull the decision over.

While a short-term correction could be on the cards, particularly if the Chinese government decide to de-peg the yuan from the dollar, the overall sentiment is: "a bubble it aint".

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