Schroders: China's shift in economic focus
Following a recent visit, we reflect on the implications for European capital goods firms of China’s shift away from investment-led development.07.05.2015 | 11:09 Uhr
The investment-driven development model that China has adopted over the last three decades and which has driven the demand for capital goods has now reached the limit of its effectiveness and will need to be adapted if the country is to continue growing. Assuming China’s growth trajectory is similar to other “miracle” economies, over the coming years, investment’s share of GDP will decrease and economic growth will slow. In this context it is very clear that the >20% growth that the capital goods companies have historically enjoyed is now a thing of the past.
Chinese capital goods firms are starting to compete on quality and innovation, not just price
We visited several local competitors across various industrial end-markets. For now, it is clear that a quality gap still remains between Chinese and Western producers; however, the gap is rapidly narrowing as the local competitors develop expertise and improve production processes.
At present the large international players will typically dominate the “high end” market in their respective industries, where product quality and innovation are key, whereas the local players compete (typically on price) in the volume end of the market. As Chinese manufacturing improves and growth slows, we expect to see local operators increasingly trying to take share higher up the value chain, both in China and internationally. This could create a negative pricing headwind for many capital good names which do not have defensible competitive advantages or where switching costs are low.
Where we would seek to invest
We believe that stock selection will be key to investment returns in the European capital goods space over the next few years. We will look to avoid companies where the investment thesis is reliant on strong Chinese demand, where we believe expectations are still too high on a medium term view (particularly those exposed to end markets where we see the highest risk such as property), and those where customer switching costs are low (opening up to the threat of increased competition).
Where we do invest in businesses exposed to China, we will favour end markets that offer structural growth, such as healthcare and consumer, or where businesses enjoy sustainable competitive advantages which will allow them to defend their market shares without giving away margin.