At Ardevora, we look for information which can help us understand the behaviour of three groups of people: company managers, financial analysts and investors. Once a year we take stock, sift through the information we think is important and try to understand why the market behaved the way it did.
The first thing that jumps out to us is error. Financial analysts, who make forecasts for company profits, were unusually wrong last year. A strangely large number of stocks delivered surprisingly strong profits in 2017. The pattern of financial analyst error looked unusual, through time and across sectors.
In 2015-16 there was a major shock. A very large number of stocks suffered a lot – poor stock price performance fed by disappointing profits, which reached its crescendo in the first quarter of 2016. A complicated mix of overzealous management behaviour in natural resource industries, as well as government-driven changes in the Chinese economy may have been the cause.
When we look at the pattern of financial analyst errors through time, it looks like we walked into a global recession in late 2015 – with lots of economically sensitive stocks suffering profit warnings. The pattern since early 2016 looks a lot like a post-recession recovery. We have been trying to figure out what drove this pattern and why it seems to have gone largely unnoticed. We think it was all about China.
Most people missed China’s stutter
We think the stutter of 2015-16 was caused by the Chinese desire to shift its economy away from ‘old’ style heavy industry. We think a centrally driven push to restructure poorly performing, inefficient old industries and the pursuit of a tighter environmental agenda caused a break in economic growth, growth which had previously spilled out of China to the benefit of a wide spread of non-Chinese companies. The stutter, we think, caused the hidden recession of 2015-16 and judging by the pattern of financial analyst error, most people did not see it coming.
But after the first quarter of 2016, it looks like the changes started to work. Apparently gloomy news on Chinese debt and zombie old economy businesses struggling was really a symptom of positive change. The Chinese economy was shifting into new industries and the nature of Chinese growth was changing.
This explains the marked shift in analyst forecast error after March 2016. There was a rapid jump in the number of emerging market stocks beating profit forecasts, spread across almost every sector, both industrial and consumer facing. But the way it spread out to the rest of the world looked different in a number of subtle ways. For us, it explains the surprises of 2017.
Implications of the successful rebalancing
Industrial technology stocks felt the benefit quickest and the most. Tech companies tied to industrial investment, not to the consumer, have seen explosive growth and surprised the most. China is investing aggressively in automation, production efficiency and R&D heavy industries.
Consumer facing non-Chinese stocks did not benefit much, outside a few notable exceptions – such as autos and luxury. This has been especially obvious for powerhouse consumer branded companies. These companies benefited from the early phases of Chinese growth, but now look increasingly locked out and are struggling to grow. We detect a deliberate shift in Chinese priorities to drive the development, wherever possible, of domestic consumer brands to supplant non-Chinese ones.
There have been old economy beneficiaries – not from demand per se, but more from the shift in Chinese priorities to efficiency and environmental protection. Vale, Rio Tinto and BHP Billiton have overcome tepid steel demand by offering a superior quality product, supplanting less-efficient alternatives. Also, a wide range of industrial chemical companies have seen profitability surprisingly boosted as Chinese competitors struggled with new environmental regulations.
Finally, Chinese companies are beginning to leapfrog overseas rivals and are turning attention to competing outside of China – for example, ANTA is pushing hard in athleisure, as is Geely in cars.
Is the Chinese economy safer than the US?
It looks like China has successfully rebalanced its economy, but it seems the US is trying to unbalance its. Trump only managed one thing last year – to get a tax reform bill passed. It looks like an exercise in fiscal stimulus, applied when there isn’t much slack in the US economy. Wage pressure is building, the Fed is tightening. China looks safer than the US from here.
China seems to hold the key to relative success for stocks. It seems to be driving sustainable growth, yet our sense is its importance is still downplayed. Another year of surprising growth looks in store.
Jeremy Lang is partner and co-founder of Ardevora Asset Management
Will form new Phaeacian Partners