Hi there, I'm David Kelly, Chief Global Strategist here at J.P. Morgan Asset Management. Welcome to Insights Now. Series of conversations designed to shine a light of clarity on the complex world of investing. In this our first season, we're focusing on future trends, the themes, ideas, and issues that will shape our future and the investment environment, not just tomorrow, but for decades to come. For global markets, there's no bigger longterm issue than the growth and evolution of China as an economic superpower. Very often, the way we think about China is dominated by short-term news, such as tensions between China and the United States in areas of trade and human rights.

These are very serious issues that should not be ignored. However, we also can't overlook the extraordinary growth in the Chinese economy, the emergence of its middle class, the technological innovation of its companies and the development of its financial markets. To discuss all of this, I'm joined today by Gabriela Santos, Global Market Strategist on our Market Insights team. Hi Gabriela, thank you for joining us here on Insights Now.

Hi David, thank you so much for having me. It's such a pleasure to be here with you.

So Gabriela, we know that China is big and it's been getting bigger for a long time, but can you give us some sense of just how big the Chinese economy has grown relative to the world economy this date?

Absolutely, and I remember thinking about this, October 1st of last year, of 2019 when China was celebrating its National Day or 70 years since the founding of the People's Republic of China. And there was just so much enthusiasm, so much to celebrate because of the tremendous growth that we've seen in China over the past few decades, in terms of the size of its economy, the income level of its population, its technological prowess, the size of its financial markets, as well as its hard and soft power. So trying to put that in perspective a little bit in terms of size, just 40 years ago, 1980, China was the eighth largest economy in the world, contributing 1% to global growth. By the early 2000s, it had become the fifth largest contributing about 15% to global growth.

We look at where we are today, China has become the second largest economy in the world, contributing about a third to global growth. If we think a little bit about what that's meant for the income level of its population, basically China has gone from being a low income country back in 1980 to becoming upper middle income country today. So in terms of GDP per capita in dollars back in 1980, it's GDP per capita was $195. Today, that's $10,000 per capita. And just if we think about by the end of this decade, by 2030, China is set to become the largest economy in the world, moving into the high income select few group of countries in the world.

Really interesting to think about how during this time, the drivers of its economy has also changed. For a few decades, there was really driven by investment spending and by its secondary industry or manufacturing. Now it's actually already driven by consumption, as well as its tertiary industry or services. So it's become much more like a developed economy during this time. It's also become much more dominated by domestic demand instead of just exports. And that perhaps not all investors realize, I mean about a decade ago, exports were huge, represented 35% of GDP for China. Now it's only 18%. So it's an economy much more driven by consumption, services and its own domestic demand. And as it continues to grow over the next decade, it's absolutely normal for its actual growth rate to come down.

So it was growing about 10% in 2010, last year it grew about 6% and that's going to continue to slow down we think to a trend growth over the next decade of about 4.4%. One interesting thing also to think about China's just how much its actual technological prowess has changed. When it was being driven by manufacturing, it was all about producing low cost, low value add types of goods, clothing, footwear, textiles. Now the kinds of things that China produces are actually much higher in terms of its value add. So one of the major items China produces is machinery and equipment. That one from being only 7% of China's exports in 2000, to being over 30% of its exports and it's only seeking to move even further up the value chain, investing a lot in research and development as a percentage of GDP. It's already the fourth country that spends the most and it's also the second country with the most patent applications.

So really China seeking to become an even more sophisticated economy going forward. Last thing to note is we tend to think about China's size in terms of the economy, but it's actually really impressive what's happened with the development of its financial markets. China now has the second largest equity market and bond market in the world. Only behind the United States. So really it's not just about accessing its economy, but also through its own financial markets as well. And with that, of course it's gaining a much larger representation in equity and bond indices. Last thing in terms of thinking about its hard and soft power, those celebrations on that national day last year certainly display China's military power and its investment in military technology.

But its soft power has also been gaining a lot of prominence around the world. So China used to be the country that received a lot of foreign direct investment. It's now moving the other way and China has actually become emerging markets, largest creditor. So I think it's hard to come up with the amount of superlatives to describe just the tremendous growth in China's economy, its financial markets, as well as its hard and soft power around the world.

That's really extraordinary and thank you so much for putting that in context because I think we sort of tune in and tune out of the story, but it really has become so dominant and will be so dominant in the years to come. Having said that, this year, the year of the pandemic and we have the issue of the coronavirus. So how has the coronavirus affected this growth in China and how is the recovery going?

Yeah, so certainly not the kind of year that we expected China to have or that it expected for itself. So the pandemic started pretty early in the year in China, February 15th was the peak day of daily new cases when China was seeing about 4,500 new cases a day. That's decreased substantially and we're now seeing about 100 daily cases in China. This is as of here at the end of August. So I think it's been a combination of just very strict quarantines that China imposed in affected cities and provinces. It also has very strict restrictions on international arrivals. It also sought to use a lot of technology to monitor its population and to have a feel for where people were going once it opened up its economy in late February and who people were coming in contact with. So a big ability to do large scale contact tracing and isolation.

In terms of its economy, of course, it suffered a very big hit, especially in February when we were seeing the strictest quarantines. So China had the first contraction in GDP that it officially has had over the last 40 years. China's first quarter GDP contracted by minus 6.8% year over year. As trying to start at opening up late February and has continued to do so over the past few months, it's economic recovery began and has only gained steam since then. So China was already able to register positive growth in the second quarter whereas the rest of the world was really feeling the bulk of the impact at that time. So second quarter GDP for China grew 3.2% year over year. If we look at the nominal GDP levels, China is actually one of the only examples in the world of a V shape recovery. It has already surpassed its 2019 levels at the end of the second quarter.

It's been interesting what's driven that recovery. It's a little bit different than the rest of the world. Hasn't been driven as much by consumption and domestic demand. It's actually been driven more by production and investment as China really encouraged the reopening of its factories. And that's really driven also a big boom in exports in China this year as its factories were back online, the rest of the world was still not quite there yet. So it was actually exporting quite a substantial amount of goods to the rest of the world.

Going forward for the rest of the year, it's going to be important to start to see some of that domestic consumption retail sales come back as people become a little bit more confident in what's going on in terms of their own futures and start spending more and more. I could say that China is pretty far ahead, shall we say, in terms of its recovery. It's not complete, it's not perfect, but it's moving ahead quite nicely.

But it's not popular. I think clearly what's happened this year with the pandemic and particularly because the pandemic started in China, even if the Chinese have dealt with it pretty efficiently, has only worsened relationships with the United States. So how do you see tensions between the United States and China going forward?

Yes, and it's become incredible every day I wake up and I take a look at the news and it seems like every day there's a headline that says that tensions between the US and China are rising. And indeed, I mean, they have risen compared to how we ended the year last year, and I think the spark for this increase in tensions was China's handling of COVID-19 and the international perception that it wasn't particularly transparent with the international community in the beginning. And then a most recent accelerant has been the upcoming presidential election in the US. This topic of China is clearly a hot topic here in the United States and an important topic for both Republicans and Democrats.

When we look at some of the surveys, for example, the survey released by the Pew Research Center, it shows that 73% of adults have an unfavorable view of China right now, 83% of Republicans, 63% of Democrats, but the trend is up regardless of partisan affiliation. So it's interesting. It's not just a President Trump focus, it's not just a Republican focus, it's really a very hot topic coming into the election. We actually have about 268 bills in Congress related to China, just going on at this moment.

What's been interesting is the tensions have not been related to trade like they were at the end of last year. It's been in a whole other realm with a big focus on technology, human rights, security, and healthcare. I think post election, maybe some of the volume of this rhetoric dowels down, but still to a higher baseline. Maybe with a president Biden victory, maybe it'll be a focus on more of a rules based discussion with China. But I still think because this is such a popular issue, it's not something that's going to go away, regardless of who wins the election in November.

Yeah. It's not going to be a short term issue, is it? Because I mean, China has been growing relative to the United States for years, has got a very different political ideology and set up and it's becoming very important to the global stage. So do you think these tensions with China are going to persist a few years?

I do. I think it's just a permanent fixture of the global landscape, the investing landscape, perhaps for our lifetime and maybe beyond. And I think maybe considering China's point of view is important. So we think of China as these last seven years, how much it's emerged onto the global stage, but actually China thinks of its history as thinking about millennia. And during that timeframe, China has spent the majority of its existence, of its history at the center of the global economy, global innovation, global trade, global geopolitics.

So China views its recent emergence as a return to its rightful place in the global order. And it's interesting China's name for itself is the middle kingdom and that really reflects their view of their traits as being culturally exceptional in terms of the global landscape. So it's seen as a return to where it actually spent a large amount of time. And driven by its own model that works for them, not necessarily for the rest of the world, but that really has worked for them.

So I think it's really something that is going to continue moving forward and continue driving this competition between the US and China, different economic models, different ideologies, competing on all of these different spheres from trade to technology, to security, human rights, the environment, healthcare. It's definitely not something that's going to go away. Of course, it's not just competition. There's also a lot of collaboration that takes place. Maybe that's a little bit less loud, but it's going to be a mix, right? Between collaboration and competition, depending on the specific issue.

When we see this, obviously this competition will continue for many decades, but looking at the increase in just the last few years, the short term tensions, particularly around technology, has that caused China to change its short term strategy about how it thinks about growing technologically?

It's interesting. In terms of technology, China of course has a big focus that for it to grow or continue growing over the next few decades, it needs to focus on the industries of the future technology. And there are actually certain spheres that China is already quite competitive on the global stage. If we think about cloud computing, a large Chinese company, Alibaba is already the third largest provider of cloud computing globally. If we think about another example of digital payments, a company like Alipay, actually already has 1.2 billion global users comparing to an American company like PayPal, which has 286 million.

Thinking about social media, china has really three of the top 10 social media companies by users. Companies like WeChat, TikTok and Weibo. There are certain industries that China's still working to move up a little bit more, 5G is a great example. Actually two Chinese companies lead the global race in terms of filing the most patents for 5G technology. It's not fully there, but it's working very hard to dominate and to write the rules of 5G technology. And one area where it's been lagging behind in terms of technology has now become a big focus for China to catch up as quickly as possible, and that's semiconductors, right?

It still relies a lot on US semiconductors or US technology for semiconductors that it imports from South Korea and Taiwan. And as we see more restrictions, more competition happening on that space, China's really trying to move up it's timetable even more of how competitive it can be in that space. So some areas already pretty competitive, some areas really a continued focus to become the leader in that space.

So I've got a China which is growing its domestic economy less dependent upon exports. It's also growing this huge technology business within China itself and there should be a lot of opportunity there. But how as an investor, should you think about investing in China while all these tensions are still very prominent between the United States and China?

Yeah, so because I think this competition's going to be a fixture here for our lifetimes, I don't think we can wait for it to calm down or to ever completely disappear. So I think we just have to learn to accept it and each time that something comes up, a headline comes up, really ask ourselves three main questions. The first, in what sphere and what realm are these tensions taking place? Because some are much less relevant at a macro level for investors. So areas like human rights are certainly very, very important, but they don't have that map for relevance for investors thinking about technology, Chinese equities, Chinese fixed income.

Something like trade is definitely much more of a relevant consideration in terms of a huge swath of companies, as well as just a huge amount of uncertainty that it can create. So far this year, the competition, the tensions have been focused much more on the realms that are less macro relevant for investors, which has allowed us to be just more noise operating in the background compared to when we had the peak of the trade tensions in 2018 and 2019.

Second big question, does the action itself, the specific announcement, the specific competition, does it actually affect corporate fundamentals on a macro level or even in a specific company level? Because actually sometimes when we look at the details of what's been announced, sometimes it tends to be a little bit more rhetoric and symbolism than actual substance in terms of timeline, in terms of the whole scope of the announcement. So that's always important to actually look beneath the headlines, look at the details.

And the third thing I think is just, we think about investing in China, does that specific competition actually change the investment opportunities in China? And I think China's reemergence on the global stage is going to continue regardless of this competition. Of course, maybe it can slow it down a bit, but there's still this tremendous story happening of the growth of China's middle class, it's technological advancement and the development of the size and breadth of its financial markets.

So if you can get past the short-term volatility and the tensions and you want to invest in China for the long run, how do you specifically do that at this point?

Two main ways. We mentioned that China's equity and bond market are the second largest in the world. So thinking first on the equity side, as we mentioned, the opportunities in China are first the growth of its middle class. So we used to think of China as, we made things in China. Now really the opportunity is that companies want to make things in for China. And that's why it's crucially important to be tapped into the growth of this middle class and the companies that are really tapped into that in China directly. And that includes everything from consumer discretionary, to education, to healthcare, to financial services. It's really a very broad concept.

We also talked a lot about innovation growing in China and just the tremendously competitive companies we have there on the technology space and actually more and more, there's a growing amount of innovation happening in healthcare as well. Just still a small part of the representation, but it's only set to increase. And it's interesting because China's equity market has grown so much. It's actually already 40% of the MSEI emerging markets. It's just mind blowing to me how much that's grown over time.

So more and more of the institutional investors we speak to or even thinking of Chinese equities as just a standalone core allocation, separate from the other discussion around emerging markets as a whole. Second on that bond side, I think that it goes a little bit under the radar sometimes that China has a huge bond market, not just amount of debt, but actual investable bond markets, including local governments, the sovereign government, as well as corporations. And more and more China has been added to not just emerging market debt indices, but global indices as well.

China as rated by the Standard and Poor's for example, is a rating agency has a rating of eight plus the same as Japan, but with a bond yield of 3% instead of negative. So more and more, I think Chinese bonds are also becoming an interesting addition to fixed income portfolios because of its more attractive yield as well as it's just very low correlation to what's happening around the world. So there's a lot of opportunity in China, despite all of this noise around competition between the US and China, and at the end of the day, it's not China or the US, it's really about both being a very key core part of investors portfolios.

Well, thank you so much, Gabriela. It does sound like there's a lot of opportunity in China and really something that US investors can't ignore for the long run.

Thank you for listening and please tune into our next episode where I'll be joined by Jack Manley, Global Market Strategist on our Market Insights team to discuss the 21st century economy and the impact of technological innovation in shaping the world and the investment environment both today and in the decades ahead.

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