Investment Team Travelogue - thornburg.com

1 Investment TeamTravelogue2 | Investment Team Travelogue : ChinaQ: What was your expectation for investing ideas going into the trip?Charlie Wilson: Th e goal for the trip was to learn about change in Chinese policy on heavy industry and environmental improvements, but I was open to where the facts would lead me. Th e fl exibility of the Th ornburg process always gives us the freedom to search for the best ideas. In this case, clean energy specialists would have been restricted by the structure of their team to ideas in solar, wind, or batteries. Th ey would not be able to leave with the view the best Investment might be a bank. Often, when we go on trips, we meet with management of companies we own, and prospect for new ideas. Th e fi rst part of the week, I attended a Morgan Stanley tech conference touch-ing on artifi cial intelligence, autonomous driving, and e-commerce and the impact on the Chinese and global economy.

2 Th e second part was hosted by CLSA, and they were trying to highlight the govern-ment s multifaceted Beautiful China theme. Th e sectors where China wants to be a leader are autos, electricity produc-tion, and emissions. Because we don t structure our team of analysts based on sectors or geographies, our analysts don t feel compelled to push a stock idea based on artifi cial boundaries. Th ey can analyze an idea or theme which may span multiple sectors or geographies and then suggest the best way to invest regardless of where it takes them. Q: Recap the economic backdrop in China. Where are we and what did you learn on the ground?CW: Th is has been a delicate balancing act: a government de-emphasis of important industries like steel produc-tion and property development. At the same time, they still are trying to support the fi nancial system, which has signifi cant exposure to the old-growth model.

3 Th e initial reaction by strategists and analysts was to avoid the old-China sectors, which appeared to be on the wrong side of policy, at least from a demand perspective. While Chinese demand for steel and coal has likely peaked, the initial view failed to incorporate the importance of Chinese supply-side reform eff orts. The sky is not falling in China. In fact, it appears to be it s the crisp horizon on view from a bullet train headed to industrial Northern China or the blue-sky vistas from a Beijing skyscraper, the air at the start of 2018 looked cleaner than it ever has for Thornburg s Charlie Wilson, a portfolio manager who recently returned from a research trip in the People s Republic. What he saw was the tangible result of government economic reforms that have shuttered ineffi cient industrial facilities notorious for sputtering soot into the air.

4 This capacity rationalization is not only good for the environment, it s improving profi tability in coal, steel, aluminum, and other businesses, and helping the fi nancial system as bad debt dissipates in the industrial sector. The air quality has improved by about 30% this winter across China, according to CLSA, with winter curtailment of commodity producers as part of Beijing s Beautiful China environmental reforms. Capacity in the steel industry has been slashed, more coal capacity may go offl ine this year, and natural gas consumption is on the rise. The government s Investment in housing is slowing. But wages are rising, China is witnessing a mini baby boom, and its thriving e-commerce market, the largest in the world, could account for 25% of all retail sales in China by s economic growth is expected to decline slightly this year to But the fi gure remains admirable next to developed world rates, especially considering the government s massive shift in the economy from resource-intensive, fi xed-asset Investment to the consumer.

5 Consumption now consistently contributes about 60% of gross domestic product (GDP), while fi xed Investment runs just more than 30% and net exports account for the remainder. A decade ago, the contribution from fi xed Investment far outweighed consumption. This shift provides an expansive hunting ground for investors across industries, from wind power and electric vehicles to commodities and fi nancials. As Wilson sees it, Old China is demonstrably helping New China, and supply-side reforms deserve more investor attention. China s doing well, reform is on track, and results are strong. Many investors don t appreciate that, says Wilson. I found places where change was happening. I was really surprised at how aggressive China has become about closing ineffi cient capacity for heavy industry and the effect that is having.

6 Despite old, at-risk loans in the industrial sector, credit quality has started to improve. Thornburg s nimble process for choosing equity investments allows analysts and portfolio managers to pluck stocks that are tied to these trends without forcing members of the team to be married to a sector weighting or geography. Indeed, China s reformation will have impacts well beyond its borders. Here are more thoughts from Wilson about the Wilson, phdPortfolio Manager and Managing DirectorQ&A with Charlie Wilson, phd | 3 The government is successfully making that switch from debt-funded, fixed- asset Investment . One of the issues was excess capacity in heavy industry, and reducing high-cost and low-efficiency production capacity in heavy industries, like coal and steel, has been an import-ant way to deal with excess in the old economy.

7 Initially, there was a lot of skepticism because most local govern-ment officials were still encouraged to drive growth through traditional means. The Chinese government wants to improve air quality and reduce credit risk due to rapid loan growth. Q: Explain some of the ups and downs of old-economy reforms. CW: Supply-side reforms came first in coal, then steel and now the aluminum sector. Most investors globally were skeptical for the first 12 months of supply-side reform; many didn t think it was sustainable. Then non-performing loans slowed, total credit growth slowed, fixed-asset Investment slowed, and consumption grew more quickly. It s hard to argue with the facts. Supply-side reform is happening and appears to be the end of 2016, supply issues in coal had become apparent; supply cuts were much larger than demand drops.

8 This was, in part, due to a change in how local government officials were moti-vated: less GDP targeting and more environment-based targets. The result was a sharp improvement in prices and profitability in the old economy. But also a reduction in leverage in that part of the economy. The cuts in supply have already started to impact air quality. Better air quality combined with the more stable outlook for old China and the financial system have encouraged policy makers to do even more. Q: What are authorities doing?CW: The incentives for local government to improve air quality are now in place. Employees won t get promotions, won t be able to keep their jobs, or could be thrown in jail if air quality does not improve. In the past, the execution requirements focused on GDP growth targets. Now the government is saying it still wants growth, but the players involved have to clean up the air.

9 There is public and international pressure, and China is taking that and helping to drive industry to be a leader in clean tech (air and energy). I think there is internal pressure from the central government to increase jobs in solar, wind, and electric batteries from heavy industry. China is executing on targets to reduce : The term Beautiful China was coined by Xi Jinping in 2012. What did you see that was new?CW: China wants to be a leader in environmental policy and the technology needed to achieve environmental goals. The term has been mentioned in more than 60 speeches by Chinese party leaders and Xi. It was also a focal point of the nearly speech Xi delivered to the Party Congress last fall. On the trip, we had the opportunity to meet with a variety of industry and policy experts as well as companies exposed to environ-mentally friendly new energy sectors.

10 Prior to this trip, I was aware that China had ambitious targets with respect to environmental policy and supply-side reform. After the trip, I am convinced China is on track to meet and exceed targets in both areas. This progress has implications across many industries outside of the obvious areas like auto production, new energy technology, and battery production. China s policy shift is also positively impacting legacy old China industries like steel, aluminum, and coal. Global steel and regional coal prices have moved up and some compa-nies that were barely profitable have become profitable again. Q: Would you own steel exposure now?CW: Regional and global steel prices have improved, and the fundamentals have also improved. With improvements in profit-ability for regional steel producers, that helps improve non-performing loans in India as well.