China may be in deflation but there is opportunity for structural winners to emerge
Chinese consumers are still seeking high-quality products but are more discerning about price
WARREN Buffett famously said: “Only when the tide goes out do you discover who’s swimming naked.”
In 2024, China’s consumer economy has dramatically pulled the tide far out. For over two decades, Chinese retail sales surged at an annualised rate of 13 per cent from 2000 to 2021. However, recent years have turned the tide. Retail sales last month saw only a 2.1 per cent rise.
Just a few years ago, consumer companies – both domestic and multinational – crafted strategies with the confidence that Chinese consumers would continue to upgrade their lifestyles.
From dairy to beauty products, premiumisation dominated, with companies heavily investing in marketing to sustain demand. This optimism left many of them unprepared for the deflationary environment and weakened consumption power that have emerged. The tide has now receded, and many companies have found themselves “swimming naked”.
As the tide of easy growth recedes, new consumer priorities in China are emerging. Frugality is taking hold, but value-seeking behaviour does not equate accepting lower quality. Chinese consumers are still seeking high-quality products but are more discerning about price. They are no longer willing to pay what some have called the “IQ tax” on overpriced, over-marketed goods. Companies that have relied on inflated pricing without delivering genuine value are now exposed.
The shift goes beyond material goods. Gen Z, in particular, seem less concerned with the material status symbols that their millennial predecessors coveted. Instead, they prioritise experiences – travel, dining and entertainment – reflecting a broader pivot in consumer spending. Companies that once thrived on selling aspirational goods are now left standing bare as they struggle to adapt.
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In this deflationary environment, only companies with strong fundamentals and innovative supply chains can continue to thrive. Winners are those that adapt to changing consumer preferences, delivering both quality products and value for money. Sectors such as hotels, beer, private-label value retailing, and home renovations seem well-positioned to benefit from these shifting consumer preferences.
The key to survival lies in supply chains, the backbone of delivering real value. Private-label retailers that leverage China’s robust supply chain capabilities to offer differentiated, high-quality products while passing savings on to consumers are the ones staying fully clothed. These companies are capturing wallet share, while competitors relying on traditional, multi-layered distribution networks struggle to keep afloat.
A handful of franchise models, too, are flourishing in this environment. As bond yields fall and investment alternatives shrink, grassroots entrepreneurs are flocking to business models with strong unit economics and attractive returns, many delivering double-digit unlevered internal rate of returns. Additionally, the fall in retail and commercial rents – down by 15 to 20 per cent or more since 2020 in top-tier markets – has made these models even more appealing.
Hotels are a perfect case study. Despite decades of consolidation, branded hotels account for just 30 per cent of rooms in China, compared to over 70 per cent in the US. Within the branded sector, the widening gap in quality between entrepreneur-led operators and state-owned enterprises is consolidating profits and quality backlogs of new sites among private-sector leaders.
Chinese travellers are still moving, with room nights booked through major hotel chains and online travel agencies growing at double-digit rates. Quality supply in the mid-scale and above segments remains scarce, presenting growth opportunities for those able to meet this demand.
Beer also stands out as a potential winner in a deflationary economy. While beer volumes peaked in 2012, premiumisation continues to gain momentum. Younger consumers, despite tightening their overall spending, still choose premium beer over pricier spirits, reflecting a value-conscious mindset. Chinese beer remains relatively inexpensive compared to regional peers – or even local milk tea and coffee – creating room for growth as preferences shift towards higher quality.
Finally, China’s renovation industry is ripe for consolidation. As the property market transitions from newly built to existing homes, many apartments in top-tier cities are primed for renovation. Younger homeowners are demanding hassle-free, full-service renovation packages at transparent, competitive prices. However, the industry remains fragmented and product-driven. The winners will be those that can set the standard for comprehensive services and scale to capture this significant market.
In today’s challenging Chinese economy, many companies are exposed as weak players, their flaws laid bare like swimmers without suits. But there is also tremendous opportunity for structural winners to emerge, capable of not only surviving but thriving as others falter.
Companies generating returns on equity well above 20 per cent are trading at crisis valuations, while continuing to enhance shareholder value through dividends and stock buybacks totalling nearly 10 per cent of their market capitalisations annually. These leaders are navigating the receding tide with resilience, while weaker competitors struggle to stay afloat.
Great companies are often forged during times of economic challenge. Leadership teams, forced to focus on core strengths, emerge stronger as the weak fall by the wayside. This was true in Japan’s post-bubble economy, and the same is unfolding in China today.
The writer is deputy fund manager, Asia-Pacific equities at M&G Investments
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