Swimming in China’s sea of deflation – and adapting to a new economy

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Warren Buffett famously said: “Only when the tide goes out do you discover who’s swimming naked,” which is increasingly apt for China’s economy. Once powered by rapid double-digit consumer growth, China now faces the stark reality of deflation and weakened consumption. Retail sales, which grew 13% annually over two decades increased by just 2.1%¹ in August 2024, pulling the tide far out.

Many companies that banked on premiumisation are now exposed. Strategies reliant on aspirational consumers are faltering, leaving businesses vulnerable. However, as always, the changing tide presents both challenges and opportunities.

A stimulus-fueled rally

Despite these headwinds, Chinese stocks have recently achieved their longest winning streak in over 15 years, with nine consecutive days of gains. This rally was fuelled by the government’s stimulus package, including interest rate cuts, measures to support the stock market, and incentives for home purchases.

While these efforts won’t create an immediate turnaround, the policy shift could create a more supportive environment for Chinese equities, especially for companies well-positioned to capitalise on these developments.

Who’s ready for the shift?

As the tide of easy growth recedes, new consumer priorities in China are emerging. Frugality has taken hold, but that does not mean consumers are accepting lower quality. Chinese consumers are still willing to spend on high-quality products, but they are more discerning about price and value. Companies that have relied on inflated pricing without delivering genuine value are being exposed. This has led to a growing shift away from over-marketed products and towards value-driven purchases.

“Chinese consumers are still willing to spend on high-quality products, but they are more discerning about price and value.”

This change is particularly evident among Generation Z (Gen Z) consumers. Unlike their millennial predecessors, who sought material status symbols, Gen Z places a greater emphasis on experiences. Whether it’s travel, dining, or entertainment, this generation is signalling a structural pivot in spending patterns that many companies are struggling to adapt to.

Winners in a low tide

While many companies are finding themselves ‘swimming naked’ in this deflationary environment, others are proving resilient. Industries like hotels, beer, private-label value retailing, and home renovations have found ways to navigate the receding tide and thrive. The key to survival lies in supply chains – those that can leverage China’s deep supply chain capabilities to offer differentiated, high-quality products while passing savings on to consumers are winning wallet share.

For example, private-label retailers that pass cost savings onto consumers through innovative supply chains are staying competitive. Meanwhile, companies that rely on traditional, multi-layered distribution networks are struggling to keep up. The fall in retail and commercial rents, down by 15-20% in top-tier markets since 2020, has also helped grassroots entrepreneurs established strong franchise models with attractive returns.

Hotels are a perfect case study. Despite decades of consolidation, branded hotels still account for only 30% of rooms in China compared to over 70% in the US². The growing divide in quality between private sector entrepreneurs and state-owned enterprises (SOEs) is consolidating profits and quality backlogs of new sites among private sector leaders. In fact, room nights booked through major hotel chains and Online Travel Agencies (OTAs) are growing at double-digit rates, especially in the midscale and above segments, where quality supply remain scarce.

Similarly, the beer industry stands out as a potential winner in this environment. While beer volumes peaked in 2012, premiumisation continues to gain momentum. Younger consumers, despite cutting back on overall spending, are still choosing premium beer over pricier spirits. This reflects a value-conscious mindset that aligns with broader shifts in spending behaviour. In fact, Chinese beer remains relatively inexpensive compared to regional peers, offering a unique growth opportunity as consumer preferences shift toward higher quality.

China’s RMB3 trillion (€387.6 billion) renovation industry is also ripe for consolidation. As the housing market transitions from newly built to existing homes, many apartments in top-tier cities are primed for renovation. Younger homeowners are demanding full-service renovation packages at transparent, competitive prices, but the industry remains fragmented and product-driven. Companies that can deliver comprehensive services and scale operations will be well-positioned to capture this market.

Opportunities in a receding tide

The recently announced stimulus measures appear to signal a more determined resolve from policymakers. Many Chinese companies are currently trading at very undemanding levels, and with the prospect of further interest rate cuts and increased fiscal spending, the policy backdrop is improving. This could potentially create a favourable environment for Chinese equities, particularly as companies act in a more shareholder-friendly manner through dividends and stock buybacks.

As the tide recedes, great companies are often forged in times of economic challenge. Leadership teams are forced to focus on their core strengths, and the strong emerge even stronger. While some companies may find themselves swimming naked, the ones that can adapt will emerge as the structural winners in China’s evolving economy.

* This article was first published, in Chinese, in the Hong Kong Economic Journal.
¹ Source: National Bureau of Statistics of China
² Source: National Bureau of Statistics of China, Inntie and Ctrip

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast. 

The content of this page reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. All information included in this page has been written for informational and educational purposes only and does not constitute an offer or solicitation to invest into any security, strategy or investment product. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents.