You don’t have to be a Sinologist to invest in China, but a study of its political trends sheds light on future economic policies that profoundly affect markets.

China for millennia has been subjected to the whims of rulers who touted the epic importance of themselves and their dynasties and reduced (or eradicated) the accomplishments of their predecessors. Today’s infighting among the country’s top leadership is no exception.

China has 1.4 billion people, with more Internet users online than there are people in the United States. And Internet penetration in China is only at about 40 percent. Similarly, while consumer spending accounts for about 70 percent of the gross domestic product (GDP) of the US, the figure in China is only about 35 percent.

The upshot for investors? A leadership transition is underway in the Middle Kingdom that is likely to result in policies that boost the consumer sector of its vast economy, with favorable long-term consequences for our portfolio holdings.

Changing of the Guard

Every five years the National Congress of the Communist Party of China convenes to examine the Chinese Communist Party’s (CCP) policy priorities, review the nation’s constitution and select the members of the Central Committee that will serve for the next five years. Every 10 years the Party Congress is used as a platform to reorganize the nation’s all-important Politburo Standing Committee, the country’s ultimate authority.

The upcoming 18th National Congress of the Communist Party of China, scheduled to convene on November 8, is one of those critical decennial meetings. This meeting is particularly important, because age and term limits are compelling seven currently serving Politburo members to step down, including President and Party General Secretary Hu Jintao and Premier Wen Jiabao.

While no one knows for certain who will make up the committee, the educated guess is that Vice-President Xi Jinping will become the party’s general secretary and the state’s president and current Vice-Premier Li Keqiang will become premier.

Mr. Xi has already had a lengthy tenure on the Standing Committee of the CCP and is a vice-chairman of the Central Military Commission, a key controlling body of the Chinese army. Given those posts, Xi has been the heir-apparent to the Party’s top position for a few years now.

Mr. Li hasn’t held posts that are quite so lustrous, but his career arc has demonstrated similar grooming. Both men have also served on the Politburo for the past five years.

Xi and Li are both part of what’s known as the “fifth generation” of leadership, meaning they came of age during China’s Cultural Revolution from 1966 – 1977. Whatever the reason, Communist leader Mao Tse-Tung in 1966 kicked off what came to be known as the Great Proletarian Cultural Revolution, a program of cultural transformation, political purification and revolutionary rededication that was enforced by legions of young people know as the Red Guards.

Waving their little red books of Quotations from Chairman Mao, the Red Guards purged remnants of China’s ancient past (including much of China’s greatest art); persecuted intellectuals (who were sent to the countryside for manual labor and “reeducation”); and rooted out counterrevolutionaries of all sorts (often through informers).

A period of widespread cultural and political unrest, members of the fifth generation came of age in a period of Chinese history marked by the execution of the leadership’s political opponents. They also had their educations interrupted when the nation’s schools and universities were closed in 1966 and students transported to rural areas to work farms as the leadership worked towards a more egalitarian societal ideal.

Most of the fifth generation leaders ultimately returned to school beginning in 1970 as universities reopened, but that period of strict authoritarian rule left an indelible mark on them. As a result, they typically seek consensus within the leadership circle when making decisions and tend to take a middle-of-the-road approach to governance, although two main factions do exist.

The son of an early Communist revolutionary, Xi is more identified with hard line traditionalist elements of the party and has had extensive experience in the administration with the wealthy coastal provinces, where much of the country’s manufacturing is based. Given that formative background, Xi favors unrestrained growth in the coastal provinces at the expense of the country’s interior. Despite his hard line reputation, he also tends to enjoy a great deal of popularity with the broad public.

By contrast, Li is usually regarded as a populist and more liberal. A trained economist, Li served with Hu Jintao and the China Communist Youth League and is consider a close ally of Hu. As a result of that relationship and experience, Li is believed to favor a strong central government which actively redistributes wealth for the richer coastal provinces to the poorer interior ones.

While there are various shades of policy orientation between Xi and Li, they are representative of the two basic schools of thought at work in Chinese governance.

As a rule, the broad Politburo and its narrower governing committees are evenly divided between populists and traditionalists, so trying to guess the identities of the remaining seven members of the Politburo Standing Committee isn’t a huge concern. While in years past that 50-50 split hasn’t prevented strong personalities with solid powerbases from wresting control of policy direction, these fifth-generation leaders are keen on forming compromises, given their youthful experiences.

Economic Ramifications

For investors, the overriding concern is what sort of economic policies the new leadership pursues.

This generation of leadership is united in the belief that it must continue market-oriented reforms and gradually loosen the state’s hold on the economy. That being said, they’re also dedicated to maintaining the unrivaled rule of the Chinese Communist Party.

Another defining feature of the fifth-generation is that most of them have been posted to several different provinces across the country over the course of their careers. Because of its exposure to both the interior and coastal regions of the country, the fifth generation will likely work to develop China’s interior and begin diverting at least some resources away from traditional manufacturing bases.

Given the challenge of running a largely export-oriented economy in the midst of ongoing global economic woes, that policy is consistent with the goal of developing a stronger, internal demand driven economy. In fact, that’s about the only choice left to the CCP.

The CCP must keep annual GDP growth above 8 percent and inflation relatively tame to maintain political legitimacy and control. As long as those conditions are met, the People’s Republic of China will remain a relatively peaceful place, aside from occasional bouts of unrest in the Quighur-dominated Xinxiang region or the Tibet Autonomous Region.

However, as the Chinese economy has matured, potential fault lines in its development strategy have emerged and GDP is threatening to dip below the magic 8 percent (see chart, below).

Source: Organisation for Economic Co-operation and Development

If the CCP is to maintain its long-term hold on power and foster the country’s rapid growth, it must tap into the potential of the country’s own domestic markets through direct subsidies and other supportive measures. That policy would bring the added benefit of shielding China’s economy from external shocks, further lessening the risk of unrest.

Our Holdings

These trends have set the table for long-term growth, for our bets on Chinese consumer industries. Belle International (Hong Kong: 1880, OTCL BELLY) and Hengan International (Hong Kong: 1044, OTC: HEGIF) will be the most salient beneficiaries of a Chinese focus on developing a stronger consumer economy.

Belle, the leading maker of woman’s footwear and athletic apparel in China, manufactures 10 of its own brands of shoes appealing to woman at almost every price point and age group. It licenses another eight brands geared primarily towards higher-end buyers. It is also a leading retailer of several major western brands of sportswear.

Revenues at the company have been growing rapidly, reaching nearly RMB30 billion (USD4 billion) last year and on track to hit RMB35 billion this year. Operating profit should come in at around RMB6 billion.

Hengan is China’s leading manufacturer of personal hygiene products such as disposable diapers, bathroom tissue and sanitary napkins and it is also pushing into the snack food market. While it’s not made much headway into that last product category as of yet, in the first six months of its current fiscal year the company saw sales of bathroom tissue and sanitary napkins rise by 12.5 percent and 22.5 percent, respectively. Diapers posted a further 7.3 percent gain in sales. That drove a 10.4 percent gain in revenues which reached HK9.0 billion, a new six-month high, and earnings per share reached HK1.32.

Despite the slowing economy most Chinese consumers have enjoyed steadily rising incomes for years, fueling consumption of all types of goods. The country’s increased pace of urbanization and economic growth has also raised a brand awareness that the country previously lacked, as consumers have become more willing to pay premium prices for what they consider higher-end products.

Belle International and Hengan International remain buys at HKD17 and HKD70, respectively.

Hengan is currently trading above its buy target, so for now only buy on dips.