According to FE Fundinfo data, the IA China/Greater China sector was the worst-performing peer group in 2023, registering a fund average fall of 20.4%. This continues a run of underperformance that has seen the MSCI China index register a fall of more than 33% over three years to 27 May 2024, and has led several commentators to suggest China was becoming ‘uninvestable’.
However, six months into 2024, fortunes seem to be improving. Not only has the IA China/Greater China sector risen 6.9% year to date, but the MSCI China index is up 11%. So was it too early to herald the demise of investing in the world’s second-largest economy?
In this month’s head to head, Downing’s Simon Evan-Cook explains why he doesn’t own any dedicated China funds, while Sean Taylor, CIO at Matthews Asia, looks at what has changed in China’s economy and markets.
Simon Evan-Cook, fund manager, VT Downing Fox Funds
We have just under 3% of our Downing Fox 100% Equity model invested in Chinese and Hong Kong stocks, but this isn’t our choice. It’s down to our selection of active global, Asian and emerging market equity managers, who we entrust with decisions like this.
In other words, what we don’t have is a dedicated China fund. This is because of the risks that surround China. At their most extreme, these could mean having your capital locked into the country in the same way as Russia. Less extreme, but still serious, is the risk that a sweeping, top-down political decision could wipe out the value of investments in individual companies or industries, which is what happened to the Chinese private education sector in 2021.
Part of our investment ethos is to stay within our ‘circle of competence’. We believe that emerging market and Asian fund managers, who live and breathe the asset class, are likely to be more competent in deciding whether to go into Chinese companies – or to pull out – than we are.
This approach worked well for us in 2022 with Russia. We held no dedicated Russia funds, leaving it to our two active emerging market managers instead, one of which had completely avoided Russia for years, while the other was nimble enough to be able to get out the minute the tanks started rolling in Ukraine.
Hence our avoidance of a dedicated China fund. They have no choice but to invest in China, so are not able to sneak out if the mood music turns (even more) sour. This also means being careful with our selection of emerging market managers. China has grown to become a significant part of their benchmark, which is a real pain in the neck.
When a benchmark has no obviously big constituents, be that at the stock, industry or country level, it allows fund managers to move freely to where the best ideas are, without undue fear of underperforming if they miss one part that does well. But when one constituent becomes too large, many feel they have to invest in it, even if they’d rather not, as the career risk of missing out if it rallies is too high to bear. So this too means that many emerging market funds are effectively tied into China just as a dedicated China fund is.
We work hard to make sure most of our funds are willing and able to avoid Chinese stocks if they feel it’s the best thing to do. It’s also why we have sympathy with those managers launching ‘ex-China’ funds to remove this benchmark problem from the decision process.
The question is then, is investing in China the best thing to do, or should it be avoided? This is, sadly, one of those gnarly investment questions that can’t be answered in advance. Not confidently, anyway. It’s clear that the risks are material, particularly the possibility of an escalation of tensions with the west. But from talking with active managers who can buy China, it’s also clear that the company valuations in China are highly compelling.
So we’re comfortable with our fairly modest, and flexible, exposure to China. Our EM managers are a naturally risk-averse bunch, meaning they haven’t bought in blindly. So the companies they have bought are high quality and, we’d hope, carrying out the kind of uncontroversial, but necessary, activity that keeps them out of the Communist Party’s headlights. This feels to me the best way to walk the thin line between risks and reward in respect of China today.
Sean Taylor, CIO, Matthews Asia
Until recently, the main question on most investors’ minds about China was, will the market ever recover? That’s now changed to, is the recovery in Chinese equities sustainable? Since the end of the pandemic, Chinese equities have been under significant pressure, with each leg down proving to be a false bottom for investors. Geopolitics and regulatory interventions have hurt investor sentiment, while economic shocks, from Covid lockdowns and problems in the real estate market, have done real damage to domestic confidence.
Lately, there’s been more good news than bad. We’ve seen an uptick in economic indicators, an absence of geopolitical tensions and promising pro-business and pro-consumer policies. Chinese equities also remain cheap in relation to global peers and investors are still underweight to China. These factors have combined to improve the perceived risk/reward in the Chinese equity market, as evidenced by the 10% rally in Chinese equities since the start of the year.
To gain some visibility on how the rest of the year may pan out, it’s worth looking in a little more detail at what has changed in China’s economy and markets. Looking at the economy, it had a poor start to the year and, in terms of the market, this seemed to have the biggest impact on small-cap stocks, which experienced steep declines. As the year progressed, economic indicators have begun to look more robust and economists have started to increase their targets more in line with the Chinese government’s 2024 growth target of 5%.
At the government level, regulatory interventions have subsided somewhat while initiatives to stimulate the economy and support markets are becoming more encouraging. The government’s purchase of Rmb200bn ($27.6bn) of equities has, in effect, put a floor under the market. Also, a nine-point capital market reform plan, focusing on raising the quality of stock offerings and improving shareholder rights, has the potential to aid foreign sentiment, in our view.
In terms of the housing market, initiatives have been relatively modest. However, we think the recently announced plan to lower down-payment requirements for homebuyers and provide some $40bn of funding to help local governments buy up excess inventory from developers – and also plans to accelerate unfinished projects – could prove to be the start of a long process in balancing supply and demand and getting the confidence of buyers back. Although the support is still relatively limited, the direction is positive.
If these measures and others start to come through they could provide a significant upside driver for China equity valuations. But the key, we believe, is going to be earnings. In the offshore markets we are seeing companies, for example, in the technology, e-commerce and discretionary consumer space, improving their profits and revenues or at least lose less money on subsidies. In the mainland A-shares market, we’re not seeing the earnings turn yet but we expect that to come as the economy improves.
Overall, we think China has turned a corner. Headwinds remain of course. China has still to work through its real estate problems and, as ever, we have to contend with geopolitics. At the tail end of the year, we have the US presidential election and while we think the potential outcomes are being factored into valuations, we remain cognisant of avoiding companies and sectors that could find themselves negatively impacted.
With marginal year-over-year improvements in earnings expectations and stock multiples trading at a large discount to their February 2021 highs, investors are gaining confidence that current valuations provide a sufficient buffer against magnified or unforeseen risks. The starting position of cheap valuations, lower ownership and government support has been a positive one and, going forward, an improving economy and earnings growth give us cause to be cautiously optimistic on the outlook for China’s markets.
This story first appeared on our sister publication, PA adviser.
