The Chinese year of the Dragon begins tomorrow, 10 February 2024. Dragons are associated with prosperity and abundance. This has been conspicuously absent from 2023’s year of the Rabbit, which has delivered a combination of volatile geopolitics, domestic economic weakness and unwelcome regulation. Chinese markets are now the ultimate contrarian investment option. Can they revive in the year ahead?
The four trusts in the AIC China sector are down between 44% and 71% over the past three years and the sector remains widely unloved. The four trusts may soon become three if the proposed merger of abrdn China with Fidelity China Special Situations goes ahead. China is one of the few stock markets that hasn’t participated in the rally since the start of November. The only bright spot has been the country’s state-owned enterprises, which benefited from a government initiative to boost productivity and shareholder returns, but this is not where active fund managers tend to ply their trade.
Nevertheless, the Chinese market now looks very cheap and the question is whether this pessimism has gone too far. Dale Nicholls, manager of Fidelity China Special Situations says: “Valuations in the Chinese equity market remain compelling both in historical terms and compared with some other major markets. Clearly, a lot of pessimism over the economy appears priced into valuations.” James Thom, manager on the abrdn Asia Dragon fund, agrees: “China is cheap and arguably over-sold. We know that it is a market dominated by retail flows and those retail flows can over-shoot.”
The economy
It is worth noting that the market has been cheap for some time, and has kept getting cheaper. By itself, it may not be a catalyst for an improvement. Any improvement in the economic data would help, but the early signs of improvement haven’t necessarily made an impact. January PMI data showed China’s manufacturing sector continuing to expand, with firms signalling sustained increases in both output and new orders[1]. The services sector also continues to grow, albeit at a slower pace than in recent months[2]. The IMF forecast growth of 4.6% in 2024 and 4.1% in 2025.
Ben Buckler, client services director at Baillie Gifford, says that consumption remains weak, and people are still adjusting to life post-Covid: “A year ago we all expected China to emerge from Covid and have a big party. Instead, it has been quite subdued. The lockdowns were invasive for the individual and invasive for private enterprises.” He says that consumers are starting to spend again, but not quick enough for the markets.
Consumption has also been held back by the property market, which has been in a downturn for around three years. Rebecca Jiang, a manager on the JPMorgan China Income & Growth Trust, says: “What started as self-inflicted correction, with the government imposing a deleverage campaign on property developers, has become a full-scale downcycle. Property prices have fallen 20% from the peak.”
Thom says investors shouldn’t underestimate the impact of this weakness: “It’s such a large part of the Chinese economy and it has such a large wealth effect for the broader population. The longer that it remains in difficulty, the longer consumer sentiment remains weak. We have seen incidents where people have bought off-plan, paid a deposit and then construction has stalled. Buyers are left in limbo, having put a large part of their savings into this deposit. The wealth effect is unwound very quickly.”
An improvement in the property market would be the first stage in any turnaround. This may be happening already. Jiang points out that China is no longer adding to the problem. It is not building more properties than people need, and the market is slowly digesting the inventories that it has sold over the past five years. The government has implemented various measures including lower mortgage requirements and support for property developers.
Nicholls says that despite sluggish economic activity, the overall trend still points towards a continued recovery in growth: “Additional measures to boost both supply and demand in the sector may be required, but a substantial amount of household savings – accumulated recently for security – sets the stage for an upswing in consumer spending once confidence is restored.” Jiang points out that it is still a growing economy with lots of opportunities. “China has been gaining market share in global trade, even with all the talk around decoupling and deglobalisation.”
Company strength
This should be an environment in which the strongest companies can thrive. While investors tend to think of the Chinese market in terms of sclerotic state-owned enterprises, and giant internet companies, there are a wealth of innovative companies. China remains a leader in areas such as environmental technology and electric cars. It is on the cusp of building its own next-generation semiconductor.
Buckler says this creates opportunities across the value chain: “China is very clear that for national security reasons, it needs to create self-sufficiency in semiconductors. We hold Silergy and SG Micro. While they’ve been hurt this year because of weaker cyclical demand these companies have also committed to long-term R&D, which has hurt earnings. We like the commitment to long-term growth, but the market doesn’t.”
There are also opportunities in artificial intelligence. The JPMorgan trust holds Foxconn Industrial internet, best-known as a supplier to Apple, but whose most valuable assets are in data centres and high-powered computing, which help drive the AI revolution. It also holds Sunresin, which specialises in industrial-use purification resins used by global drugs companies.
In general, Nicholls believes the worst is over for corporate earnings and a recovery could be a key driver for investor confidence to come back. However, selectivity will still be very important. Even if the Chinese economy starts to put some of its problems behind it, there are still structural difficulties that investors need to side-step.
There are other factors that may improve sentiment towards Chinese markets. Relations between China and the US have been quietly improving, with the two sides meeting in meeting in November for an inconclusive, but symbolic meeting. Government interference in areas such as social media has been difficult, but arguably necessary to manage the competitive landscape effectively. This interference appears to be easing, with the government recognising the importance of innovation in driving economic growth.
Admittedly, these arguments were being made a year ago, but short-term rallies such as that in January last year show that investors haven’t given up completely. Buckler says the long-term story remains sound: “It’s still the second largest economy and the second largest stock market. It is under-represented and under-appreciated. There is still an emerging middle-class and burgeoning consumption trend. Investors tend to focus on the problems rather than China’s strengths.”
[1] https://www.pmi.spglobal.com/Public/Home/PressRelease/5dc7af8ed9ca447a8e60dfdff1ced82a
[2] https://www.caixinglobal.com/2024-02-05/china-services-activity-maintains-growth-but-at-slower-pace-caixin-pmi-shows-102163240.html