At the start of February, Wall Street analysts Renaissance Macro reported a clear ‘capitulation signal’ in the Chinese market. At the time, this analysis looked optimistic. Outflows continued from the Chinese market, there were no signs of an improvement in the economic outlook and investors remained thoroughly disillusioned. However, their analysis proved prescient. After three years of dismal returns, green shoots have started to emerge.
It is very early days, but over the past month, the IA China/Greater China sector is up 3.5%. This compares to a decline in the India sector of 3.5%. This suggests that some parts of the country’s stockmarket are starting to fire up. There are other tentative signs of a shift. Net retail sales from the sector dwindled to £25m in February, less than half of January’s levels. Discount levels on investment trusts have also moved in from historically wide levels.
There appear to be some signs of improvement in the country’s economy. The country’s GDP figure grew faster than expected in first quarter of 2024, rising 5.3% versus a Reuters’ poll showing consensus expectations of 4.6%. The government has brought in selected stimulus measures, which are driving growth, even if the hoped-for ‘big bazooka’ remains elusive.
Fund managers also appear increasingly optimistic, given low valuations and stronger growth prospects. James Donald, head of emerging markets, Lazard Asset Management, says: “I don’t want to sidestep some of the risks, such as China’s relationship with Taiwan. However, if it doesn’t materialise, there is every chance that China will be one of the best stockmarkets in the next five to 10 years.
“We’re now in a position where the Chinese market is probably the most hated in the world. There are some highly profitable, fantastic businesses that we couldn’t get close to buying three or four years ago, now they’re value stocks.” Across the Lazard funds, it is the first time they’ve had index-level exposure in recent history.
Dale Nicholls, manager of the Fidelity China Special Situations fund, says he has dialled up the gearing on the trust and it now sits at over 20%. “At a time when the market is cheap, sentiment is bad and there’s lots of opportunity, gearing will be higher. That’s where we are now.”
Ongoing problems
That said, no-one downplays the very real challenges that the Chinese economy faces. Xavier Hovasse, head of emerging equities at Carmignac, says: “The top down story for China is quite ugly. The property market is a disaster; they have over-built and inventories are very high. The population is shrinking; while data is difficult to obtain, it seems that the number of babies born has shrunk from 18 million to 10-11 million.”
Donald says the real estate sector is still six or seven years away from being a contributor to the economy. Foreign direct investment is likely to be weak, given ongoing geopolitical tensions. He adds: “It comes down to the consumer. The consumer has a lot in the bank, but they’re very pessimistic.”
There are some signs of life for the consumer. Domestic travel is improving, for example. During the Chinese New Year festival in mid-February, the country’s Ministry of Culture and Tourism reported an estimated 474 million domestic travel trips. This was a 34% increase over the previous year and is a first step for Chinese consumers in starting to spend again. However, few managers are expecting consumer spending to reignite with any vigour.
Valuation anomalies
The real appeal in the Chinese market remains the low valuations. Hovasse says: “It’s the most inefficient market. There are constant booms and busts.” He says he continues to find all sorts of anomalies in the Chinese market, including an education company where the shares dropped 95% because the government said it couldn’t make a profit on one of its businesses. “It was worth a third of its net cash and its other two businesses were still contributing to cash flow. This is deep, deep, deep value.”
Nicholls also highlights these sorts of opportunities. One of his portfolio companies paid out 70% of its market capitalisation as a special dividend in 2023. He points out that net issuance has been a drag on returns from the Chinese market, creating excess supply that has needed to be digested, but Chinese companies are learning their lessons: “That mindset around capital return to shareholders is really changing. That dilution will improve and could go negative in 2024.”
He believes that many companies have prioritised ‘land grab’, but clearer market structures are now emerging, giving more capacity to pay money back to shareholders. They are encouraging management teams to adopt buybacks: “We’re focused on our engagement with company. If we’re not going to get paid by the market, we’d like to be paid by the companies.”
Geopolitics
Geopolitics has been a major factor in China’s weakness and this remains a concern in spite of thawing relations with the US. The US election is likely to bring continued rhetoric on China, with both Democrats and Republicans talking tough.
However, in general, fund managers do not see a confrontation over Taiwan as a key risk. Hovasse says the Chinese government has shown restraint over Taiwan. It had been assumed that China would support Putin in its invasion of Ukraine, he says, but that support has not materialised to any significant degree. He adds: “The reaction of the Western world was not expected to be that harsh. Putin wouldn’t have bought hundreds of millions of US and European bonds if had anticipated the response. Even if Jinping thought about invading Taiwan, the reaction of the west to Russia probably makes it less likely. It would be irrational and a disaster for the domestic economy.”
All fund managers recognise that there are still some difficult areas of the market. The auto space, for example, is a difficult area. Real estate remains tough. Hovasse and Nicholls both say it is vitally important to have a capable analyst team to sieve through the markets. There are still plenty of companies that are only quasi private and investors need to be careful that their interests are being looked after.
It has been a long and difficult road for the Chinese market. Any turnaround is unlikely to be instant or linear. However, the valuation anomalies seen in Chinese markets, some thawing on geopolitics, and marginally stronger growth may be the start of a shift.
