Written by John Pellegry, Product Director, Invesco
The China Rally
No one will have missed China’s re-opening story. The MSCI China index is up 50% since the trough in October last year. As it turns out, China is not Russia and investors were wrong to panic.
The drip of positive news coming out of China is a sea change from 3-6 months ago as discussed in Fiona Yang’s (Fund Manager) well-timed blog: China Reopening update. Moving from Zero-Covid to herd immunity; supportive measures for the property sector; warm words and approval of licenses for the internet companies; détente with Australia; the list goes on… Recent quotes from our Teams chat include: “it’s all happening”, from James McDermottroe (Deputy Fund Manager); and, “too much good news for me to handle!” from Will Lam (Co-Head of Asia & EM Equities), during a well-deserved break pondering what the next contrarian opportunity might be!
We believe we have consistently added value in HK/China in the Asian and Emerging Markets Equities strategies by avoiding frothy areas and in the recent bounce from the trough by owning a good mix of underappreciated names whether ‘growth’ or ‘value’.
The Asian and Emerging Markets Equities strategies are all underweight their respective benchmarks for the most expensive market, India, which has added value given its recent poor performance, while Indonesia has also bore the brunt of renewed interest towards China. Great timing for fund managers Ian Hargreaves and Fiona Yang, who are currently in Indonesia meeting companies.
Being there before it happens
One of the strengths of contrarian investing is a deep-rooted awareness of underpriced value and to capture it before others do.
Finding value in China was not predicated on what has been dubbed ‘the mother of U-turns’, which caught everyone by surprise including ourselves. The real question was whether the Zero-Covid policy was tenable over a 3-5-year investment horizon. We thought not. We argued that expectations embedded in valuations were too low for many Chinese companies as the overall market edged towards book value.
We increased our active exposure to China by around 12% over the course of 18 months, going from a significant underweight to a slight overweight. Indeed, our approach is to lean into risk because markets don’t tend to reward investors for certainty and what feels comfortable.
In that sense, a contrarian approach is not about predicting the future, it’s about capitalising on excessive negativity. This approach can be especially rewarding at inflection points like these.
What next for China?
Despite the sharp rally, we still see value in China. The market is essentially back to where it was mid-2022. The earnings outlook for companies in China has fundamentally improved and there is plenty of scope for positive surprises which can validate a re-rating towards historical average levels. The market is still 45% away from the historical average P/B of 1.9x (Source Bloomberg 31st December 2022)
There is pent-up demand for goods and services. Chinese households have accumulated a lot of savings, estimated at 30% of disposable income compared to the typical 10-15% (Source: Goldman Sachs, WIND, PBOC as of 20 January 2023). If 2019 demand was a roughly ‘normal’ year then demand in say H2 2023 may be super-normal, which could see some positive surprises. This bodes well for the consumer sector, which accounts for a significant portion of our China exposure in our strategies and which we have been adding, including China A-shares.
We are beginning to see the effects of a more benign regulatory environment for large internet companies – and are selectively overweight leading e-commerce and online media platforms.
While some exuberance over the shift in policy is palpable, the reality on the ground is still very challenging and it remains to be seen how infections during the Lunar New Year migration affect public and corporate behaviour.
As one client put it “we’re looking for evidence of a recovery before committing money”. With investors still digesting the swift turn of events in China but also concerned about a US recession, markets may be choppy and offer good entry points at the stock level over the course of 2023. The rest of Asia can benefit indirectly from China’s reopening as the centre of gravity in the region.
What next for the rest of Asia and EM?
It is difficult to overstate China’s influence on the region and the wider emerging markets. 60% of China’s trade is intra-Asia and China’s pull on commodities demand remains strong at the margin without relying on a resumption of debt-fuelled capital spending which is unlikely.
Chinese tourists represented 20% of international tourism spending according to pre-pandemic estimates. According to data from Ctrip – the Chinese travel platform – travel bookings by Chinese tourists over the last couple of weeks for Southeast Asia has increased 10-fold compared to a year ago, particularly for Thailand, Singapore and Indonesia. The Tourism Authority of Thailand are expecting 300,000 Chinese tourists in Q1 alone. Other major Asian destinations include Macau, Hong Kong, Taiwan and Australia. This is encouraging at a time when advanced economies are slowing.
China’s closest trading partners such as Korea and Taiwan in our opinion are set to benefit, and valuations there where we believe have become attractive thanks to the imminent fall in price for semiconductor companies (in our opinion) – the point at which the upside potential is greatest – so we have been adding.
The pick-up in pro-growth policies, intra-Asian trade, and tourism we believe should also support domestic demand in the rest of Asia – we are overweight financials, especially insurance companies, and auto-related businesses in Korea and Indonesia.
Many non-Asia emerging markets such as Brazil and other oil producing nations have lagged the recent rally, reversing some of their earlier strong performance. Opportunities are now emerging in Latam where we have been adding.
The Asia and EM underperformance is long in the tooth. Over a decade. Although this was justifiably driven by lower earnings growth compared to US equities when denominated in US-dollars, this may change. US-dollar strength is being challenged by an imminent recession in the US to root out inflation. While inflation in the US may be stickier than expected it is declining, which may lead to an easing of financial conditions at a time when Asia is recovering. Inflation is less of an issue in Asia which provides some policy flexibility. Finally, the China reopening puts a floor on the economic and earnings growth downgrades seen in 2022 – we believe a narrowing of the valuation may be on the cards.
Conclusion: Our portfolios have benefited from the China rebound across all of our strategies but it’s not the only game in town – the rest of Asia and EM have scope to benefit and surprise positively.