Q What could 2020 hold for Chinese equities?
Geopolitical and macro noise surrounding the asset class in 2019 is likely to persist in 2020, as these headwinds continue. This has driven some short-term volatility in Chinese equities, but when looking at the year so far the MSCI China Index is up 7.6%, while the MSCI China A Onshore Index is up 24.6%.1
This is despite a backdrop of disappointing economic data, such as exports and industrial production figures. Looking forward to 2020, however, we can already see some signs of the economy bottoming out. Manufacturing data, for example, incrementally improved in September. Investors can also feel some reassurance that globally central banks are easing. In China, we are seeing selective easing, both on the monetary and fiscal side, but in a very controlled manner.
Q What are the fundamentals indicating for Chinese equities?
When looking at the two countries engaged in a trade war, they have something in common. Taking into account first-half earnings and the run rate globally,2 both the US and China stand out as being ahead of run rate. This feels counter-intuitive, but highlights the fact that China isn’t significantly dependent on exports, both from a domestic economic growth and corporate earnings perspective.
Companies have been reporting better-than-expected earnings for two consecutive quarters now. Where there have been downgrades, the pace of these has slowed. Moreover, valuations are quite cheap and trading below their long-term average. The market is trading at around 12.9 times on a price-to-earnings basis on this year’s earnings and 11 times on next year’s.
Q Where are you finding opportunities in Chinese equities?
Accessing long-term structural trends like the ongoing premiumisation enacted by the Chinese consumer. The evolving middle class is expanding, with incomes growing at around 5% to 6% annually. The consumer is upgrading to more premium products and brands, while there is also a big shift to domestic Chinese brands. This enables companies in the consumer staples and discretionary sectors to earn higher margins on such products or brands.
Another beneficiary of this trend is appliance companies, where we hold a number of names that sell large appliances to the Chinese consumer. Other companies we find attractive are digital pioneers sitting in the media and entertainment sector, but whose sphere of influence extends across other industries.
There is also upside potential to be captured from industry consolidation. As growth has slowed, the number of competitors within various industries has increased. We are seeing bigger, more successful companies that have superior brands and better management teams growing their market share, while smaller companies with poor quality product that are badly managed are exiting the industry. So it is very much an environment conducive for stock-pickers.
Q Where are the risks for investors in Chinese equities?
A key risk for 2020 and beyond is the realignment of the relationship between China and the US and how the trade tensions progress. In our view, currently the direct impact upon the companies that we invest in is limited, but if, for example, the US continues to put more Chinese technology companies on restricted lists, it could have further implications. This should be considered in light of China’s own moves towards achieving technological prowess, as shown by the launch of the Nasdaq-style STAR board to encourage more Chinese companies to come back home and list onshore.
While China may be decoupling from the US, global economic growth expectations and investor sentiment in response to this will impact China. So whether we have a global recession in 2020 or at some point thereafter, there would be contagion for the perceived-to-be riskier asset classes like Chinese equities.
Lastly, a potential risk is around domestic reform progress in China, which includes state-owned enterprise (SOEs) reform as well as the clean-up within the banking industry. If appetite wanes for that, this will have longer-term risks and implications for the economy. However, we believe progress will continue under President Xi.
Chinese equities are one of those asset classes where there is always going to be some controversy, whether it is trade wars or domestic reform. For 4Factor, what is key is to focus on bottom-up investing, assessing company fundamentals and selecting the winners that can excel through change or restructuring.
Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
All investments carry the risk of capital loss.
1 As at 30 September 2019.
2 The run rate refers to the financial performance of a company based on using current financial information as a predictor of future performance.