How can investors crack China’s unbreakable code? Darius McDermott, managing director, Fund Calibre takes a view
I’m sure most of you would’ve watched The Imitation Game at some point in the past few years. For those that haven’t, the film stars Benedict Cumberbatch as Alan Turing, the mathematician, computer scientist and cryptanalyst, who heads a team tasked with trying to break the Enigma machine, which the Nazis used to send coded messages during the Second World War.
Enigma was deemed to be unbreakable – because at midnight its codes would change, meaning the team would often have to start again.
I won’t ruin the end of the film but having watched it again a few weeks ago it did remind me a bit of the conundrum facing investors in China at the moment – because every time you think you have a grasp of the economy, the government changes the landscape overnight.
Last year was an annus horribilis for anyone investing in China, following a regulatory crackdown by the Chinese government that adversely affected companies in sectors such as technology and property. The average China equity fund lost 10.7 per cent during 2021, while the MSCI China fell 21 per cent**.
The year ahead also looks mixed – China is turning more accommodative in its policies, but new Covid variants and persistent inflation remain key risks. So, can the market return to its previous successes?
Clearly there are dangers. The first is geopolitical risk, which is rife, with China threatening the US’ supremacy as the world’s leading superpower – the latter will not take that lying down and is already looking to limit China’s growing military power and push sanctions onto China following the Trade War.
We have also to consider the bursting of China’s property bubble – history suggests recession is imminent when this happens. Property accounts for around 80 per cent of Chinese household wealth, which compares with the likes of Tokyo at 65 per cent in 1989*** – the bubble has been deflating there ever since!
You must also prepare for the unexpected. Anyone who is risk averse is making a Faustian Bargain when they invest in a country with such an overbearing state. We saw this with the ‘Common Prosperity’ goal last year, but it was not the first time the government caught the market out. If your company ends up in the firing line, so be it – as technology, gaming and education stocks all found out.
However, the opportunity is also every bit as compelling, particularly as investors continue to de-risk from the region. We know the rapid growth of the middle class – as it moves to a consumption-led economy – is a long-term tailwind for Chinese equities.
Simply put, the market is significantly cheaper. As Fidelity China Special Situations manager Dale Nicholls points out, some stocks with lesser regulatory risk have also been sold off. For example, many smaller companies have fallen despite the fact they will actually be beneficiaries of regulatory action in areas like anti-trust. He also says the valuation gap versus global peers is now excessive, despite similar regulatory challenges in several markets****.
There’s a strong argument we’ve already seen the worst of the regulatory tightening from the Chinese government – and we have seen these types of actions before, for example in the online gaming sector in 2018. Ultimately the Chinese government will want a robust private sector and foreign investment to help it reach its long-term economic goals.
Nicholls also highlights the differing approaches to monetary policy between China and the west. He says: “China is certainly at a different stage in the cycle with an easing bias, that history shows often supports markets. Having approached the initial Covid-19 pandemic differently to the loose monetary policy of western governments, China’s central bank has more levers to pull to encourage growth after the slowdown of 2021.”****
We have also to consider the potential of A-Shares, a relatively new story to retail investors globally. They open the door to a huge number of untapped opportunities across the entire market and are also significantly uncorrelated to global equities.
To me China looks a good, long-term opportunity – you just need to prepare for major bumps on that journey.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
*Source: FE fundinfo, total returns in sterling, calendar year 2021 for the IA China/Greater
**Source: FE fundinfo, MSCI China, total returns in sterling, calendar year 2021
***Source: FSSA Investment Managers – Can China claw back performance in the year of the Tiger – February 2022
****Source: Fidelity – Three reasons why China could roar in the year of the Tiger – January 2022
This article was first published in the May 2022 issue of Professional Paraplanner.
[Main image: 5h_dMuX_7RE-unsplash]
