In this brief note, we analyse what’s been happening in China using a question-and-answer format.
What are the key facts?
There have been a lot of developments recently, most of them positive. Nevertheless, a couple of well-used cliches still epitomise the underlying level of investor skittishness.
Investors are taking a “glass-half-empty” approach to ministerial briefings and remain quick to “jump at shadows” whenever a new development occurs.
We’ve been endeavouring to tune out the distractions and focus on the facts. Here are the key facts as we see them:
Investors are underweight China
On October 1, the Financial Times reported:
“A monthly survey of global fund managers by Bank of America showed that in September, being short or negative on Chinese stocks was seen as the second-most crowded trade in the world, behind buying the so-called Magnificent Seven tech stocks that have driven US markets to record highs this year.”
Chinese stocks are cheap
Chinese stocks have significantly outperformed those of other Asian markets this year. Nevertheless, Chinese stocks, particularly those listed in Hong Kong, are relatively cheap.
The following chart shows the median one-year forward PE for stocks (covered by at least 3 analysts with turnover greater than $US1m per day) listed in our key markets.
Chart 1: Median 1Y Forward PE in Asia Source: OQFM
Stocks listed in Hong Kong have a median forward P/E ratio just above 10, slightly below the level in Korea. We excluded India from this chart because this market is not in our stock universe. If we were to include India, we would need to significantly expand the y-axis scale, as it is far and away the most expensive market in the region.
The Chinese government is serious about reviving the property market, the stock market, and the economy
There will be a lot of noise over the next few weeks as investors analyse policy announcements. However, the underlying intent is clear: the Chinese government is focused on stimulating the economy and addressing impediments to growth, notably the weak property market.
This is not to say, there won’t be some underwhelming announcements, especially given expectations are high. However, we are encouraged by the number of initiatives being announced. Friday’s announcement by the People’s Bank of China to support the stock market via share buyback and re-lending facilities is the latest of numerous announcements made over the last few weeks.
It should also be noted that China is currently grappling with deflation, which enables the easing of monetary policy. While the government's reluctance to engage in quantitative easing limits its options, the recent decision to issue “special treasury bonds” effectively achieves a similar result. The remedy for deflation typically involves lower interest rates and increased money supply, which generally benefits the stock market.
Some investors will likely always be bearish on China
On September 30, a Bloomberg news story with the headline “Lombard Odier Dumped Entire China Allocation, Won’t Buy Rebound”. The story quoted the firm’s CIO who “eliminated all China assets” in November last year and gloated it worked “tremendously well”.
Investors are often reluctant to abandon a strategy that has proven successful, such as being net short or underweight China, due to a significant behavioural bias.
There are also sound reasons to avoid Chinese equities. The most recent edition of The Economist included a very negative article on Chinese stocks citing “poor corporate governance, a high share of state-owned firms and the government’s habit of blindsiding investors with policy shifts”. The article did not mention stock valuations; however, we believe these risks are fully priced into the market.
One risk that is difficult to quantify is geopolitical risk. In particular, tensions between China and Taiwan are likely to persist, and there is always the threat of escalation.
Furthermore, prejudices likely influence sentiment towards China, perhaps subconsciously. This is likely to continue.
How has the fund performed this month?
The fund has continued to perform strongly in October. Our Chinese positions have performed particularly well.
Are there similarities between Japan in the 1990s and China now?
There is lots of chatter about China’s potential “Japanification”. This is mainly predicated on poor demographics, high debt, and an overvalued property market.
While it’s true that China’s economy faces the same challenges that Japan has been grappling with over the last three decades, there’s a huge difference from an investment perspective: Chinese equities are currently cheap while Japanese equities were experiencing one of the biggest financial market bubbles of all time.
The following extract is from Man Group’s website:
“In 1989, the market boom led to Japan accounting for 37% of global stocks by market cap. The Nikkei 225, was trading at 60 times its earnings over the trailing 12 months, and it had an above 8 times Price to Book ratio”.
Simply put, Japanese equities were priced with expectations of significant growth and favourable developments. In contrast, Chinese equities are priced as if anticipating a sustained economic downturn. This is a big difference and, in our view, makes any market comparisons between China now and Japan in the 1990s meaningless.
How are we positioned in China?
As we’ve previously documented, we take a holistic approach to analysing our exposure to China. Our analysis encompasses our Chinese stocks, Hong Kong-listed stocks, Chinese ADRs, and stocks with China exposure listed elsewhere in Asia (excluding China and Hong Kong).
In the comprehensive report we wrote recently, we included mispricing anomalies we’re seeking to exploit in China:
Long H-shares and short A-shares with a positive carry
Long deeply discounted H-shares
Long H-shares and short stocks exposed to Chinese demand and/or supply chains listed in Asia ex-China.
This report proved to be very prescient, and we still believe this positioning is appropriate.
In addition, we have recently adjusted our exposure to stocks which will potentially be impacted by the imposition of tariffs and reduced our net exposure to momentum factors, as described below.
Short Chinese manufacturers exposed to tariffs
Donald Trump, the self-proclaimed “Tariff Man”, has proposed a 60% tariff on imports from China. He’s also proposed tariffs on all imports, regardless of their origin, but at a lower level, probably around 10%.
There is some debate as to whether this is a negotiating ploy and whether Trump could impose tariffs without Congress’s support, but we believe the threat is real.
Recently, we prepared a list of stocks that would be impacted by punitive tariffs with the intention of taking a neutral or a net short position within this cohort. Normally, when we embark on this type of risk positioning, it’s a challenging process because we have to sell stocks that appear attractive and/or buy stocks that seem unattractive based on our quant process. In this instance, however, we were already net short these stocks.
As the election has drawn closer and the odds of a Trump victory have improved, we have slightly increased our net short exposure to these stocks.
Net short momentum factors
Typically, we are slightly net long winners over the past two years and net short losers over the same time-period. In Hong Kong, we have recently adjusted our momentum exposure to a net short position on 2-year momentum.
This adjustment was made primarily by covering our short positions in stocks that have underperformed over the last two years but have recently outperformed following a reversal in investor sentiment. We believe these stocks may continue to outperform if the market rally sustains.
How severe is the anti-China sentiment?
In a world where partisanship is becoming increasingly pronounced, adopting an anti-China stance is the exception. It's the one issue that seems to unite people across the political spectrum.
There are numerous examples of this, particularly from the US election campaign, where politicians compete to show who is the toughest on China.
However, my favourite example of anti-China sentiment comes from the country of my birth: Australia. I find this interesting, given the Australian economy has been a huge beneficiary of China's rise from extreme poverty to an economic superpower over the last four decades.
In September 2021, Kimberly Kitching, a senator from the Australian Labor Party (the mainstream left-wing political party), complained about Australian funds having investments in Chinese stocks, specifically citing Tencent. The following extract is from The Australian newspaper.
“There are three reasons why Australian investors and fund managers need to ask themselves some tough questions. They need to ask whether their money is safe there in a country where the state can confiscate any asset at any time,” she told The Australian.
“They need to ask whether they are enabling human rights abuses in Xinjiang, Hong Kong and Tibet.
“And, they need to ask whether they are supporting a regime that seems to be more and more hostile in its rhetoric aimed at neighbours, at our region and at our values. History teaches us to take threats from authoritarian regimes very seriously.”
Personally, as an Australian fund manager who has numerous positions in Chinese stocks, I was astounded by this view. However, I probably shouldn’t have been surprised. As The Economist reported in May 2021, this type of “pinko paranoia plays to a xenophobic, racist undercurrent that has long run through Australian life”.
What’s the outlook?
We believe the portfolio is appropriately positioned with respect to our exposure to China.
It's remarkable that there are currently A-H pairs where the H-share offers a superior dividend yield, and the difference in dividend yield exceeds the current cost of borrowing, thus generating a positive carry. We are also confident in our long positions on H-shares which we believe are unjustifiably cheap both in absolute terms and relative to their A-share listings.
As with all mispricing anomalies, particularly in the current market environment, they may persist for some time. However, we are hopeful that the recent reversal in investor sentiment will act as a catalyst for these anomalies in China to unwind.
We also believe that taking a net short position in stocks dependent on Chinese demand and/or Chinese supply chains, which are not priced as low as the distressed levels seen in Chinese stocks listed in Hong Kong, is a smart and appropriate way to hedge our overall China exposure.
Regarding the US election, we believe the biggest risk (to our China portfolio) is punitive tariffs, and that we’re appropriately positioned should this risk materialise.
Finally, we note that we have done a good job generating alpha across our broad universe of Chinese stocks during periods of investor pessimism and, the more recent, reversal in investor sentiment. We are optimistic that this success will continue.
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