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December 2020

2020 Review

The combination of the Covid-19 outbreak that appeared first in China with the confrontational approach adopted by the Trump administration on all matters relating to China led to a collision course that accelerated the path of history, in our views. The United States has spared no effort to openly inflict as much pain as possible on China, be it with more import tariffs, a ban on exports of US-designed technologies to Chinese chipmakers, a ban on imports of Huawei telecommunication equipment, or by restricting access to US public markets by Chinese corporates. In doing so, the United States succeeded in bringing on board several allies who may have underestimated the consequences of their decisions to follow the US rhetoric.

In return China doubled down with its uncompromising and forceful approach, paying no attention whatsoever to outside criticisms, pursuing its battle against Covid in the same unrelenting way as it managed its economy, its internal issues (Hong Kong, Xinjiang) and its relationships with its dissenting trading partners (Australia). The result is that all forms of internal contestation have been annihilated, foreign opinion towards China and the Chinese government is at record lows, while the pace of the post-Covid economic rebound stands out as a testimony of the success of its radical approach that left no room for public debate. 

There is no better way to assess the strength of the Chinese economy relative to the rest of the world in 2020 than by looking at its trade numbers: Despite two years of tariffs imposed on Chinese exports that were supposed to push manufacturers out of China, the trade surplus between China and the United States has never been as high as it is now. In other words, import tariffs set by the United States were totally useless, the only victims being American consumers. Chinese exports represented 14.8% of global exports in August 2020, an all-time high.

As the government overcame the spread of the pandemic only a few months after the initial outbreak in Wuhan, the Chinese manufacturing and supply chain competitive edge took the front stage. In the second half of 2020, as the rest of the world was paralysed by the pandemic, Chinese factories and cargo facilities were operating at full speed supplying the world with masks, ventilators and protective gears.  

China’s decision to keep on running a traditional monetary policy of positive real interest rates also made the country an outlier in a world dominated by quantitative easing and free money. It triggered a powerful rally in the RMB (alongside gold and bitcoins that are hedges against inflation and currency devaluation resulting from money printing) when at the same time the Chinese government opened widely its capital markets to foreign investors. The Bond Connect platform that allows foreign investors to get exposure to RMB denominated bonds keeps on attracting more and more capital from overseas investors, reaching USD3bn of daily turnover on average in 2020.

Foreign investment banks, fund managers, brokers, custodians, life insurance companies, credit card companies and rating agencies can now apply to set up majority-owned subsidiaries in China to conduct RMB business, effectively opening China’s USD50 trillion financial service industry to foreign players. It is now possible to apply for an American Express credit card in RMB in China.

The combination of a resilient economy with positive interest rates and a rising currency triggered a strong performance for Chinese equity markets in 2020. The CSI300 index that tracks down the largest companies listed in Shanghai and Shenzhen gained 27.2% in 2020.

The widening growth gap between China and other large economies (GDP growth is expected to have been +2.0% in China in 2020 vs -4.4% for the world, -7.6% for the European Union and -3.5% for the US – Source Bloomberg) was a direct consequence of the management of the pandemic, which can be best described as having been both efficient and authoritarian. It has led the UK-based Centre for Economics and Business Research to recently estimate that China will overtake the United States as the largest economy in the world in 2028, five years sooner than it expected just a year ago.

From a US perspective, it can only be a scary prediction. This is the reason why we do not anticipate any softening of the US approach towards China under a Biden administration, nor do we anticipate the Chinese government to accommodate criticisms anytime soon, either domestically or internationally. In other words, any idea of a possible return to the Obama era of the US and China cuddling each other is wishful thinking, in our views. We should be ready for more anti-China rhetoric from the US and more friction in return.

Outside of China the situation is more diverse. North Asia, i.e. Taiwan and Korea are doing well. The pandemic is by and large under control in these two places, and a vaccine will be soon widely available. The technology advance of Taiwan can be best assessed by Intel’s recent admission of failure in developing the same 7nm chips that Taiwan’s TSMC had been making since April 2018. It is not a coincidence that Korea and Taiwan joined China on the top of the list of the best performing stock markets in the world in 2020, Korea’s KOSPI index having gained 30.8% and the Taiwanese TAIEX index having gained 22.8%.

The situation unfortunately is different in South and South-East Asia where the pandemic is still raging. Widespread availability of a Covid vaccine will take many months in these countries as populations are vast, as GDP per capita remains low and as access to foreign supply sources will not be entertained in priority. The first half of 2021 will most likely still be driven by another succession of lockdowns and relaxation as new waves of contamination come and go.

In India, despite the Covid outbreak not being under control and remaining difficult to assess, the local equity market performed well in 2020, up 14.9% as measured by the Nifty index. This is the result of a strong economic rebound within a country where the activity is improving, where lockdowns are sporadic and difficult to enforce and where Covid-related statistics are patchy at best.

2021 OUTLOOK

We foresee the divergence in monetary policies between China and the rest of the world to last for at least a couple of years, pushing the RMB to higher levels in 2021 with little reaction to be expected from the Central government. This will attract further liquidity into China that is expected to keep on running an open-arm policy towards foreign investors.

The latest sign of such policy is coming from Brussels where a China-EU Comprehensive Agreement on investments was recently reached, pulling the rug below the United States feet in its effort to isolate China as much as it can. As mentioned above, tension between the US and China will likely remain high under a Biden administration.

We foresee the Chinese government tackling two structural issues it is facing in 2021. The first one is the excessive leverage of certain large property developers, with the enforcement of stringent rules under the supervision of the banking regulator. The second one is the cracking down of the abusive behaviour of dominant internet and e-commerce companies. Alibaba, Ant Group, Tencent, Meituan, Pinduoduo and a few others are under scrutiny, with Ant under intense pressure to restructure its operations following the recent derailing of its mega-IPO. We believe China can be as successful dealing with these structural issues as it had been in the past when it tackled shadow banking, unregulated P2P lending and the so-called property bubble driven by speculative buyers. This is a 2021 theme that may trigger rotation out of the Chinese internet behemoths in favour of cyclical and old economy sectors that had been underperforming during the pandemic.

We believe 2021 will be the year when the largest financial institutions in the world will set up their majority-owned operations in China, do business in China as well as sell their local expertise to the rest of the world. BlackRock, Citi, UBS, JP Morgan, Morgan Stanley, Goldman Sachs have recently taken advantage of the recent Chinese deregulation and done just that. This is China’s version of the Big Bang the City of London experienced in 1986. Vanguard and Fidelity are rumoured to follow soon. This should be beneficial to the Chinese equity and bond markets at a time when all index providers are increasing the relative weight of China in their indices.

We would not be surprised to see South East Asia outperform North Asia for the simple reason that the post-Covid economic recovery has not even started there. With the anticipation of a vaccine being made available in these countries in the second half of the year, markets could soon anticipate the impact of a re-opening of countries that depend so much on tourism, on the infusion of foreign capital and that had been laggards in 2020.

We anticipate India to become more proactive in 2021 than it had been in 2020 with its monetary and fiscal policies. The finance minister has already indicated that a deepening fiscal deficit would not be an obstacle to economic stimulation. With a repo rate currently at 4%, India has room to cut interest rates further assuming inflation remains under control. India and China typically tend to be inversely correlated with flows often moving from one to the other. An underperformance of China in a post-Covid world would be another reason to expect a good performance of India in 2021.

PORTFOLIO REVIEW

Looking back, 2020 must have been one of the most memorable years for money managers. We witnessed an unexpected spectacular bear-market slump in the first quarter triggered by a once-in-a-lifetime pandemic. The three consecutive quarters of bull-market rally that followed driven by the Chinese economy’s speedy recovery, by unprecedented liquidity injection by central banks and by fiscal support around the globe to fight the economic impact of Covid were equally surprising and seemingly unstoppable.

During the year, we made a few critical decisions in the management of our portfolios. ‘To remain fully invested’ was one of them. We also decided to boost the portfolio concentration by increasing core names’ average weighting and by reducing the weight gaps with the index behemoths. By doing so, we highlighted our highest conviction picks and at the same time we provided the funds with increased sectorial diversification and buffers to mitigate risks. We significantly slashed mega-cap benchmark exposure, i.e. the internet and technology stocks, and invested more in smaller high conviction names to generate alpha. We also initiated an ‘Opportunity Basket’ to accommodate relatively expensive stocks. We acknowledge that the recent years’ Central bank liquidity-driven bull run pushed valuation multiples beyond historical trading ranges for many stocks. This trend may not reverse anytime soon. We decided to carve out a portion of our portfolios, i.e. the ‘Opportunity Basket’ to embrace this ‘New Normal’.

Despite all these changes, our stock-picking criteria remains the same: To pick long term winners in the region with proven track records, clear competitive edges, sustainable growth upside and trustworthy and able management. The way we do our job remains mostly the same too. Even though we could not travel much in 2020 due to the pandemic, we significantly boosted our universe research depth by setting up dozens of company conference calls every month.

We will carry on with these principles in 2021.

ASIA PORTFOLIO

After a resilient month of January, the portfolio fell slightly behind the index in the following three months amid the sharp sell-off. Fortunately, the performance caught up quickly starting from May, laying a solid base to end 2020 more than 9% ahead of the benchmark, generating an absolute return for the full year of 31.7%.

The top five performance attributors in 2020 included Hangzhou Tigermed (+174% holding period return, or HPR, with a 3.3% average weight), Hansol Chemical (+97% HPR with a 4.2% average weight), Xinyi Glass (+146% HPR with a 1.7% average weight), SITC (+94% HPR with a 3.75% average weight) and Li Ning (+129% HPR with a 2% average weight). On the negative side, the bottom five performance attributors included Indusind Bank, Bank BTPN Syariah, China Jinmao, and BOC Aviation, which dropped by 42%, 11%, 19.8% and 19.5% during the holding period with 0.57%, 3.94%, 1.7% and 0.66% average weightings respectively. The fact that we did not own Nio, a Chinese electric car manufacturer that went up by 1112% with a 26bps average weight in the index, also hurt slightly.

As at the end of December 2019, we had 31 names in the portfolio. Fifteen of them that represented 39% of the portfolio at the start of the year did not make it to the end of 2020 due to our change of convictions. The portfolio had 27 stocks at the end of December 2020. The 16 names we kept throughout the year include four benchmark heavy-weights – Tencent, Alibaba, TSMC and Samsung Electronics. Their combined weighting was reduced from 21% at the start of 2020 to 9.5% at the end. The other twelve core names’ exposure got further boosted in 2020 to represent 48% of the portfolio at the end of December 2020 compared with 37% a year earlier. We are glad they contributed significantly to the absolute and relative performance. We added 11 names during the year, including two from India, one from Taiwan, one from South Korea, and two Chinese A-shares. These additions contributed positively to the performance of the fund, especially the addition of Li Ning, Xinyi Glass and Will Semiconductor.

CHINA PORTFOLIO

2020 was no doubt a tough year. Despite a resilient January, the portfolio did poorly in February and March in both relative and absolute terms, ending the first quarter down 13.7% and 3% behind the benchmark. The performance caught up gradually over the following quarters as the market turned, but it was not until December that the portfolio outperformed decisively the index, laying a solid base to end 2020 with a 8.3% full year outperformance over the benchmark and an absolute performance of 35.0%.

The top five performance attributors in 2020 included Hangzhou TigerMed (+174% holding period return, or HPR, with a 3.8% average weight), Xinyi Glass (+120% HPR with a 4% average weight), Li Ning (+131% HPR with a 4% average weight), SITC (+94% HPR with a 4.4% average weight) and our timely trimming of Alibaba prior to its recent market correction. On the negative side, the average cash weight of 8.9% was the biggest factor. Other bottom performance attributors included the fact that we did not own Nio, Pinduoduo and JD.COM, which gained 1112%, 3670%, 150% with 0.57%, 0.78%, 1.98% average benchmark weights respectively, and the poor performance of Jinmao, which dropped by 19% with a 2.2% average weight. 

At the end of December 2019, we had 23 names. Eleven of them representing 42% of the portfolio at that time did not make it to the end of 2020 due to our change of convictions. We also had 23 stocks at the end of 2020. The 12 names that we kept include three large benchmark names – Tencent, Alibaba and China Merchant Bank. Their combined weighting was reduced from 21.4% to 15.6% over the past twelve months. The other nine core names saw their combined weighting in the portfolio boosted in 2020, from 31% to 43% over the past twelve months. They contributed very significantly to the absolute and relative performance of the fund. We added eleven names during the past year, five core names and six names that fit into the Opportunity Basket. We are happy with these trades overall, especially the addition of Bilibili and Will Semiconductor that performed exceptionally well.

The information and material provided herein do not in any case represent advice, offer, sollicitation or recommendation to invest in specific investments. The information contained herein is issued by JK Capital Management Limited. To the best of its knowledge and belief, JK Capital Management Limited considers the information contained herein is accurate as at the date of publication. However, no warranty is given on the accuracy, adequacy or completeness of the information. Neither JK Capital Management Limited, nor its affiliates, directors and employees assumes any liabilities (including any third party liability) in respect of any errors or omissions on this report. Under no circumstances should this information or any part of it be copied, reproduced or redistributed. 

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