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December 2022

2022 REVIEW

2022 is a year that investors around the world will find difficult to forget. The invasion of Ukraine by Russia in the first quarter, the impact it had on commodities prices, on inflation globally and on interest rates, the ever-rising tensions between the United States and China, and the successive lockdowns of Chinese cities under the zero-Covid policy with the resulting disruptions of global supply chains were obstacles that made the year look like a never-ending purgatory.

One of the main take-aways of 2022 is, in our view, how wrong most economists were when predicting earlier that we had entered an era of sustainable zero inflation. The consequences of the invasion of Ukraine in February and of the zero-Covid policy of China highlighted how unprepared the world was when the inflation tsunami hit and how risky it was for corporates to rely on one single country for critical supplies. It will likely have long term consequences for supply chains across Asia.

The fear of an upcoming recession in the west fuelled by soaring interest rates triggered a steep correction of technology stocks around the world. Overcapacity in logic chips, memory chips and all kinds of passive components started to appear early in the year as demand for smartphones and computing devices dwindled, leading to a derating of the entire sector. Tensions over the summer around Taiwan where most semiconductors are manufactured which led to a live rehearsal of a maritime blockade of the island by China certainly did not help as a hot war between the United States and China suddenly became a possible scenario. Korea and Taiwan markets did not perform well in 2022 as a result.

Tensions between the US and China reached an unprecedented level as the US Congress and the White House repeatedly imposed sanctions on Chinese chipmakers and on their suppliers, local and foreign, in effect preventing China from developing or buying from third parties the advanced chips that are critical to its technology and military development. A new type of cold war may have started as a result in 2022 and there is no reason to believe that it will abate anytime soon. Any investment within the Asian technology sector needs to take into consideration this new paradigm.

The commodity spike in the first half of the year combined with a reopening of the world to tourism (with the notable exception of China) had beneficial impacts for many countries around Asia, including Indonesia and Malaysia that benefitted from rising crude oil, palm oil and thermal coal prices, as well as the tourism-driven economy of Thailand. The commodity boom may have already run its course, but the rebound in tourism certainly has not.

The steep rise of interest rates in the United States had a negative impact on many Asian currencies as the US dollar kept on rising for most of the year, pulling institutional money out of Asian equity markets as the risk/return profile offered by US Treasuries became all of a sudden a magnet for liquidity. It was a major headwind for emerging markets in 2022, especially across Asia.

2022 was also the year when the three-year zero-Covid policy of China suddenly crumbled under the rapid spread of the latest variants, under the unbearable economic impact such policy has had, and under people’s pressure as Chinese citizens could no longer take it. After three years of a whack-a-mole strategy implemented by the Chinese government to eliminate the virus which led to ruthless lockdowns and to brutal measures, especially in Shanghai over a period of two months, the Chinese government suddenly abandoned the fight in November and embarked in the reopening of the country without any form of advanced preparation, a low vaccination rate among the elderly and limited supplies of analgesic and antipyretic drugs. Historians will likely debate for years about the underlying motivations and ultimate demise of this self-destructive policy that confounded observers round the world. The zero-Covid policy of China and its impact on the economy had been the main reason for the dismal performance of Chinese equity markets over the past two years. The MSCI China index lost 23.5% in 2022 after having lost 22.4% in 2021. Thankfully, it is now over.

The zero-Covid policy of China of the past three years was an opportunity for India to attract new businesses as many multinational corporations woke up to the reality that their high, if not exclusive level of dependence upon Chinese suppliers was an Achilles heel. The “China +1” strategy developed by India over the past years saw some real traction in 2022 when Apple’s key suppliers Foxconn and Pegatron opened factories in India to manufacture the most advanced version of the iPhone, taking business away from China. We believe delocalization away from China is a long-term trend that the end of the zero-Covid policy will not derail. It may well have been the catalyst that will end up transforming Indian supply chains and bring along the infrastructure investments the country has always needed, thus becoming the most impactful long-term consequence of the ruinous zero-Covid policy of China.

2023 OUTLOOK

Despite the disorderly reopening of China that will inevitably see some short-term negative impact on economic activity, we are bullish for the rest of the year. Three years of lockdowns combined with numerous restraining measures followed by a sudden reopening will likely see pent-up demand being unleashed. The impact may be seen in macroeconomic statistics as early as the second quarter of 2023. This is enough for us to believe that the dismal performance of Chinese equity markets over the past two years won’t be repeated, barring exceptional events akin to those that pummelled the world in 2022.

This is even more likely that the Chinese government has reasons to stimulate domestic consumption and the private sector, as well as investments in real estate, to shield the local economy from the impact a forthcoming recession in the western world may have on Chinese exporters. The Central Economic Work Conference held by China’s leadership already provided advance notification of such stimulation in mid-December 2022. Chinese households have saved a third of their income in 2022 by cutting their consumption expenditures. Household savings were three times larger in 2022 than they were on average between 2016 and 2018. The challenge is to convince these households using fiscal policy tools that extraordinary savings are no longer justified.

The impact of China’s reopening on the world will be significant, if only because it is the second largest economy, responsible for half of refined copper, nickel and zinc demand, 60% of iron ore demand and close to 20% of global oil consumption. Exacerbating the trend, inventories of raw materials are running particularly low after three years of economic doldrums. As a result, inflation across the world may not come down as fast as previously anticipated, and monetary policies may remain tight in the western world. It is also likely that accelerated growth in China will have a positive impact on the yuan, the Chinese currency.

A rebound of China’s economy should be beneficial to the rest of Asia, China being the largest trading partner of all countries across the region, with the notable exception of India. The caveat is for the technology sector of Korea and Taiwan that will be impacted by the forthcoming recession in developed economies as well as by additional measures the United States will inevitably take to prevent China from getting access to advanced chips and equipment. Southeast Asia will likely benefit from a tourism boom driven by Chinese travellers, as well as by a strong China-driven demand for commodities.

As often the wild card remains India that has once again proven in 2022 that it is a master at navigating geopolitical events. It took advantage of the invasion of Ukraine and of western sanctions against Russia to have Russia become its largest supplier of oil while western countries turned a blind eye. It also did a good job selling itself as a credible alternative to China’s supply chain. Despite the positive long term views we have on India, we cannot neglect the fact that Indian and Chinese equity markets are decorrelated, if not often negatively correlated with flows going back and forth from one to the other. Furthermore India is expensive when China is remarkably cheap.

PORTFOLIO REVIEW

Source : Bloomberg, JKC – January 2023

For many investors, 2022 was one of the most challenging years. For the first time in decades, many felt speechless trying to explain what was happening in China, us included, at a time when it was already difficult to assess the full repercussions of Russia’s invasion of Ukraine, of unprecedented US-China geopolitical tensions and of the global ripple effect of a fast succession of US Fed rates hikes. The year-end Chinese stock market rebound has happened quickly but restoring investors’ confidence towards the Chinese government’s historically proven meritocracy-based decision-making process will take years.

In the three years prior to 2022, the manager outperformed the respective benchmarks in two up/bull markets and one down/bear market. In 2019 and 2020, JKC China returned 30.3% and 34.9%, while the MSCI China index gained 20.4% and 26.7%, respectively; JKC Asia returned 27.7% and 31.7%, while the MSCI Asia ex. Japan index gained 15.4% and 22.5%, respectively. Then in 2021, JKC China was highly resilient, down 2.6%, while the MSCI China index dropped by 22.4%. The same year JKC Asia gained 7.2% when the MSCI Asia ex Japan index dropped by 6.4%. Our objective was to carry on with the outperformance, but then came 2022 which was like no other year.

As a fundamental stock picker, the manager works well in an environment where investment uncertainties can be underwritten by making rational assumptions. We pick and ‘hide’ in good companies that fit our investment philosophy and we avoid those that don’t. Using 2021 as an example, it was also a bear market for Chinese stocks. The manager’s stock-picking skills were in good use as we avoided several sectors and big benchmark companies that faced tough reforms and government crackdowns and positioned ourselves with companies with strong fundamentals that soared even in the bear market.

However, 2022 was a “no place to hide” case with once-in-decades of chaos which impacted every individual and each line of business in China. To be more specific, one sector outshined all others – the energy sector that is loaded with fossil fuel and thermal coal producers that funds registered under Article 8 of the SFDR such as ours cannot own.

We witnessed so many irrational behaviours regarding the single biggest risk, i.e. China’s zero-Covid policy in the third year of the pandemic when Covid had long proven elsewhere in the world that it won’t go away. During the year, we did make stock-picking mistakes, but the profound economic and business impact of China’s zero-Covid policy, on both the downside and the upside (when it was removed), was the main performance swing factor of our funds. We did not ride the volatilities well. We stuck to some core names that got hit hard; we trimmed/exited others in the darkest hours and missed the rebound. We positioned conservatively in the first ten months on the way down (JKC China actually performed in line with the index during this period) and lagged during the end of the year rally as China’s reopening was so unexpected and executed in such a hasty way, benefiting the much-beaten-down benchmark mega-caps that we don’t own.

In 2023, we are hopeful that China is finally back on track and irrational policies no longer dictate stock market performance, which will be good news for China and the region at large. As a manager, we need to minimize stock-picking mistakes while sticking to our stock selection criteria of choosing long-term winners that can ride through cycles with proven track records, clear competitive edges, sustainable growth upside and trustworthy and able management.

ASIA PORTFOLIO

The LF JKC Asia Equity fund (I USD share class) declined by 25.3% when the MSCI Asia ex. Japan index went down by 21.5%. Our China and India stock selections were the biggest performance drags. All our Taiwan stocks outperformed the index when our Korea and Indonesia stock performance was a mixed bag. Throughout the year, we exited nine stocks and replenished nine.

Specifically on performance attribution, Indian Energy Exchange, which contributed to ~450bps outperformance of the fund in 2021 by more than doubling during our holding period, corrected by 50% in 2022. We took some profit on the stock as the valuation became stretched and concerns over business growth started to build up, but we should have done more. We are reviewing the company’s 2023 outlook. Will Semiconductor and Silergy were hit hard by the rapidly changing semiconductor cycle as the industry went through fast restocking following supply chain constraints in 2021 and equally fast destocking due to dwindling demand as global economies slowed down with rising interest rates and Chinese economy’s meltdown. We exited Will Semiconductor as we don’t like the management’s new growth strategy that is overly aggressive. Shandong Linglong Tyre was a wrong stock pick – we thought the tyre industry had built up higher entry barriers following years of consolidation when in reality, this is hardly the case when liquidity was abundant for small players to set up new tyre lines. We exited the stock and need to do a better job on industry analysis.
On the positive side, BOC Aviation based in Singapore, Poya International and Voltronic from Taiwan, Medikaloka Hermina in Indonesia and GMM Pfaudler in India contributed positively to the full-year performance.

CHINA PORTFOLIO

The LF JKC China Equity fund (I USD share class) declined by 28.6% when the index went down by 23.5%. Our industrial and consumer staple stock selection did the best when our information technology, financials, and consumer discretionary picks dragged the performance. Throughout the year, we exited nine stocks and added seven new ones.

Specifically on performance attribution, Meidong Auto, the Porsche (and other luxury auto brands) dealer, was the biggest negative contributor. We still like the company as it has top-quality management which focuses relentlessly on efficiency and returns with outstanding financial results. But 2022 was the worst year for them as people simply could not leave their homes to visit Meidong dealerships. 2023 will be a much better year for them. Will Semiconductor, Silergy, and Shandong Linglong Tyre also hurt the performance.
On the positive side, BOC Aviation, Yum China, Hefei Meiya and Zhejiang Sanhua contributed positively to the full-year performance.

 OUR ESG ENDEAVOURS IN 2022

After the exponential increase in fund flows into ESG assets in 2021 globally, interest in ESG investing faded considerably due to the challenging macro environment, complex geopolitical tensions, and even political polarisation in certain parts of the world. Many of these global events including the invasion of Ukraine, China’s zero-Covid policy, global energy shortages and the cost-of-living crisis have promoted rounds of internal discussions around what “transition” and “sustainable” means in practice, as these issues are likely to meaningfully shape the direction and pace of ESG investing adoption.

Thanks to the unwavering support of our clients and investors, we continued to increase our efforts by further incorporating ESG considerations into our investment decision-making processes and strengthening engagements with portfolio companies.

With our updated proprietary ESG research methodology and Proxy Voting Policy, internal ESG research coverage has now been extended to not only companies within the portfolios but also to the majority of those on our watchlist, while every single vote we cast is now rigorously examined through the ESG lens. Amid these challenging times, we nonetheless strengthened our stewardship efforts through both collective and individual engagements on a wide variety of ESG topics such as emission reduction, labour practices, gender diversity, corporate governance, disclosure and regulation.

It has also been a year of ESG regulations overhaul, with a particular focus on mitigating greenwashing risks as regulators across the globe ramp up efforts to strengthen disclosure regulations for both corporate issuers and asset managers. As a result, JK Capital is now fully compliant with the Hong Kong Securities and Futures Commission’s climate-related risks disclosure and management framework and with the EU’s Sustainable Finance Disclosure Regulation (SFDR) for Article 8 funds. While a significant number of peer funds have downgraded their SFDR designation due to increased regulatory scrutiny over the recent months, our funds remained unwaveringly committed to investing and disclosing in full compliance with the requirements under Article 8.

To continue to improve portfolio companies’ ESG disclosure quality, the topic of tightening corporate disclosure regulation has also been repeatedly brought up during our conversations with companies, as well as in the form of ESG newsletters and engagement letters. Overall, we believe that such increased regulatory scrutiny would eventually work in our funds’ favour due to the “quality tilt” embedded in our strategies.

With improved disclosure and clarity of ESG in the investment process, we expect ESG investing to continue to adapt in 2023 as normalcy gradually returns to the market. In the new year and as always, we remain fully committed to constantly refining and improving our ESG integration approach in our investment processes, with the ultimate aim of delivering superior and sustainable capital returns to our clients and investors.

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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