July 2023
THE CIO’S PERSPECTIVE
Reflecting on the first half of the year, we can only be amazed by how wrong the investment community at large, including ourselves, could have been about the post-Covid reopening of China. Looking back we should have been suspicious when the Chinese government set a low growth target for this year of “about 5%”, well below the base case of most economists. This mistake led us, as well as many of our peers, to overweight China in Asian portfolios and to overweight Chinese consumer discretionary companies that, in theory at least, should have benefited from the end of three years of lockdowns.
Admittedly this sentiment of euphoria did happen, but it did not last long – one month to be precise (January 2023). Then geopolitics took over with the “balloon incident”, tensions between the United States and China rose to new heights, and the macro indicators of China all started to deteriorate one after the other.
Why were we all wrong about the Chinese rebound?
We failed to appreciate the long-lasting impact the zero-Covid policy of China had on the Chinese population. Despite incentives given such as relaxations of home purchase restrictions and tax breaks on the purchase of new energy vehicles, there is still to this day very limited appetite for people to embark in large-ticket spendings. A sentiment of financial insecurity prevails.
We also failed to see how three years of administrative crackdowns against key sectors of the economy created structural imbalances. Employment is one of them. After the government orchestrated the restructuring of the entire internet sector, students who prepared for careers within the platform economy found the doors shut. In addition, because the government enticed students to stay at school longer than initially planned during the pandemic, they now find themselves overqualified for the jobs being offered. There is today on one hand an acute shortage of migrant workers and on the other hand a rising unemployment rate for young graduates. The fact that factories were forced to shut down sent many migrant workers back home, and many of them never returned, especially the younger ones who prefer to deliver food in their home town than work in a factory thousands of kilometres away.
In 2014, 17.1% of all migrant workers were 50 years old or above. That number shot up to 29.2% at the end of 2022 according to the National Bureau of Statistics. In the meantime 20.8% of the 15-24 years old have been unemployed at some stage over the past three months, a record high. And this number is expected to rise further in the coming months as 11.6 million students just graduated, another record high. These are social issues the Chinese government never had to face in modern years.
We spent the past few months waiting for stimulus measures that would be significant enough for the Chinese ship to change course, but to no avail. To the point that we start thinking that such forceful measures may never come. The Chinese government has always been against the idea of handing out cheques to its citizens (so called “helicopter money”), preferring to focus on infrastructure investments instead. However, the return on investments of such projects is no longer what it used to be: Local municipalities and their banks are now sitting on a vast number of loss-making infrastructure projects. Rhodium, a consultancy firm, recently analyzed the financial profile of 2892 Local Government Financial Vehicles and their RMB54 trillion of debt (equivalent to 45% of China’s GDP) to find out that only 567 of them had enough cash to cover their short term obligations, many projects having failed to deliver the cash flows they were supposed to generate. The pressure is thus on the banks to roll over these loans to prevent them from defaulting at a time when their net interest margin is already at a record low 1.74%, and dropping. Under these circumstances, launching vast infrastructure programs for the sake of stimulating the economy could be a tipping point for the banking sector, and a risk the leadership may not want to take.
This would explain why monetary policy measures taken over the past weeks were inconsequential, with various rates cut by not more than 10 basis points. It is also why we prefer to remain prudent for the rest of the year, and why we refuse to bet on a large scale stimulus. On the positive side, one can only notice that China had been an underperforming market since 2021, and that the MSCI China index is now trading at 1.1x book value, only 10% above the all-time low it hit in February 2016. At this level, it would not take a big spark to ignite the market.
Outside of China, we are finally seeing some light at the end of the semiconductor tunnel. The strong performance of AI related chip companies is pulling memory chip makers out of the doldrum. It is creating traction for chip testing and packaging companies, and we now expect passive and smartphone component makers to slowly emerge from more than a year of misery. This is beneficial to Taiwan and Korea, the two best performing markets of Asia ex. Japan so far this year.
The country within Asia that has benefitted the most of the difficulties China has been facing is without any doubt India. Prime minister Modi played remarkably well the paradigm shift that the Ukraine war brought to the world. He is now the friend that all western leaders want to have, especially when it comes to containing China. And it is not only politicians: The pace at which Apple suppliers are rebalancing their operations from China to India is remarkable. After being banned from China, American memory chip maker Micron is also turning to India which welcomes it with open arms. From a top down perspective, it is understandable why India is the country that many managers want to overweight these days. But one needs to be aware that despite the attractive top down geopolitical story, investing in a profoundly decentralized country where local politics and vested interests tend to systematically derail initiatives is far from being straightforward. India is a very complicated country to say the least.
WORDS FROM THE MANAGER
Source : Bloomberg, JKC – July 2023
Compared to the past few months, June ended up being a positive one even though it went through two very distinct halves. During the first half, the Chinese market rose by almost 10% while Asian indices rose by almost 6% on renewed hope for improved US-China relationships and for the announcement of a stimulus package to boost China’s economy. Both hopes faded in the second half. As a result our funds went through a high level of volatility. We ended up performing broadly in line with the market over the month.
As stated earlier and in our previous reports, we are among the investors who were too optimistic about China’s reopening. The past few months taught us that not only the economy and the overall level of confidence got hurt in 2022 much more than we thought, that more time will be needed for the economy to recover, but also that structural issues that were embedded even before the Covid era have started to show their impact. That would include a low birth rate, an ageing population and too much reliance on the real estate sector. It appears that the Chinese government is less interested in boosting short-term growth for the sake of it, as opposed to focusing on the roots of these structural problems that will likely take years to tackle, at the risk of disappointing financial markets that only focus on the short term.
The past months also taught us that even though fundamental stock pickers might in the end be right about their high-conviction calls, managing the risk exposure during highly volatile periods is equally important. After all, managers’ performance is measured by risk-adjusted returns within a certain time horizon and not by absolute investment returns without time constraints. High-conviction investing managers like us should also be open-minded to ask this question: what if I am wrong? If exiting a stock altogether during a correction is a bad decision, what should be the appropriate risk-adjusted weighting to help ride the volatility? Over the past few months, we made some tough decisions to trim positions we are still convinced about in order to manage risks. For instance, we lowered the top 10 holdings’ aggregate weight in the China fund to 51% from a peak of 61%, and in the Asia fund to 45.8% from a peak of 54.4%. The portfolios today have lower risks concentration and, therefore, reduced volatility.
CHINA PORTFOLIO
La Francaise JKC China Equity saw its NAV per share rise by 2.9% in June when the MSCI China index rose by 3.4%.
Year-to-date, the fund is down by 9.7% while the MSCI China index is down by 6.0%.
The cash position of the fund stood at 5.7 % at the end of the month.
Due to their exposure to Tesla’s future robot business, Ningbo Tuopu and Zhejiang Sanhua were the top performance contributors. They went up 36% and 15%, respectively. Shenzhou International and BOC Aviation also did well, up 19.3% and 12.7%. Meidong and Silergy continued to suffer from weak sentiment, although both share prices have started to show signs of stabilisation. We reduced the weight on Meidong and Silergy to manage the risks and we took some profit on Tuopu and Sanhua. We initiated Sany Heavy International to exploit China’s smart mining and smart port investment trend. Finally, we exited Techtronic Industries as we lost the high level of conviction we had for this name.
ASIA PORTFOLIO
La Francaise JKC Asia Equity saw its NAV per share rise by 2.9% in June when the MSCI Asia ex-Japan rose by 2.2%.
Year-to-date, the fund is down by 4.4% while the MSCI Asia ex. Japan index is up by 1.8%.
The cash position of the fund stood at 5.2 % at the end of the month.
Ningbo Tuopu and Shenzhou International were the top performance contributors, together with BOC Aviation, Leeno Industrial and Poya International. On the flip side, Indian Energy Exchange dropped by 16% due to the fear of regulatory reform – we believe such reform does not have the pre-conditions needed to be carried out, but we trimmed the weight to manage risk. Our exposure to Meidong and Silergy continues to hurt, and we also cut both to reduce risks. We initiated Park Systems in Korea last month and added Sany Heavy International in June.
OUR ESG ENDEAVOURS THIS MONTH
In June, the International Sustainability Standards Board (ISSB) issued its long-anticipated standards – IFRS S1 (General Requirements for Disclosure of Sustainability-related Financial Information) and IFRS S2 (Climate-related Disclosures). Building on the principles of the TCFD recommendations, the standards require companies to disclose the sustainability risks and opportunities as well as climate-related disclosures starting in FY2024. Despite its unique relationship with the International Accounting Standards Board, the ISSB has no power to enforce its standards to be adopted even in countries that are currently adopting the IFRS accounting standards and therefore it is working with market regulators around the world on a case-by-case basis to boost adoption.
On our own turf, the Stock Exchange of Hong Kong already published a consultation paper introducing new climate-related disclosures aligned with the ISSB. The proposals mark a significant milestone in achieving the commitment to mandate TCFD-aligned disclosures by 2025. Regulators in other Asian markets such as Japan, China and Indonesia are said to be working closely with the ISSB to adopt the standards to varying extents.
In mid-June JK Capital also kick-started its PRI reporting for FY2022, fulfilling our obligation as an UN PRI signatory and long-term supporter.After the UN PRI went through two years of disruption preventing all members from reporting updates, we aim to showcase our progress and efforts in sustainable investment as a responsible investor under the updated reporting framework.
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