September 2023
THE CIO’S PERSPECTIVE
There is no question that the economic situation of China is a source of concern, and that there has been a degradation of indicators over the past few months which we commented at length. However, the competition for the most eye-catching headlines about China in western media aimed at the general public of August beachgoers made us realise that there is a widening disconnection between the reality on the ground and what is being portrayed in the press.
Public confidence within China as measured by Ipsos, a global market research agency, remains above the past six-year average. Household revenues are on the rise, growing approximately by 8% YoY, enticing people to repay their mortgages by anticipation. PMI indicators have been rising lately, the average of the official and the Caixin manufacturing PMIs hitting its highest level for the past five months (50.4, which indicates a slight acceleration of the economy).
The same general public articles referred to above described that China had entered into deflation in July, with a CPI reading of -0.3% YoY. However, they typically failed to mention that this was entirely due to pork price and oil price having dropped by 26% and 25% over the past twelve months. Excluding food and energy, core inflation actually rose in July, clocking at +0.8%. China is not a country in deflation.
Retail sales growth was 3.1% and 2.5% YoY in June and July respectively, which are certainly not impressive numbers but not terrible ones either. Looking at the sovereign risk of China as a measure of market stress, credit default swaps on Chinese government bonds stand well below their average of the past 15 years.
This difference in perception about the situation in China is best illustrated by funds flows transiting through the Stock Connect platform that allows foreign investors to trade in domestic A shares and domestic investors to trade in Chinese shares listed offshore (in Hong Kong). August saw the largest net monthly outflow since November 2014, USD 12.4bn worth of foreign investors selling A shares, while domestic investors were net buyers of Chinese shares trading offshore to the tone of USD 9.7bn, the largest net purchase since January 2021. Such a divergence between inflows on one side of the Stock Connect and outflows on the other side was unprecedented.
This is not to say that China does not have issues. It is going through a systemic and self-inflicted property crisis that is having profound repercussions throughout the entire economy. It is such that it will probably force the government to embark in fiscal reforms as the current tax revenue model that relies to a large extent on land sales is broken.
After two years of seeing sales collapse and scores of private property developers default one after the other without taking much action to stop the bloodbath and restore confidence, the government has finally acted in August by announcing unprecedented structural reforms that have the potential to gradually change the course of the sector, and by repercussion of the economy.
The first reform relates to minimum downpayment. Going forward, the minimum downpayment will be 20% for a first flat and 30% for a second flat across the entire country, with the same rules applying to the largest Tier 1 and to the smallest Tier 5 cities. The previous rules were different from one city to another. For instance, Guangzhou municipality was requesting a 70% cash downpayment from buyers of a second flat, and Beijing as much as 85%.
The second reform is the fact that a borrower who has entirely repaid a mortgage and is applying for a new one to buy a new flat (which would typically be the case of a couple wishing to upgrade with the arrival of a child) would be considered as a first-time buyer all over again. Until now, this borrower was considered as a second-time buyer with punitive downpayment restrictions applying such as those mentioned above if he or she wanted to sell his/her flat to buy another one, essentially suppressing liquidity on the secondary market.
The third reform allows borrowers to renegotiate their existing mortgages with their bank. Until now, it was illegal. This is even more relevant that mortgage rates were cut several times over the past months. PBoC, the Chinese central bank, has given instructions to all banks to accommodate such requests. PBoC estimates that the cost to borrowers will be reduced by approximately 80bps for those who will seek to renegotiate their current mortgage.
These are structural changes that align China with practices around the world. Whether these reforms will be enough to restore confidence in the system is too early to say, but it will likely contribute to the liquidity of the physical market, especially the secondary market, and bring back some appetite on the demand side, in our views.
As to the supply side of the property sector, it is our own guess that the government will end up taking necessary actions to take over the plethoric inventory of half-finished property projects sitting on the balance sheet of bankrupt property developers, using state-owned enterprises, and in effect nationalising the entire sector. We have already seen several instances of such “nationalisations”. Most recently, state-owned China Overseas Land and Investment bought 26.7% of a project in Guangzhou belonging to Country Garden, a major private developer on the verge of default.
Another structural issue the government needs to tackle is youth unemployment that keeps on hitting new highs. This is the consequence of three years of zero-Covid policy and lockdowns, as well as the consequence of the impact of the government crackdown against the internet companies that used to recruit hundreds of thousands of new graduates every year.
The increase in the number of new college and university graduates was 1.7m in June 2022, an all-time high, to reach a total of 10.8m. This number rose further by 0.8m in June 2023, to reach 11.6m. Going forward, the increase is expected to drop to 0.4m in June 2024 and the total number of graduates to plateau around 12m in the coming years as the impact of Covid-related policies subside. Meanwhile, the crackdown against the platform economy is over. First half results of companies including Alibaba, Pinduoduo and Meituan were good, and hirings have resumed. Alongside an economy growing anywhere between 4.5% and 5% per annum, we believe the issue of youth unemployment will gradually recede, especially if the government decides to step in by providing tax incentives to employers.
So far this year market participants were clearly disappointed by the lack of forceful decisions made by the Chinese government. Markets always prefer bazooka-type of decisions that have an immediate impact. As investors started realising that it would not happen, markets corrected past the initial reopening euphoria we enjoyed at the start of the year. Even though the performance of Chinese equities, as well as of Asian market indices that are heavily tilted towards China, have been disappointing so far this year, these performances certainly do not align with the gloomy description painted over the summer by western media. For sure the economic situation of China will not turn around overnight, but as explained above there are signs that the trough might be behind us.
Outside of China we were glad to see the end to the political deadlock in Thailand that saw the appointment of a new prime minister delayed by two months. The situation could have easily gone out of control with social unrest. We are watching with interest the upcoming presidential elections next year in Taiwan, in Indonesia, and of course in India where populist measures will likely be announced to guarantee an easy win for Narendra Modi and his Bharatiya Janata Party.
India remains a bright spot in Asia, with a GDP growth in the second calendar quarter of 2023 hitting 7.8% YoY, up from 6.1% in the first quarter. The most surprising component was private consumption that accelerated by 2.7% QoQ in Q2, up from 1.0% in Q1, and from a negative 0.2% in Q4 last year. The Indian manufacturing PMI reached 58.6 in August, up from 57.7 in July, driven by the new orders components sub-PMI that reached 63.2, up from 61.6 a month earlier, the highest level it reached since the 2020 lockdown of the entire country.
WORDS FROM THE MANAGER
Monthly Performance
Source: Bloomberg, JKC – September 2023
We made significant portfolio changes during the month. The first set of changes is technical and transitory: we added Tencent, Alibaba and Meituan back to the China fund after strategically reducing them three years ago and completely exiting all mega caps two years ago.
The key reason for avoiding the sector back then was the regulatory storm against the internet giants over their aggressive expansion. Valuations were also on the high end of the trading range with risk and return pointing to the downside. During the past two years, the internet mega caps underperformed the market with valuations coming down dramatically. Alibaba is now trading at 9.7x forward PE vs. its long-term average of 20.5x. Tencent is trading at 16.7x forward PE vs its long-term average of 23.6x. As for Meituan, it is finally on track to turn sustainably profitable. And all of them reported earnings that beat analysts’ forecasts. Growth is coming back for this sector.
We still believe the internet giants are behind their prime. They will probably never return to the era of high growth and high valuation backed by a supportive policy environment and limited competition. But the worst is apparently over.
Given their still enormous 33% weight in the MSCI China index (13% for Tencent, 9.5% for Alibaba, 4.2% for Meituan, 2.5% for PDD, 2% for Netease and 2% for Baidu), it makes sense for us to reduce the tracking error and hedge any mean-reversion risks. We decided to allocate a 13% weight to the three main internet companies. The intention going forward is to observe and only reduce the exposure to the internet sector when mean-reversion risks start to abate. We will then replace these names with our alpha- generating high conviction names as China’s business environment and confidence stabilize.
The second set of portfolio changes is structural. Since our Asia fund was set up in 2011, we kept China’s weighting between 40-50% most of the time as we saw many secular growth opportunities with the right policy support in various industries. Chinese stock markets in Shanghai, Shenzhen and Hong Kong also offer the best liquidity and depth that no other markets can match. Over the past five years, as geopolitical tension steadily rose, we witnessed an increasingly hostile operating environment for Chinese companies when exporting their products and services or when expanding overseas; it has become difficult, if not impossible, to import certain critical components for Chinese companies to catch up with their global peers and to become globally competitive, especially in the technology sector. Domestically, as China gradually moves away from its dependence on its property sector to secure growth, the economic slowdown is inevitable as the country focuses increasingly on quality rather than quantity.
A 5% GDP growth has become a tough goal to achieve. A slower quality-driven growth means fewer opportunities for all and selective opportunities for some. In addition, over the past two years China’s policy regarding the post-Covid re-opening of its economy and related government support deviated greatly from what stock investors, and to some degree the general public and business community believe to be appropriate. Companies oriented towards the domestic market are facing tough competition with limited upside due to weak demand, making their lives not much better than that of exporters. The Chinese government might have decided to act the way it did for a lack of better alternatives in their eyes, but the embedded unpredictability of its policies have spooked more than one, us included, leading to a higher risk premium than in the pre-Covid era.
At the same time, we have become increasingly optimistic on Korea and Taiwan over the medium term being the beneficiaries of the US-China rivalry. We believe many Taiwanese and Korean companies will gain market shares over their Chinese counterparts as they are setting up operations overseas while Chinese companies in brand-new growing markets such as green energy and semiconductors are being suppressed by geopolitical forces. The only issue with Korea and Taiwan is that their domestic markets are very small, leaving the exporters and global players the only real investment candidates.
We are most excited about India. With all the stars aligned, we believe the era of India has come, just like the China era came some twenty years ago. India faces the best geopolitical climate today, thanks to the US-China tension and Prime Minister Modi’s decade-long efforts to lift India on the global stage. India will benefit the most from the transformation of global supply chains, from its ‘China Plus One’ strategy and from its abundant labour pool. Unlike Korea and Taiwan, India also has a large domestic market. Moreover, reforms over the past decade have started to show their impact.
To name a few, we salute the implementation of GST (or VAT as it is called in Europe), which eased the way of doing business and improved the fiscal situation of the country. Combined with the biometric registration of its entire population that facilitated direct money transfers from the central government to everyone, India’s transformation into a digital economy is now leading the world. The rollout of massive infrastructure and of the Production Linked Incentive scheme that focuses on subsidies to certain strategic sectors turned the “Make In India” grand plan into a very realistic one.
The Indian government forecasts its economy to grow by 6-6.5% this fiscal year, putting it among the world’s fastest-growing large economies. S&P Global forecasts that India’s economy would overtake Japan and Germany’s to become the world’s third largest by 2030, driven by offshoring, investments in manufacturing, growing digital infrastructure and energy transition. We see plenty of opportunities over the next decade in India for both domestic industries and exporters.
As such, we reduced in our Asia fund our China weighting from 50.1% to 37.8% in August while the weighting of China in the index came down from 40.5% to 39.4%. We increased our India weighting from 7.6% to 16.5% while the weighting of India in the index went up from 16.2% to 17.2%. We are keeping an equal weighting on Taiwan and Southeast Asia. We have a 4% underweight in Korea which we intend to reduce.
Such adjustments during a single month might look drastic for both funds, but they reflect our contemplation over the past few years. Going forward, we are inclined to maintain the portfolio’s China weighting in the range of 30-40% (10% lower than their historical long-term range) and raise India’s weighting to the range of 20-30% (historically it was below 15%). We intend to remain close to the benchmark weighting in Taiwan and Korea, while maintaining an opportunistic approach in Southeast Asia.
Nevertheless, we remain fundamental stock pickers. The top-down allocations detailed above reflect our strategic thinking, yet we continue to focus on identifying high conviction companies to generate alpha for our investors.
CHINA PORTFOLIO
La Francaise JKC China Equity saw its NAV per share drop by 7.0% in August when the MSCI China index dropped by 8.5%.
Year-to-date, the fund is down by 11.8% while the MSCI China index is down by 6.0%.
The cash position of the fund stood at 8.2% at the end of the month.
Shanghai Friendess, Ningbo Tuopu and Zhejiang Sanhua were the best performance attributors in August, going up by 16.5%, 4.5% and 4.9% respectively. Li Ning with a 5% weighting, dropped by 21% and SITC, with a 1% weighting, dropped by 16%, which hurt the performance. A lack of Pinduoduo (PDD) with a 2% benchmark weighting that gained 10.2% also hurt a bit. As for trades, we added back Tencent, Alibaba and Meituan as mentioned earlier. We exited lower conviction holdings China International Capital Corporation, Shenzhen Mindray, SITC International and Silergy, and we added JCHX Mining Management Co Ltd, a global mining contractor.
ASIA PORTFOLIO
La Francaise JKC Asia Equity saw its NAV per share drop by 7.4% in August when the MSCI Asia ex-Japan dropped by 6.6%.
Year-to-date, the fund is down by 9.3% while the MSCI Asia ex. Japan index gained 0.5%.
The cash position of the fund stood at 11.6 % at the end of the month.
Ningbo Tuopu, GMM Pfaudler and Chroma contributed the most to the performance. They went up 4.5%, 6.5% and 0.1% respectively. On the flip side, Li Ning, Rianlon and Hansol Chemical hurt the relative performance having dropped by 21%, 14.6% and 21% respectively. As for trades, we exited lower conviction holdings China International Capital Corporation, Indian Energy Exchange and Silergy, and we initiated positions in Eicher Motors, Bajaj Auto, India ETF Nifty 50 and KPIT Technologies.
OUR ESG ENDEAVOURS THIS MONTH
In the ESG space, the month of August started off with the European Commission finally adopting the European Sustainability Reporting Standards (ESRS) which is the set of rules and requirements for companies to report on sustainability-related impacts, opportunities and risks under the European Union’s upcoming Corporate Sustainable Reporting Directive (CSRD). This is a major milestone towards the implementation of the law, with reporting set to begin for some companies as soon as the 2024 financial year. Later in the month, the Commission also adopted detailed reporting rules for the Carbon Border Adjustment Mechanism’s (CBAM) transitional phase. Both regulations are expected to have spill-over effects outside of the EU as they apply to non-EU companies and to products imported from outside of the bloc, therefore facilitating the adoption of more rigorous measuring and reporting rules globally.
Following the public consultation on the China Certified Emissions Reduction (CCER) scheme last month, China officially re-launched its long-awaited scheme by releasing detailed requirements on account setting and trading rules. Upon the revitalization, CCER units are expected to be generated from projects such as forestry carbon sinks, methane utilization and renewable energy generation, and therefore providing additional revenue streams for such project developers.
To fulfil our obligations as an UN PRI signatory and more importantly provide transparency to our investors, JK Capital completed its FY2022 reporting materials. We look forward to receiving the Transparency Report and Assessment Report shortly and sharing them with our investors.
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