Fidelity China Fund update
- November saw a sector rotation to selected value-oriented high-quality stocks, which benefited the strategy. Additionally, a persistent improvement in economic activities in China, coupled with successful COVID 19 vaccination trials, boosted investor sentiment and rekindled interest in cyclical stocks, which have lagged given the growth rally.
- The strategy’s long-standing investment style remains in place, with an exposure to companies that provide earnings visibility over a three to five-year horizon. There is also a focus on well-managed businesses that have a long runway of growth and are beneficiaries of the structural shifts in China.
- A hugely under-recognised opportunity in China is the income paradigm, which is a significant tailwind over the longer term.
- During this phase of heightened uncertainty and volatility, the manager maintains the importance of focusing on asset-based valuations and on dividend cushions versus discounted cash flows.
- The manager has a value and contrarian style that is reflected in the fund’s positioning. Her bottom-up approach focuses on determining the intrinsic value of a company rather than pursuing themes. Jing compares companies within sectors, with global peers where relevant and vs. their own history as a part of her fundamental analysis of investment opportunities.
- The strategy continues to offer a diversified exposure across the entire Chinese equities market and Jing’s investment style remains very different to others in the fund’s peer group - diversification is important.
Total net returns represent past performance only. Past performance is not a reliable indicator of future performance. Returns of the Fund can be volatile and in some periods may be negative. The return of capital is not guaranteed. Benchmark: MSCI China Index NR. NR at the end of the benchmark name indicates the return is calculated including reinvesting net dividends. The dividend is reinvested after deduction of withholding tax, applying the withholding tax rate to non-resident individuals who do not benefit from double taxation treaties.
Market and portfolio performance
- Chinese equities gained in November due to positive news flows around COVID-19 vaccination development and upbeat economic data.
- Sentiment was further supported by the establishment of a China-backed trade bloc; fifteen Asia-Pacific countries signed the Regional Comprehensive Economic Partnership (RCEP), forming the world’s largest trading bloc. However, China-US trade tensions continued to cap gains.
- Donald Trump’s administration issued an executive order that effectively bans Americans from investing in Chinese companies that support China's military, in a move that further escalates already high tensions between the two economies.
- On the economic front, China posted a broad-based recovery in October leading the way for a solid rebound in the final quarter of the year. Industrial output, which was the main target of stimulus provided by policy measures, rose 6.9% in October from a year earlier, higher than market expectation of 6.5%.
- Fixed assets investments gained 1.8% in the January to October period, beating expectations. Retail sales, a key measure of consumer confidence, rose 4.3% in October from a year earlier, rising from 3.3% gain in September. Chinese unemployment rate also showed marginal decline in October amid a broad-based recovery. China’s GDP rebounded to 4.9% growth in the third quarter, compared with a 6.8% contraction in the first quarter followed by a 3.2% expansion in the second quarter.
- Growth is expected to be robust in the final quarter with full year growth of around 2%, way ahead of all major global economies.
- Policy has now turned towards a more neutral stance.
- In November, we saw a sector rotation to selected value-oriented high-quality stocks, which benefited the strategy.
- The fund returned 1.5% while the index returned -2.05% in November. A persistent improvement in economic activity in China, coupled with successful trials of COVID-19 vaccines boosted investors sentiment and rekindled interest in cyclical stocks that had lagged the recent growth rally.
- Whilst it remains difficult to pinpoint when we will see a meaningful mean reversion from growth to value, a more prolonged rotation occurred this month.
Source: Refinitiv Datastream, 3 December 2020.
- China’s macro backdrop is supportive for such a rotation. What we have seen is fiscal support in terms of infrastructure investment and support for consumers and the SME segment. These catalysts that support a cyclical recovery (indicated by property numbers etc), which combined with where bond yields are (inflationary indicator) should underpin value sectors in China.
- Whether this trend will continue is difficult to determine, but for a further rotation into value, there are three catalysts that need to occur:
- 1. The earnings cycle to turn positive on improving macro post COVID-19 - we need to see positive earnings revisions from a global perspective. After the bottoming of an earnings cycle, the first phase of an upward turn tends to see beneficiaries from traditional macro sensitive sectors like materials, industrials and energy.
- 2. Inflation expectation needs to flatten out and to turn positive - the consensus view of zero/low rates needs to change, which in turn would trigger a switch from bonds into equities; likely beneficiaries are cyclicals and value stocks. It is interesting to note that there are more positive signs. For example, demand for commodities such as copper, aluminium, iron ore and soft commodities (sugar, paper, glass) has moved into positive territory. This, coupled with quite low inventory in the system, could further underpin a demand recovery next year, which could see higher pricing and rising inflationary expectations.
- 3. Investor positioning to move out of ‘crowded trades’ - China has seen an extreme divergence between value and growth, with China growth sectors massively outperforming value. This difference is also significantly more versus the US value/growth difference.
- If we look at the 7-year government bond yield (which is a good proxy for growth expectations and a good indicator that matches the economic cycle in China), with the steady pace of recovery over the year we have seen this pick up quite strongly since the bottom in the second quarter this year. Note, that China is also currently the only country from an EM perspective where we are seeing a pick-up in bond yields.
- Valuations in China versus historical levels remain high (1x above standard deviation). However, relative to DM and other EM countries, valuations are not too expensive - particularly if you consider the earnings momentum in 2021. Whilst a lot of the positive earnings expectation and growth optimism has been priced into current valuations, on a macro level, the manager remains confident that China will continue to see a sustainable economic growth recovery.
Stock specifics - November
- Aluminium Corporation of China and Jiangxi Copper. Copper prices rose as demand for the metal is highly sensitive to economic growth.
- Preferred holdings in financials and energy sectors also contributed to performance as investors rotated into value-oriented sectors that have trading at undemanding valuations. These include China Merchants Bank, China Construction Bank and CNOOC.
- Elsewhere, the underweight allocations to ecommerce giant Alibaba and internet-related technology conglomerate Tencent Holdings proved rewarding amid a rotation away from growth.
- Shares in state-owned automobile manufacturer Dongfeng Motor rose ahead of its planned listing on the ChiNext stock market. Dongfeng’s joint ventures with Nissan and Honda are likely to lift earnings from new car launches.
- Gains were partially offset by the overweight allocation to China Mobile whose shares were caught in sector wide weakness after the US administration included prominent telecommunication names into the list of companies barred from investment by US investors.
- The position in China Overseas Land also weighed on returns after Chinese authorities aimed at curtailing borrowings of top Chinese property developers.
- The manager has a value and contrarian style that is reflected in the fund’s positioning. Her bottom-up approach focuses on determining the intrinsic value of a company rather than pursuing themes.
- As an aggregate of the manager’s security selection process, the fund remains notably overweight in the financials, energy and materials sectors.
- Among key active positions, China Life Insurance is the largest overweight holding in the portfolio. The company stands to benefit from long-term structural growth in the Chinese insurance industry. Its management is focused on enhancing its product mix and improving agent productivity
- State-owned telecommunications operator China Mobile is another significant holding in the portfolio. It is a key beneficiary of the 5G rollout in China, as it is likely to enjoy faster 5G subscriber growth with alleviated capital expenditure pressures. The company also maintains an attractive dividend policy.
- Exploration and production company CNOOC’s strong balance sheet and low-cost profile will help it to weather a challenging environment. Superior project execution and its focus on tapping low cost resources remain key drivers of long-term growth. A hugely under-recognised opportunity in China is the income paradigm, which is a significant tailwind for the portfolio. The fund’s metrics clearly reflect the very strong income angle that is on offer at attractive valuation levels. This is a noteworthy cushion in the portfolio. During this phase of heightened uncertainty, the manager maintains that it is quite important to focus on asset-based valuations and on dividend cushions versus discounted cash flows, which in themselves are hard to predict with any degree of accuracy.
- China’s economy was the first to experience severe disruption due to the coronavirus outbreak and has been the first to begin to recover. As the world’s second largest economy with links to supply chains globally, the pace of recovery in China is of paramount importance for the global economy. China continues to show signs of recovery on the economic front, albeit with the pace of improvement moderating relative to that seen in 2Q. Robust Q3 GDP was supported by stronger services and external demand. The key drivers would be China's continued export market share gain and steady service sector normalization, as key laggards, travel and leisure, are gaining momentum after loosening of restrictions in mid-July.
- Recent growth in export activity is in-line with the broader recovery in demand amid re-opening of export markets. Although the external sector continued to fare well, risks remain as some of China’s main trading partners are heavily impacted by the pandemic. The global economy was already on a very fragile footing before the COVID-19 outbreak. Real growth drivers remain scarce, with the global economy relying on easy liquidity for too long. In light of this, investors are probably too optimistic on the pace of recovery and are collectively looking at the possibility of a strong rebound in earnings in a post COVID world. A re-escalation of trade tensions with the US and a second wave of COVID-19 are the main downside risks.
- The fund remains very exposed to the domestic China revenue story as Jing believes that exports could be a risk for China this year. The domestic focus will help to alleviate the headwinds that comes with the trade war. There has been an escalation in friction between the two economies leading up to November. It is also worth highlighting that many countries (outside the headline news about the relationship between the US and China) are re-assessing their trade relationships with other economies, e.g. Australia. Chinese policymakers are further reiterating the importance of seeing a recovery domestically speaking plus ensuring China’s supply chains are not disrupted. Second waves are always a risk, but as we have seen China has been very effective in preventing any smaller outbreaks from spreading.
- On the US presidential election. With a Biden victory, the result is marginally positive for the US-China relationship over the medium term. A Democrat President may bring the US-China relationship back to its position before 2016. The Chinese domestic economy has seen sustained demand recovery in the past two quarters with plenty policy tools ready in place. However, weakness from external demand (either due to a second wave of COVID-19 or a delay of US stimulus) may lead to downside risk to growth in Q4 and 1H of 2021.
- The global economy continues to thrive on stimulus support. It could witness more fiscal stimulus support in light of limited room for monetary easing. Recent announcements by the Federal Reserve of a more lenient approach towards inflation management is likely to keep interest rates lower for longer which may result in increased liquidity, impacting asset prices in Asia. On the monetary policy front, the central bank of China has shown restraint but has provided ample liquidity to the banking system, although the magnitude is smaller and more targeted versus previous cycles. There has also been substantial fiscal policy support in China. It has been directed at bolstering production rather than income. As a result, industrial production has recovered strongly whereas the rebound in retail spending has been considerably less
- It is also worth noting that the value discount to growth within China and globally is at levels that have been seldom seen before. Higher valuation sectors have seen further concentration, an indication that returns are purely being driven by liquidity rather than fundamentals. A narrow band of bellwether stocks has been rallying, mostly in the technology and internet related names. This trend has remained the so far to date, although we have over Q3 seen more mixed numbers which may indicate a potential switch. However, we cannot predict when this dynamic will change.
Over the long term, China remains an attractive destination for capital inflows driven by structural growth and strong innovation trends. During this phase of heightened uncertainty, it is important to focus on asset-based valuations and on dividend cushions versus discounted cash flows, which in themselves are hard to predict with any degree of accuracy. The holdings in Fidelity China Fund are more resilient to earnings downgrade versus the broader market, offer superior cash flow and dividend yield and are trading at lower valuation multiples offering higher return potential over the medium term.
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