GAM, the Switzerland-listed investment house, argues it makes sense to have China equities exposure to capture a likely narrowing of the gap between these assets and the world's overall market.
China’s break with economic communism – if not yet a move towards liberalism in politics – is well known and ranks alongside the fall of the Berlin Wall in importance. More recently, China has had to negotiate a shift away from a country driven by manufacturing and exports towards one more geared around domestic consumption and investment. It is sometimes said that no major economy has ever pulled off such a shift without going through some kind of financial wobble. Right now there are concerns about levels of debt and the fragility of its financial system. Even so, the world’s second-largest economy has come a long way from the brutalities and savage poverty of the 50s and 60s. The rise of China and the ascent of a new, populous middle class in the country is one of the reasons why, globally at least, wealth management remains a lucrative area.
In this article, Jian Shi Cortesi, portfolio manager at Zurich-listed investment house GAM, deals with some questions about the changes going on in China’s economy.
Can you explain why the Chinese stock market offers catch-up potential?
Sure - it’s largely based on recent underperformance. Since the end of 2009 (when capital markets had largely stabilised following the global financial crisis), the MSCI China index has risen by about 10 per cent in US dollar terms (to 31 December 2016). But that figure includes reinvested dividends. In aggregate, share prices are marginally lower at the end of 2016 than they were seven years earlier, which equates to an underperformance of the MSCI World index of around 70 per cent over those seven calendar years.
Can you identify a catalyst for the catch-up?
There are four key reasons to believe that Chinese stocks are poised to rebound. First, and most important, the macro picture is improving by virtue of broad-based economic strength and diminishing pressure on the Chinese yuan. Second, valuations are compelling, partly in reflection of the period of underperformance, with the MSCI China index trading at a forward price/earnings (P/E) ratio of 13 times earnings. It is also noteworthy that technology comprises a relatively high proportion of the index (around 33 per cent) and, if internet stocks are excluded, the forward P/E of the residual index is around 10x. Third, China’s rating has recently been elevated by a number of brokerages, including a triple upgrade from Goldman Sachs. Fourth, China remains a large underweight in many global portfolios, meaning that investors are yet to participate in the recovery - macro improvements and broker upgrades alone should compel investors to raise exposure.
How does the P/E of your portfolio compare with that of the index?
It is actually a bit higher but there are good reasons for this. We are focusing on the evolution of the Chinese economy from export to consumer driven, so naturally the portfolio is aligned to consumption themes and trends. As such, we hold quite a heavy exposure to consumer-related technology stocks. These typically trade at elevated P/E ratios because of their higher growth potential. In addition, we also like to selectively invest in turnaround situations. These can also trade at very high multiples because their earnings tend to be very depressed relative to future expectations, which are based on prospective margin expansion.
In the West, markets have tended to re-rate ahead of earnings growth. How does China compare in this respect?
The broad rally in developed markets has been predicated on a recurring valuation expansion for a number of years. Hence, stocks have steadily become more expensive, and this is a natural by-product, or even an intended consequence, of the asset-purchase programmes of central banks. Conversely, we saw a big trough in P/E multiples in China around a year ago due to deep concerns over the yuan valuation. Consequently, we have, so far, seen just 12 months of P/E expansion from a very low base in China, so I am optimistic about the prospects for an extended stock market rally.
So, you are positioned for a rebound, but how do you insulate downside risk?
In terms of risk characteristics, the strategy has exhibited a slightly higher standard deviation than its benchmark index, indicating a marginally greater variability in performance, but the strategy’s maximum drawdown is significantly lower than that of the benchmark. This reflects our tactical use of low-beta stocks, which supplement the high-conviction picks within the portfolio. Low-beta and large-cap stocks typically prove more resilient than the broader market during periods of risk aversion.
Are you concerned about the likely impact of Trump’s policy agenda on China?
If the US president pursues his manifesto pledges on protectionism, the effect will be felt across the whole of Asia; it’s not really a China story as such. However, we are focused on domestic consumption themes so we mostly invest in companies that create products and services in China and sell them to the local market. Consequently, in terms of the Trump trade impact, we have a big advantage in that we are well insulated because of our low exposure to exporters.
Is the Chinese economic slowdown set to continue?
Over the last 6-12 months we have seen a broad-based recovery in China and this is flagged by pretty much any metric you care to choose. Industrial production, property sales, domestic consumption, exports and inflation indicators have all trended up. However, over the longer-term, Chinese GDP will simply have to slow down because of its status as the world’s second-largest economy – it is more than 60% of the size of the US economy and cannot possibly maintain the current pace of growth forever.
Nevertheless, the really important point is that the headline GDP number, which most people focus on, is seriously beguiling because of the underlying divergence in performance across industries. Some are growing at around 20 per cent per annum as consumers spend more in areas such as education, travel and entertainment. Conversely, ‘old economy’ heavy industries are really struggling. Consequently, we are confident that our portfolio is concentrated in areas where stocks are likely to outperform the broader market. We therefore have scope to continue to generate substantial alpha, while we expect our sector tilts to add incremental value.