Contrarian China: unravelling investment potential

In the more buoyant markets of the past few months, one sector has conspicuously been left behind: China. After a grim year in 2023, when active funds lost an average of 20.2%*, stock markets have continued to tumble in 2024. It has left markets looking cheap, and given investors a dilemma: is China on the cusp of an astonishing recovery or does its new pariah status with the West make it a quick way to lose money?

In spite of the strength of global markets, the average China/Greater China fund has lost 7.5% for the year to date in 2024**. It begins a fourth year of declines for the Chinese stock market and even the most optimistic investors are starting to give up hope of a turnaround. Another £35m flowed out of the – already tiny – sector in November***.

Setting the scene

The reasons for the weakness are well-established. China’s recovery from Covid has been far slower than expected. Official data puts GDP growth at 5.2% in 2023****, with weak consumer and business confidence and mounting local government debt. The country is wrestling with a significant property crisis, which is holding back stimulus measures. Global and domestic investors have lost patience.

Geopolitical concerns have also played a role. The US has sought to protect its key industries from Chinese interference, limiting the extent to which its corporate sector can trade with its rival superpower. It has also placed limits on Chinese imports in areas such as technology. This doesn’t just apply to US companies. Dutch semiconductor group ASML, for example, has been forced to halt exports of its hi-tech chip-makers to China.

While China has put plans in place to improve its self-reliance in areas such as technology through its ‘Made in China 2025’ programme, this will take time to evolve. China has already built a compelling lead in areas such as renewable energy, but semiconductors and robotics have further to go.

Property problems

Central to China’s problems is its property sector. Debt-driven property development fuelled a real estate bubble in the 2010s, from which the country is still trying to recover. In 2020, the government began a crack down, while trying to avoid a full-blown crash. It has been a difficult tightrope, with Evergrande, the country’s second largest property developer, the most high profile casualty of the crisis. It filed for bankruptcy in August 2023^.

The still-indebted property sector slowdown has two key knock-on effects. It has prevented the Chinese government from announcing significant stimulus measures to boost the economy and the hoped-for ‘big bazooka’ stimulus has not materialised. The government fears that looser credit conditions will fuel another bubble, leaving a similarly difficult legacy to that seen in the property market.

The property crisis also impacts on consumer spending. There is an important read-through from property prices to consumer confidence. As house prices have dropped, it has curbed the nascent consumer spending boom, at a time when growth in the country’s manufacturing sector is also slowing.

An improving outlook?

Against this grim backdrop, why would anyone look to invest in China? It has become the ultimate contrarian investment. Rebecca Jiang, manager of the JPMorgan China Growth & Income trust describes the attitude of many investors towards China as ‘desperate and pessimistic’ at the trust’s recent results presentation. The answer is that it may have reached rock bottom.

It is plausible that the economic outlook may improve. With targeted stimulus measures from the government, a stabilisation in the property market and investment in key industries, some improvement is possible over the next 12 months. Rebecca says: “The policy response to the slowdown was slow. For a long time, the government’s priority was to deflate the asset bubble in the property market, but as economic growth has kept weakening, the response has geared up to be more proactive.”

Tessa Wong, Chinese equities product specialist on the team managing the Allianz China A-Shares fund, says: “While there are some very real structural issues that lie behind the weak economy, in our view there are also cyclical factors at work which, to an extent, can be alleviated by more supportive government policy … China rarely fails to meet its growth targets. It happened in 2022, due to Covid, and policymakers will be determined, just as they have been this year, to make sure this is not repeated. It is very likely that policy support will need to be larger in 2024 than it was last year. The government will have little choice but to do more.” She says this stimulus is happening already.

Key sectors in China

There are a number of sectors in which China excels and this is where many active managers focus their attention. The Allianz China A-Shares fund, for example, bases its strategy around five key areas – self-sufficiency, innovation-enabled upgrades (including AI), domestic consumption, financial market reform and green tech and renewables.

There are exciting companies, tapping into strong levels of growth. The JPMorgan China Growth & Income trust invests in Foxconn Industrial internet, for example^^. It is best-known as an Apple assembler, but its most valuable assets are in data centres and high-powered computing, which help drive the AI revolution. It has factories around the world. Another holding is Sunresin^^, which specialises in industrial-use purification resins, which are used by global drugs companies. The team is even finding opportunities in real estate companies, with a holding in shopping centre specialist China Resources MixC^^.

Depressed valuation

Perhaps most importantly, after more than three years of declines, market valuations are also very depressed. Tessa Wong says: “The MSCI China A Onshore Index trades close to 11x forward PE, well below longer-term average levels. This should, in the worst case, provide some downside buffer. And in a more optimistic scenario, if China proves itself to be more economically resilient than expected, then this could trigger a meaningful rerating.”

Rebecca agrees: “At the moment, we believe, valuations are extremely supportive. There is a lot of pessimism in valuations. I question whether this is justified. Share prices of the asset class and this trust could be sensitive to policy support and perhaps an improvement in fundamental economic performance.”

Multi-asset managers are also taking another look at China. Steven Andrews, manager of M&G Episode Income fund, is closely watching Chinese equities, adding: “PMIs are still in expansion territory (and slightly above global PMIs) which does not appear to have been appreciated by the market. Instead, the market appears fixated on the weaker-than-expected economic recovery and the woes of the property sector, which we believe has already been priced in. The recent intensification of this focus on downside price risk as the primary rationale of the China bears, heightens the sense that the market is at or near extreme pessimism which historically signals a good buying opportunity.”

The Allianz team sees China at a strategic economic crossroads. On the one hand, it needs to wean itself off the previous growth model based on capital-intensive property and infrastructure. On the other hand, it needs to find replacement growth from other areas, in particular to pivot to higher-value, more innovation-driven sectors.

This, it says, will be key to addressing some of the country’s macroeconomic challenges. It will also go some way to answering the thorny question of whether China should play a role in investor portfolios in the year ahead.

*Source: FE Analytics, total returns in sterling, 30 December 2022 to 29 December 2023

**Source: FE Analytics, total returns in sterling, 2 January 2024 to 30 January 2024

***Source: Investment Association, November 2023

****Source: Reuters, 17 January 2024

^Source: BBC, 18 August 2023

^^Source: JPMorgan, Annual General Meeting, 26 January 2024