Funds that can take advantage of a volatile China

In July, China’s retail sales increased by 2.5 per cent year on year, down from 3.1 per cent growth in June and below market estimates of 4.5 per cent. Data company Trading Economics says that July “was the seventh straight month of increase in retail trade but the softest pace in the sequence”. Jason Hollands, managing director of Bestinvest, adds that “Chinese consumers evidently remain wary of spending and are instead rebuilding savings”.

And China, Asia and emerging market funds available to UK private investors often have high exposure to consumer companies. For example, consumer discretionary and staples stocks accounted for 31.5 per cent and 7.3 per cent, respectively, of Baillie Gifford China (GB00B39RMM81) at the end of July while GAM Star China Equity (IE00B3CTFS84) had nearly a third of its assets in consumer discretionary stocks at the end of June. Also, the four China investment trusts have large portions of their assets in consumer stocks (see table).

 

China investment trust exposure to consumer stocks
Trust	% in consumer discretionary	% in consumer staples	Consumer stocks’ % of total assets
Abrdn China Investment Company	21.6	13.8	35.4
Baillie Gifford China Growth Trust	26.6	8	34.6
Fidelity China Special Situations*	38.5	6.9	45.4
JPMorgan China Growth & Income	24.5	6	30.5
Source: Trust managers as at 31 July 2023 and *30 June 2023.

 

A huge amount of Chinese gross domestic product (GDP), meanwhile, depends on the property and construction market. And this has experienced a number of problems recently that could be “feeding through to weaker consumer confidence”, says James Yardley, senior research analyst at Chelsea Financial Services. “The fear is the economy and consumer could weaken further from here.”

The Chinese real-estate sector is estimated to account for around a quarter of Chinese GDP and has created a huge number of jobs. The property sector is estimated to account for almost 10 per cent of employment in China, according to Mirabaud Group. However, rating agency Standard & Poor’s says that more than 50 Chinese property developers have defaulted on debt payments over the past three years. “The disproportionate wealth effect of property on Chinese consumers means consumer activity, both on the discretionary and staples side, is likely to remain constrained for as long as the property sector outlook remains poor,” says Jason Da Silva, director, global investment strategy at Arbuthnot Latham.

Concerns about China, meanwhile, have led global investors to reduce exposure to it, resulting in share price falls. “There are a lot of good reasons to avoid China, emerging markets and Asia funds at the moment,” argues Yardley. For example, “the collapsing property market, shadow banking concerns, weak economy, authoritarian government, poor demographics and increasing geopolitical tension”.

 

Reasons for exposure

However, despite short-term problems, managers of China funds argue that over longer periods Chinese consumer and other sectors such as technology and solar will grow.

“Consumption will grow, particularly in services such as leisure, tourism, and food and beverage,” says Rebecca Jiang, co-manager of JPMorgan China Growth & Income (JCGI). “For example, consumption offers many opportunities, from the ability to upgrade as consumers become wealthier, to high-tech medical products and services in areas of the market with lower regulatory risk, and liquor stocks which will benefit from a rise in post-lockdown socialising.”

At the end of July, this investment trust’s 10 largest holdings included e-commerce platforms Meituan (HK: 3690), Alibaba (HK: 9988), JD.com (HK:9618) and PDD (US:PDD), and travel booking website Trip.com (HK:9961).

Elizabeth Kwik, co-manager of abrdn China Investment Company (ACIC), says: “While the monthly retail sales figure has slowed since April, we are not too concerned, for several reasons. Based on feedback we have received from our colleagues on the ground, the consumption recovery in China is still happening, albeit at an uneven and relatively slower pace than previously anticipated. Categories such as restaurant services, auto sales and online goods sales have shown encouraging demand trends this year. That said, spending per person in the economy still has room to catch up and we continue to hear positive updates from company management about footfall. We could potentially see a sustained and meaningful recovery over the coming months and into 2024, particularly as consumers have a better outlook for their income and bonus prospects heading into next year. There is an oversupply in the economy, which is keeping prices down. As existing inventories are being drawn down prices could rise again and companies could start investing to build capacity that could improve employment and income prospects.

“[However], in view of the near-term challenges we have trimmed our exposure to consumer discretionary to be more in line with [MSCI China All Shares Index]. We expect discretionary stocks to rise along with an improvement in consumer confidence. We have topped up/initiated consumer staples names where we have good earnings visibility and trimmed/exited those where conviction has fallen. The targeted and calibrated stimulus measures that China has announced thus far will work, but it will take time so it is a matter of patience. That [said,] valuations in the A-share market, especially for some very strong business franchises, are very compelling which makes the opportunities even more favourable.”

Dale Nicholls, manager of Fidelity China Special Situations (FCSS), an investment trust focused on the rise of the Chinese consumer, believes that consumption will drive growth though it will be bumpy and vary across different areas. “There is a confidence issue amongst Chinese consumers but they are cashed-up with record household savings, so I am still positive and see a path to recovery,” he explained in July. “The beneficiaries of reopening – particularly travel and certain consumer stocks – have already seen a significant upswing. This has made the investment case less compelling for some companies and overall, I have reduced exposure.”

He is still “finding a range of opportunities in the consumer space, but selectivity is key. For instance, NBY Design is a leading player in the designer fashion apparel industry. Its differentiated fashion-forward product offerings are backed by a strong and stable local design team. It also leverages its strong cash flows to pay a healthy dividend. The jewellery market is expected to see attractive growth and we expect Lao Feng Xiang (CN: 600612) to gain market share and be a long-term winner in the jewellery sector, which is around RMB800bn and growing at a compound annual rate of between 7 and 8 per cent.”

Analysts also see potential. Da Silva believes that “there are still plenty of structural tailwinds for selected consumer-orientated companies in China but investors will need to be more discerning in their stock selection. China, Asia, and emerging markets economies are still anticipated to outpace the growth of most developed nations over the long term. Moreover, the valuations of these markets stand notably cheaper compared to their historical levels. An aspect often overlooked when considering an allocation to China, Asia and emerging markets is the impact of currency fluctuations on returns. We expect over the long term the dollar will weaken, given it is currently overvalued. Dollar weakness tends to particularly benefit Chinese, Asian and emerging markets currencies which should enhance overall returns from these regions.” 

Yardley, meanwhile, argues that “a lot of bad news is already priced into the market and Chinese companies have generally reported reasonable results. China is still an incredibly large and important market with hundreds of millions of consumers. If things don’t turn out to be so bad you could make a very strong return by going against the crowd.”

So investors with a long-term investment horizon could consider exposure. “China is cheap and still offers fascinating long-term growth opportunities but in the shorter term there are sizeable problems to overcome,” says Ben Yearsley, investment director at Shore Financial Planning. “The uncertainty could create a good long-term buying opportunity [and] many funds such as FSSA Asia Focus (GB00BWNGXJ86) have been switching out of India into China over the past 18 months on valuation grounds.”

 

Funds for measured exposure to China

If you invest in a China, Asia or emerging markets fund you should be able to tolerate bouts of volatility. Price volatility of domestic-listed Chinese stocks in particular is typically higher than that of those listed in more developed countries. “Around 70 per cent of equities in China are owned directly by [private] consumers who often see the stock market as a means to speculate,” says Da Silva. “Therefore when risk aversion takes hold, like now, stock market sentiment suffers and there is little in the way of longer-term money to pick up the slack.”

Companies in China, Asia and emerging markets funds invest in are also subject to political risk.

But Yardley argues that these areas “are are too big and important for a high-risk growth investor to ignore entirely. They have some very innovative tech companies which are now trading quite cheaply. However, you don’t need a very big exposure or direct Chinese fund unless you have a particular contrarian view. A single-country China fund should be considered very high risk. You can still get high exposure from an Asian or emerging markets fund.”

If you opt for a single country China fund, Yardley suggests FSSA Greater China Growth (GB0033874321) because its manager “Martin Lau is an excellent and experienced investor and has delivered outstanding returns over many years. His approach tends to be less volatile than the market making it a good fund to hold for the long term.”

Yearsley highlights Matthews China Small Companies (LU2075925870) which invests at least 65 per cent of its net assets in equities of small companies in China. Its managers target lesser-known small entrepreneurial companies in industries that are leveraged to China’s economy driven by fast-growing domestic consumer demand. The fund’s largest sector exposure at the end of July was industrials, which accounted for 23.6 per cent of its assets, but it also had 18.7 and 5.6 per cent in consumer discretionary and consumer staples, respectively. Its 10 largest holdings included Jason Furniture Hangzhou (CN:603816), Anhui Yingjia Distillery (CN:603198) and electric bike producer Yadea (HK:1586).

Yearsley says that high-risk growth investors could consider investing around 20 per cent and medium risk investors could consider having between 10 and 20 per cent of their investment portfolios in China, Asia and emerging markets funds. But “lower risk investors should have under 10 per cent of their equity exposure in [China, Asia and emerging markets funds],” he adds.

And Yardley thinks that medium-risk growth investors “don’t need direct exposure to China [but] might want a little Asian exposure as it’s such a critical continent and growth engine for the world. A bit of Asia in a small weight for the long term is sensible.”

For broader exposure, FSSA Asia Focus (GB00BWNGXJ86) had about 30 per cent of its assets in China at the end of July and over 20 per cent in consumer stocks.

Fund performance (cumulative total returns)
Fund/benchmark	1 year (%)	3 years (%)	5 years (%)	10 years (%)
abrdn China Investment Company share price	-22.04	-17.64	-12.33	24.88
Baillie Gifford China Growth Trust share price	-24.57	-39.86	-28.36	16.40
Baillie Gifford China Fund	-23.13	-37.40	-7.35	117.94
Fidelity China Special Situations share price	-14.79	-32.09	-2.61	157.65
FSSA Greater China Growth	-14.54	-11.10	14.91	120.81
GAM Star China Equity	-25.29	-46.65	-34.69	11.58
JPMorgan China Growth & Income share price	-29.51	-46.35	5.01	112.89
MSCI China Index	-15.10	-35.05	-19.07	57.48
IA China/Greater China sector average	-19.92	-29.28	-8.64	69.63
Matthews China Small Companies*	-21.26	-30.03	19.27	159.24
MSCI China Small Cap Index	-24.69	-34.83	-34.44	0.95
FSSA Asia Focus	-9.75	3.98	15.31
MSCI AC Asia Pacific ex Japan Index	-8.04	-1.30	7.81	89.44
IA Asia Pacific Excluding Japan sector average	-8.74	2.16	12.39	94.45
Source: FE fundinfo as at 28 Aug 2023
*The history of this unit/share class has been extended, at FE fundinfo’s discretion, to give a sense of a longer track record of the fund as a whole.