Market Review
The benchmark MSCI China index declined -1.7% in Euros during the second quarter of the calendar year.
While Asian markets had a positive month of September, the quarter overall was overshadowed by a string of negative news on the macroeconomics & politics front: a synchronized global slowdown in economic activity, the devaluation of the Renminbi past the 7-handle in August, the deepening trenches in the US-China trade war, and the escalation of demonstrations in Hong Kong.
Performance Review
Most positions in the fund experienced declines this past quarter. The NESTOR China fund is exposed primarily to H shares and thus both the Mainland China-focused H-shares as well as the Hong Kong domestic tickers detracted from performance. This was true across smaller companies such as Oriental Watch, Tsit Wing and Consun Pharma, and larger blue chips such as AIA and Luk Fook. Significant positive contributions came from the technology supply sector.
US-listed ADRs came under pressure in late September and early October following a suggestion by President Trump that the US shall de-register Chinese firms listed on US exchanges, and forbid major indices to invest in China. We believe this threat is highly unlikely to be carried out in practice since US pension and endowments funds would be among the major victims of such a move.
Companies generally reported acceptable results for the first half, and expectations for the second half are relatively strong. However for the Hong Kong focused retail & consumer segments, managements’ indications for July-September operating performance suggest dramatic year-on-year revenue declines as people either took to the streets to demonstrate, or staid in their homes. Very few Hong Kongers went out for a meal or went shopping. Tourist arrivals are down almost a third year-on-year. For select stocks, a lot of this has been priced in at this point, and we are seeing several companies trading near liquidation values.
Outlook and Strategy
From China’s perspective it is important to understand the trade war not as a simple dispute over the goods trade surplus in the current account, but as a broader intent by the West to engage in “China containment”. Political leanings aside, it is rational for the West to look for an answer to China’s economic and technological rise to at least the number two power in the world. It is in this context that the latest US measures (and tweets) moved on from tariffs to outright bans on technology exports and to the latest attack on foreign capital flows into Chinese capital markets more broadly.
China is not short on capital, but it is vulnerable. Foreign currency reserves still firmly stand above US$3 trillion, however stability here has been masked by significant foreign money flows offsetting renewed capital flight. Importantly, these are backward-looking indicators, and the more current/forward-looking activity indicators suggest a short-term uplift in the mainland economy.
Turning to bottom-up investing, we have been deepening our research in several thematic areas including healthcare, education and clean energy in China. In early 2021, the People’s Republic of China will adopt its 14th Five-Year-Plan. We anticipate that these three sectors will be given significant attention, based on early indicators such as research funding by the various ministries. China equities (in both H and A shares) typically closely follow policy expectations and pronouncements. A thematic portfolio thus has a good chance of doing well into this timeline, and it is worth the get work done early, ahead of 2021.