NESTOR China - Quarterly Report 4/2019

NESTOR China fund raise by +6.8% during Q4, lagging MSCI China benchmark

The benchmark MSCI China index rose +12.4% in Euros during the fourth quarter of the calendar year.

As for Asia-Pacific as a whole, half of the index performance came in throughout December, as large cap markets, led by the Hong Kong heavyweights and the technology sector, rallied in anticipation and later confirmation of the “Phase 1” trade truce. Both mainland and local Hong Kong stocks had earlier been severely depressed by trade & growth concerns in China, and ongoing demonstrations in the city, respectively.

Performance Review

Alibaba and Tencent make up a whopping 30% of the MSCI China which makes this index a very difficult comparison for a UCITS fund, first because regulatory requirements do not allow such a weighting thus creating a permanent underweight relative to the index, and second only two stocks would dominate performance. 

This past quarter, fund absolute performance was positively driven by positive performance reversals in tech names in the portfolio, with six names among our top ten gainers. The major detractor was property services company Hopefluent.

As for NESTOR China, earnings season hasn’t started yet, but it is worthwhile to look at consensus forecasts for the markets under our coverage. Strong performance during 2019 was driven by multiple expansion. While earnings growth during 2019 came in about flat, analysts are expecting a strong rebound of earnings growth in China of 15-20%.

Outlook and Strategy

It is important to view the “Phase 1” trade deal as a truce rather than conclusion of a confrontation between the US and China, that will be with us for decades to come. Around $380bn of goods will still be subject to tariffs, and according to Oxford Economics, the average tariff on Chinese imports is still 19% - more than six-fold the 3% rate prior to the onset of the trade war. The technology sector and intellectual property rights are likely next, as China’s challenge to US dominance is increasingly built on leadership in new technologies such as artificial intelligence.

Nevertheless, this Phase 1 deal, combined with the US presidential election cycle (which drove the inclusion of agricultural goods into this deal), should give markets a chance to focus on China’s fundamentals and credit cycle as the next major pace-setter.

The key worries are well known: China’s total debt to GDP has risen to a high level of greater than 300%, and the accumulation debt occurred over a relatively short timetable which historically is associated with malivnestment and the build-up of bad debts in the financial system. Both Japan and Korea underwent a similar investment-led boom to transform their economies during the 1980s and 1960s respectively. However, China today is significantly older (its workforce is shrinking), and more leveraged than its East Asian peers at the point of their transition.

The party is very much aware of these developments, and has oscillated between providing stimulus and imposing lending discipline. This included forcing certain sectors to absorb losses, reduce credit growth, and tolerating defaults - only to reverse course. It appears the rising number of corporate defaults during 2019, at around $19bn (incl. $3bn bond defaults), is prompting the government to ease once more. December’s aggregate financing number (a measure of credit creation) was 27% higher than estimates and came in at 2.1 trillion yuan.

Navigating these ebbs and flows of domestic liquidity provision will matter not only to China investors, but all Asian or in fact global investment strategies.

The frustrating thing with investing in Chinese equities is the fact that fundamentals matter a lot less, and in particular mainlanders trade equities following policy rather than earnings. We are currently closely following policy signals for the alternative lending sector where several so-called fintech lenders have racked up significant off-balance sheet leverage of up to ten times their book value, and are an obvious target for government intervention – however there are of course beneficiaries of this theme, i.e. lenders that have been preparing for government action reigning in consumer debt.

The global introduction of the 5G standard in telecommunication is another major thematic research area, investments like Sunny Optical have been an early expression of this in the portfolio. It has been difficult to be a long-term investor in this theme as the trade war talk disproportionately affected the technology supply chain. But this is the point of thematic investing, to identify growing segments somewhat outside of the economic cycle and market cycles.