Market Review
The benchmark MSCI AC Asia Pacific ex-Japan fell -7.0% in Euros during the third quarter of the year, and is around flat year-to-date.
It is fair to say this quarter in Asia has been all about China and in particular the impact of a series of government interventions. Xi remains willing to sacrifice parts of the economy in pursuit of power consolidation as well as the party’s societal goals. The crackdown on tech platforms and for-profit education in July are examples. Markets fell significantly, as this single sector intervention increased the market’s overall risk premium for policy risk in China. In August, the emerging problems at Evergrande and the property sector, and in September and October, the energy crunch, contributed to a difficult environment for most of the shares that the fund owns.
We find the performance divergence of A-shares and H-shares notable, where A shares have outperformed. Domestic investors in China appear more constructive on Chinese enterprises than foreign investors. Southeast Asia, which has been ever the laggard these last few years, now has a chance to shine in relative performance. During October, there have been some signs of foreign investor flows specifically seeking out “non-China Asia”.
Performance Review
As at 30 September the fund is slightly up calendar year to date, at +0.9% compared to a +2.0% rise in the index. After three consecutive quarters of outperformance, this third quarter of 2021 saw underperformance in the fund. For the whole last twelve months the fund is still outperforming at +18.7% compared to a 15.7% rise in the benchmark.
This past quarter, the fund experienced losses primarily through its A-share and related exposures during the most difficult month of July. Further, the (modest) real estate exposure became a drag during a sharp correction for the sector, and a few technology names also hurt the portfolio. Winners this quarter were investments in the renewable theme, as investors feel increasingly comfortable in backing the green energy transition in China.
Outlook and Strategy
In the US and parts of Europe strong demand, labour shortages (partially fed by a high savings rate and transfer payments) and supply chain bottlenecks have seen goods prices, consumer prices, and to some extent wages, spike. In Asia, where economies are a few steps behind in the Covid reopening, inflation rates remain near their all-time lows in most countries, and this is despite relatively high energy prices. In the case of Southeast Asia this is largely due to strong central banks, and a relative lack of monetary or fiscal stimulus compared to the advanced economies. It is also partially true of China, where however we shared on the divergence in high PPI (producer prices) and low CPI (consumer prices) indices measuring price stability in the last quarterly update. This spread has further widened and producer prices have accelerated. This should support industrial profits and the fund is actively trying to position this way ahead of full-year results and positive profit alerts.
The power shortage in China was a further shock to the system. This looks about one half self-inflicted and one half being at the mercy of global markets. China has been for many years on a quest to green its economy and energy generation. Beijing sets targets at the provincial level for overall amounts of energy consumed, as well as the energy intensity of production. Most provinces had been behind those targets during the first half, and now have to make up. This also had been a particularly high energy consumption year as China was busy producing and exporting goods to Western markets where most of demand had shifted to physical wares rather than services. As a result, factories and power plants, many of which owned by companies we interact with regularly, had to reduce their production volumes. China announced a cement production restriction order at the end of August with implementation from September. Guangdong regulated that average electricity consumption in September would be reduced by 40% compared to the prior month, with another 50% reduction in October. Guangxi is even stricter with 60% reduction. China will further restrict activity to allow for clean air to accompany the Beijing Winter Olympics in February 2022. These interventions however coincided with a partly regional, and partly global shortage and price spike in coal and natural gas, and processing industries couldn’t get access to these raw materials. Power plants had to shut down because they would be producing at a loss with spiking feedstock prices and rigid domestic power prices (electricity is not a free market).
A lot has been written about Chinese property and Evergrande by analysts and the financial press. The most important takeaways as they appear to us as a forward-looking investor: Of nearly US$300bn liabilities at Evergrande, “only” a third are financial liabilities i.e. bank loans and bonds, the other two thirds are prepayments from customers and dues to suppliers. These $200bn probably affect more than ten million immediate family members of homebuyers and millions of employees of suppliers. This creates a political imperative to finish the construction of the work-in progress. We understand this is precisely what is happening on the ground with local governments arranging for completions. The CCP leadership must be very confident to have this crisis under control: the government is steering projects almost exclusively into the SOE sector’s hands, and the government is not actively crowding in private capital. Further implosions of Fortune Land and Kaisa notwithstanding, Beijing remains keen to teach the sector a lesson and remove moral hazard. Auctions for new land sales to developers are seeing a steep decline, and construction activity would naturally slow down. At some point, the government would need to selectively allow for some easing.
The expectation (and we belonged to this camp) that President Xi would not want to upset the apple cart on course to his third term couldn’t be further from what transpired. On the contrary he appears so reassured of his transition that he chose this window, with China’s population locked inside the country, to carry out long-delayed reforms. This is creating winners and losers for the fund to re-position. For example, stock-market listed firms are typically stronger than the private listed companies, and will emerge out of this crisis taking market share from the smaller players (including in real estate). Given the plethora of policy shifts by Xi and the desire for tighter control, and a bias that has disadvantaged the private sector, we are seeing opportunities in well-managed and reforming state-owned enterprises (SOEs). The State-owned Assets Supervision and Administration Commission of the State Council (SASAC) used to discourage but is now encouraging share-based executive compensation in SOEs, and is encouraging dividend payments, all signs of increasing alignment with minority shareholders.
These have been tumultuous few months for China. Shares are now priced for significant upside if a meltdown scenario is avoided. Likewise, Southeast Asia’s past decade of near sideways performance has left most of its shares in deep value territory. A tightening of monetary policy in developed markets thus need not be negative for Asia Pacific. While long duration valuations on the Nasdaq would be at risk, (short duration) value in emerging markets may have its time.
Florian Weidinger, Hansabay