Despite trade tensions and a slowing economy, there is a positive case to be made for China’s A-share market aside from valuations. Household income continues to grow 10% a year and the government continues to hike minimum wages. Furthermore, due to demographics, there is a shortage of skilled blue-collar workers. The income growth of the average household matters much more to earnings than the GDP of the overall economy.
Low Valuations Bring Opportunities in Cyclical Sectors
The most interesting opportunities are in cyclical and trade-related sectors in China that have crashed and for which earnings expectations and valuations are very low:
- China autos – Auto sales were down sharply in 2H 2018, with negativity on these stocks as bad as it has ever been and valuations at their lowest point. However, it is important to bear in mind that auto penetration in China is still low compared with other countries in Asia Pacific, indicating that the structural story remains intact. The industry has temporarily shifted from structural to cyclical growth and potential policy easing might provide additional support.
- China property – Inventory levels are low and affordability outside the top few cities is very good, offering opportunities for high-quality property companies to gain market share and compound earnings throughout different market cycles. Property is an important engine of the economy that has been quiet for a few years, and the government is already easing policy in this sector.
- Trade-related companies – While the outlook for trade with the US is muddy, the US accounts for less than 20% of China’s exports. We are mindful that net exports are not a big driver of economic growth in China, but export-related industries remain important employers. Given the depressed valuations that A-shares are trading at, we are of the view that the bad news has largely been priced in.
A key factor to watch is China’s unemployment rate, which remains low at under 4% as of the end of 2018. In early 2009, a sharp uptick in Chinese companies telling their workers not to come back to the factories after Chinese New Year alarmed officials. Officials will be laser-focused on whether unemployment can become a problem after the upcoming Chinese New Year holiday in a week.
Regardless, we believe high-quality companies that can compound earnings in different cycles and through macro ups and downs can continue to perform well in this environment.
Key Risks – The following risks are materially relevant to the fund:
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