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Be brave on China when others are fearful

27 February 2024 Gareth Stokes

The fact that Chinese equities are so out of favour at the moment brings to mind Warren Buffet’s oft-quoted investment philosophy: “be fearful when others are greedy, and be greedy when others are fearful”. As 2024 got underway, FAnews set out to learn more about prospects for global financial markets with a strong focus on the world’s second largest economy

We found some answers at a media briefing titled ‘Investment Outlook in the Year of the Dragon’ hosted by global asset manager, Ninety One. Philip Saunders, a director at the Ninety One Investment Institute, got the briefing underway. He said that 2023 had been one of the toughest years in his four-decades of financial markets experience and that there were likely further challenges in store for the coming year. 

Mixed macro signals

According to Saunders, the continuing overhang from the COVID pandemic had distorted many of the traditional macroeconomic signals. This phenomena resulted in “extraordinarily narrow equity markets” as evidenced by the domination of United States (US) equity returns by just seven shares, christened the Magnificent Seven. The distortions also caused heightened uncertainty around how global central banks would respond to volatile inflation. “Western central banks have been one step behind on interest rates; they tend to have a bit of a rear-view-mirror approach informed by lagging data,” Saunders said. 

Entering 2024 there was broad acceptance that interest rates had peaked; but central banks were delaying entering a cutting cycle until they had a clearer view of inflation. “The lagged impact of the monetary policy tightening, particularly in the US, has not been fully seen [and] there is the potential for more economic ‘bumps’ in the road,” Saunders said. He added that reaching a peak in inflation and interest rates was helpful; but warned that developed market inflation would settle at a higher level than seen during the decade emerging from the Global Financial Crisis (GFC). Overall, however, many developed market economies may enter a disinflationary period this year. 

Buy on the volatility dips

Saunders said that the Eurozone economy was already in recession, and that many countries in the region were  at risk of entering deeper recession over the coming 12-months. In contrast, the US looks likely to avoid recession altogether. Although economists are still waiting for the full impact of interest rate cuts to filter through to that economy there are promising signs that the country’s leading recession indicators, once thought of as infallible, are wrong. In this context, asset managers will probably bide their time, leveraging market pullbacks to increase exposures to their preferred asset classes and equities. 

After some comment on secular re-leveraging in the Japanese economy, Saunders suggested that the normalisation of inflation and interest rates at a higher level contributed to a much healthier macroeconomic environment than what prevailed during long periods of ultra-low interest rates. “Ultra-low interest rates encourage capital misallocation; a reset in the cost of capital is, therefore, a positive over the medium- to longer-term,” he said. The test facing asset managers is to figure out how far and how aggressively central banks will cut interest rates, and to what extent the bond market will benefit. 

Central banks in emerging market economies were praised for tightening their monetary policy stances aggressively and pre-emptively in 2022-23, while the Bank of England, European Central Bank and US Federal Reserve were criticised for taking too long to respond to inflationary pressures. The result is that “there is a lot of opportunity for income-centric investors in emerging market bonds rather than conventional high yield debt and investment grade credit,” Saunders said. Ninety One indicated they had  been adding duration to global bond portfolios since the third quarter of 2023. 

Shares favoured over precious metal

Gold cracked a mention for holding up “remarkably well” despite the headwinds caused by higher real interest rates and a strong dollar. According to Saunders, the physical metal is in a structural bull market that makes it enticing for private investors to own, though there are better asset classes for fund managers to allocate capital to. For example, there are a number of gold shares that are “extraordinarily cheap relative to the metal” presently, and thus offer a more sensible alternative for short- to medium-term portfolio exposures. 

Investment decisionmakers are struggling to form a clear picture on China’s prospects. “The expected post-COVID recovery was pretty muted due to the structural challenges that China faces,” said Saunders. He said that investors had entered 2024 conflating the country’s short-term versus medium- to longer-term issues, and that the short-term environment was increasingly supportive of the Chinese economy. Ninety One then offered three arguments to counter the ‘doom and gloom’ consensus view on the world’s second largest economy. 

The first argument took the form of a question: If China is facing a liquidity trap, why are commodity prices so well-behaved? The second argument was more of an observation, being that Chinese equity markets were being driven down by US investors who had bought Chinese equities at high earnings multiples, were disappointed by the returns on these investments, and subsequently decided the country was un-investible. 

And third, was that quality Chinese shares were available at extraordinary prices. “We think that we are in a sort of bottoming process; whilst we are not expecting an ebullient recovery there is no reason for China’s economy not to do reasonably well in the Year of the Dragon,” Saunders said. Should you and your clients be adding China to your offshore portfolios? 

Countless constraints keeping China down

Wenchang Ma, Co-Portfolio Manager for All China Equity at Ninety One confirmed that the Chinese equity market kicked off 2024 on the back foot, extending the momentum from the preceding 12-months. She added that Chinese equities had been falling over the past three years with a combined onshore and offshore Chinese listed equities market fall of about 40%. This lacklustre performance was due to China’s property deleveraging; the slow pace of consumption-led growth post-COVID; and insufficient policy to translate into the real economy. Geopolitics and global interest rate hikes have not helped either. 

“Despite all the challenges, the current market risk-reward looks more tilted to the upside,” Wenchang said. “Investor sentiment and asset allocation is close to extreme negativity [and] Chinese market valuations are almost back to the post-COVID reopening levels and quite close to the global financial crisis (GFC) level”. Sentiment and valuations are at such extremes that the MSCI China is trading on an eight times forward price earnings, and Chinese markets are trading at a 20-30% discount to their long-term average and offering a 40-50% discount to the MSCI World. 

In addition, global active managers’ allocations to China are at near record lows. Returning to Buffett’s advice of “being greedy only when others are fearful” this might be the perfect moment to increase exposures to that economy. “We have been accumulating exposure to Chinese companies across our global portfolios,” Saunders said. “There is quality on offer at extraordinarily attractive prices”. 

His sentiment was shared by Wenchang who said there were plenty of alpha opportunities among Chinese companies. Aside from the long list of companies generating 20% earnings growth or better over the last 12-months, it was also possible to snap up companies showing 9-10% dividend yields. “The risk reward is very much tilted to the upside for the Chinese markets,” she said. 

Disinflation and uncertainty

Disinflation, or at the very least a higher level of global inflation, and uncertainty emerged as two key financial market themes for 2024. “There are lots of elections going on this year, with the US presidential election standing out as the most important,” said Saunders. He reminded journalists that both Biden and Trump were fiscally profligate which meant that investors would have to keep a close watch on the funding of the US deficit. Under this ‘cloud’ asset managers should not get too ambitious about the returns from long-duration US bonds. 

Turning to geopolitics, Saunders said the market remained concerned over the relationship between China and the US. “The rift is going to continue but we think its going to be less kinetic [this year] simply because both the Americans and the Chinese have little interest in increasing tensions,” he concluded.  “Investors should not get to too carried away with geopolitical risks but rather focus on the market fundamentals in order to get investment decisions right”. 

Writer’s thoughts:

Deciding where to position your client’s global assets can be a trying task. Entering 2024, are you adding to China exposure, or do you intend staying faithful to the US and its Magnificent Seven equity bonanza? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.

 

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