During the 3rd quarter, the fund lagged the MSCI Emerging Markets index by 3.4%. The greatest drag came from Korea and Taiwan as well as our Latin American energy positions. This was partly offset by a very strong performance from our Chinese portfolio which was up by an average of 29%, largely during the final days of September. Investors rushing to rebuild positions in China by selling everything else as well as numerous market holidays did cause some unusual end of month moves in other Asian markets.
The rally in our Chinese holdings has taken us from a neutral to a modest overweight position against the index. We did reposition the portfolio even more towards consumer stocks and reduced exposure to banks in China as we see the latter being asked to support the former by the government. We have also used weakness in Taiwan and elsewhere to add to companies that are exposed to a possible Chinese recovery but have been used as a source of funds by global investors. We have reduced exposure to oil and gas given the unfavourable medium term supply/demand outlook but maintain a few smaller positions that show extreme undervaluation.
As we write these words some weeks after the initial excitement, it remains unclear how large or how effective
Chinese stimulus efforts will be. What has been signalled is that the highest levels of government have begun to
take the economic malaise seriously. It finally seems possible that China could implement the largest and most
co-ordinated package of monetary and fiscal measures since the global financial crisis, but details are only being trickled out gradually. This may be because decisions have not yet been taken or part of a deliberate strategy to ensure markets are constantly anticipating further good news. Clearly there is no silver bullet for all of Chinas problems but there may be a pathway towards restoring some economic balance. Either way, it will only become obvious in hindsight whether the measures succeed in pulling China out of its current malaise. Their effectiveness depends on kick-starting a positive feedback loop where confidence is restored to consumers leading them to open their wallets and generating growth. It is classic `animal spirits` as described by Keynes.
While we cant predict the outcome, markets need to start pricing some possibility of success in shoring up demand. With Chinese stocks having been highly depressed and under-owned by global investors, it is not surprising that we have had a sharp rally. This has taken the MSCI China index back to near 11x P/E, somewhat above middle of its recent range – no longer extraordinarily cheap but certainly not in bubble territory. However, the valuation is based on depressed earnings – should stimulus measures be successful, we could see meaningful upwards revisions in earnings expectations. Internet retailers earnings are especially highly geared to a possible recovery as they have been working on improving efficiency during the difficult times. The rally in stock markets, if it continues, could help build up fragile confidence that might eventually become self-sustaining.
Of course, there remains the possibility that government measures prove ineffective due to timid implementation, geopolitics or simple bad luck – we are dealing with animal spirits after all! Such a scenario would lead to even worse outcomes as a resumption in falling stock markets would produce a negative wealth effect across Chinas 200m retail investors to compound the impact from falling property prices. It would potentially leave the government with little ammunition to address an even more depressed consumer and likely out of good ideas (but potentially trying out some bad ones). It is also clear that engineering a cyclical rebound will not solve deep structural issues – these require a deep re-think of the governments economic objectives including long-cherished growth targets.
Looking ahead, we need to consider all possible scenarios. Our bottom-up valuation analysis keeps us invested in China even after the rally as markets remain sceptical of positive outcomes. Our appreciation of the challenges faced by the leadership and uncertainty about decision making prevent us from building more aggressively overweight positions. And yet, this is as positive as we have been on the market for a number of years.
