Morning Note: An update on our thoughts on China and the Fidelity China Special Situations Fund.
Market News
US CPI of 3.4% is expected, and 3.5% ex food and energy. Following this, the FOMC is expected to leave interest rates unchanged, with investors looking to Chairman Powell’s comments regarding a rate-cut timetable. The 10-year Treasury currently yields 4.40%, while gold is $2,317 an ounce.
In China, May CPI rose by only 0.3%, slightly below the 0.4% forecast, while PPI rose 1.4%. Factory prices dropped for the 20th month in a row. The data failed to signal a strong rebound, with stubbornly low inflation putting pressure on the PBOC to cut rates.
US equity markets moved higher last night – S&P 500 (+0.3%), Nasdaq (+0.9%) – with Apple up 7% as it more than reversed the previous session’s losses. Oracle also rose sharply after-hours on strong results. This morning in Asia, markets were mixed: Nikkei 225 (-0.7%); Hang Seng (-1.3%); Shanghai Composite (+0.3%). The FTSE 100 is currently trading 0.4% higher at 8,181. Rentokil is up 16% higher on a report that activist investor Nelson Peltz’s Trian Fund Management has taken a sizeable stake.
UK manufacturing production fell by 1.4% month on month in April, worse than the 0.2% decline expected, while industrial production was down 0.9%. Sterling currently buys $1.2740 and €1.1859.
The oil price continued to recover on the back of lower US inventories and currently trades at $82.40 a barrel. Oil output in the US is expected to rise more than previously forecast this year, reaching a record of over 13.2m b/d, as shale explorers remain in growth mode, the EIA said.
The Bank of France cut its economic outlook for the next two years. It sees 2025 GDP growth at 1.2%, compared with a 1.5% forecast in March. Fitch Ratings said France’s snap election heightens fiscal and reform uncertainty but there are no immediate implications the country’s AA-/Stable rating. Press reports suggest that despite all the warnings from the industry, the EU Commission will inform car manufacturers that it will provisionally impose special tariffs of up to 25% on EVs from China from next month.
Source: Bloomberg
China Update & Fidelity China Special Situations
At Patronus Partners, we believe the evolution of foreign policy that began under Donald Trump saw the US take a backward step in its commitment to global institutions and a hardening of attitude towards China. Whilst the Biden administration has sought to re-engage globally, its attitude towards China has been equally hawkish.
China is the upcoming challenger to US dominance as the sole global superpower. Its One-belt-one-road initiative that seeks to increase connectivity, cooperation, and trade across the Eurasian land mass is a highly visible example of this. In recent history, China has employed a mercantilist and highly successful growth policy. However, the increasing focus by the US administration on the bi-lateral trade imbalance is motivating China to change its behaviour. Firstly, it is looking for alternatives to US Treasuries to invest its surplus income from trade, such as real and strategic assets. Secondly, it is reducing the dependency on the US dollar to settle important imports such as energy by launching an oil futures contract settled in Chinese yuan. As China tries to grow into a role befitting of its size and importance on the global scale, it has the potential to create major disruptions to the established world order.
While the arrival of the Biden Administration in Washington offered a natural opportunity to reset the relationship on a more positive footing, it is now clear that the US has given up trying to bring China into its sphere of influence and has resolved itself to enter and prevail in what it has termed a “Great Power Competition”. The meeting between Biden and Xi in San Francisco was widely reported as being “productive” – it is likely that a détente suits both parties at this juncture. From Xi’s perspective he has significant domestic economic issues to deal with, not least the stresses in the property sector. Biden has falling poll ratings and an election to fight in less than six months. Nevertheless, China’s “partnership without limits” with Russia indicates the adversarial nature of US-China relations going forward.
There are times when geopolitics are benign and don’t have large influences on asset prices; this is not one of those times. However, the very nature of a great power conflict is that like the cold war, it plays out over a long period and its intensity ebbs and flows. The sanctions, posturing, and strategic power plays will continue as part of a trend that is still firmly in place. However, it feels like both leaders are very keen to get a message out that they can at the very least “play nicely” when it is in both their short-term interests to do so.
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Fidelity China Special Situations PLC (FCSS) recently published its Annual Financial Report. FCSS is a UK-listed closed-ended investment trust which aims to achieve long-term capital growth from an actively managed portfolio made up primarily of securities issued by companies listed in China or Hong Kong, and Chinese companies listed elsewhere. The fund has been managed by the highly regarded Dale Nichols since 2014.
Earlier in the year, FCSS merged with abrdn China Investment Company, following which the enlarged company continues to be managed in accordance with its existing investment objective and policy. The deal led to an increase in assets – up £126m to over £1.3bn (at 31 May 2024) – over which to spread the company’s fixed costs, helping to reduce the level of ongoing charges for all investors.
The company believes having a large research team on the ground in China is fundamental to success in seeking out the best opportunities, particularly among smaller and medium-sized companies, where the relatively higher growth potential has yet to be reflected in share prices, and investor awareness is low.
In the financial year to 31 March 2024, with global uncertainties and geopolitical concerns remaining heightened, as well as a softer-than-expected economy recovery in the wake of COVID restrictions being lifted, investors in China have once more faced a challenging year. The NAV total return decreased by 16.3%, although it out-performed the benchmark MSCI China Index return of -18.8% (in sterling terms). The share price declined in line with the NAV (-16.4%) as the discount remained pretty much the same. Despite struggling of late, over his 10-year tenure, the manager has generated a total shareholder return of 125.7%, some 75 percentage points ahead of the benchmark index return of 49.3%.
The manager highlights that main driving force of the Chinese economy in the past 10 years has been investment – whether at the government, business, or household level – leading to improvements in infrastructure, strong export growth, and a property boom. More recently, however, export growth has weakened because of global supply chain diversification away from China as well as US trade reluctance (expressed via tariffs and sanctions), and infrastructure is now developed to the point where the marginal impact of additional investment is reduced. Concerns remain in the property market, particularly in the new-build sector, which has a stronger contribution to overall growth. With these three stalwarts of economic growth curtailed, a 5% GDP growth target would be a good outcome that underscores China’s resilience. While a US plan to further restrict sales of advanced semiconductors to China adds an element of uncertainty, particularly in some areas of technology and automation, it is leading to a wave of Chinese invention and investment to compensate. So far, China has surprised in its ability to keep innovating in microchips, in particular. It is also leading the world in electric vehicles, green energy technologies, and battery technology and is making strong progress with AI.
China’s gradual shift towards consumption-driven growth, fuelled by an expanding middle class, rising incomes and technological innovation, provides a solid backdrop for companies to thrive. Consumer trends like experience-based spending, health consciousness, and premiumisation continue to grow. There is also an increasing preference among Chinese consumers and corporates for Chinese brands and local suppliers, resulting in domestic companies taking ever greater market share in what remains one of the world’s largest markets.
As a result, the fund remains focused on stocks and sectors that appear well positioned to benefit from China’s long-term structural growth drivers. By investing in the domestic economy, the manager mitigates much of the geopolitical risk of investing in China. The growth of the middle class from a population of 1.4bn people provides a momentum to consumer spending.
During the period, the biggest contributors to outperformance were stock selection in the consumer discretionary (the largest sector weighting at c. 40%), industrials, and consumer staples sectors. The fund was overweight in all these sectors compared to the benchmark. In absolute terms, the fund’s energy stocks were the best performers, although their weighting is a very small part of the portfolio (2%) and is underweight versus the benchmark. The biggest drag on relative returns was the overweight exposure to financials and materials, while the worst absolute performance was in real estate.
The five largest positions are Tencent Holdings, Ping An (insurance), PDD (Pinduoduo e-commerce platform), Alibaba Group, and Pony.ai (Toyota-backed autonomous vehicle technology), together comprising c. 27% of the gross asset exposure. With more than 100 stocks in total, the fund has a long tail, providing a broad exposure to a wide range of potential growth opportunities.
The fund’s mandate allows for investment in unlisted companies (up to 15% of gross assets, and currently 12.8% in six assets), taking advantage of their early-stage growth before they become listed on the public markets. During the period, three unlisted holdings achieved their IPO. With valuations in the listed equity market currently at historically low levels, the manager has said that any potential new private investments would have to be very attractive in order to win a place in the portfolio. The company has confidence in the strength of the detailed process for the valuation of its unlisted holdings – they are assessed regularly by Fidelity’s dedicated Fair Value Committee with advice from Kroll, a third-party valuation specialist.
Because of confidence in the long-term growth characteristics of the Chinese economy, the manager includes an element of gearing in the portfolio – 20.8% at the end of the period. We would highlight that although gearing can enhance long-term returns, being more than 100% invested means the NAV and share price may be more volatile and can accentuate losses in a falling market.
The manager highlights that Chinese companies – even in the state-owned sector – are becoming increasingly focused on rewarding minority shareholders, including through the payment of dividends. This has helped the fund grow its dividend since launch. A payout of 6.40p has been declared this year, up 2.4%, equal to a yield of 3%.
The fund has a tiered fee structure of 0.85% on the first £1.5bn of net assets, reducing to 0.65% on net assets over £1.5bn. There is also a variable element, +/- 0.2% based on performance relative to the benchmark. As a result of the out-performance against the benchmark in the latest year, there was also a variable element of 0.15% to give a total ongoing charges ratio (which includes the costs of running the company) of 1.13%.
The board operates a formal discount control policy whereby it seeks to maintain the discount in single digits in normal market conditions and will repurchase shares with the objective of stabilising the share price discount within a single-digit range. During the year, the discount widened slightly from 9.7% to 10.2%, and currently sits at around 10.6%, and the board authorised the repurchase of £45.9m of shares, representing 3.5% of the issued share capital.
Looking forward, the manager points out that while the Chinese economy remains sluggish, having failed to reap fully the benefits from the post-COVID reopening, there are undoubtedly signs of improvement. In addition, China’s financial markets in the shorter-term are often heavily influenced by geopolitics and macro decisions, which have been more of an issue in the last few years, amid one of the longest and harshest regulatory environments. Despite this, regulation trends are typically somewhat cyclical, and the government is now increasingly focused on economic growth. At the same time, the manager says it is heartening to see that the Chinese authorities have not been panicked into implementing one-off large measures to boost the economy. They are going about things in a gradually stimulating fashion on both the fiscal and the monetary side, which will hopefully lead to a more balanced outcome.
Meanwhile, the manager believes that with Chinese equity market valuations at particularly low levels, both relative to their own history and in a global context, there should be many opportunities for investors to participate profitably in the recovery. Perhaps the major risk to the manager’s cautiously positive outlook is the forthcoming US Presidential election. US relations with China have stabilised somewhat, although increasing tariffs and trade restrictions remain a concern. There is a significant risk that relations could worsen, and US may implement measures such as raising tariffs on imports from China to 60%, which would significantly harm Chinese exporters and would depress global trade and exacerbate US inflation trends. However, the companies in the portfolio continue to show strong earnings growth, and the manager remains confident the market will come to appreciate the value on offer in the future.
Source: Bloomberg