Fidelity: The Asia Call: China deep dive

Key points

• The recent 50 basis points cut to China’s reserve requirement ratio (RRR), aimed at supporting small and medium enterprises, should boost growth as well as the broader equities market. 
• While increased regulation in China’s technology sector will slow the pace of monetisation in some companies, it is also creating selective buying opportunities among the long-term winners.  
• China’s move to net zero is creating winners and losers and provides active investors with a fertile ground for alpha hunting

Key takeaways

Catherine Yeung: What are the key drivers of China’s macro story currently?

Victoria Mio: The impact of Covid-19 on the global economy has been far-reaching. We have seen four key characteristics during this process: economies that have been hit first by the pandemic have usually been the first to emerge; second is the long tail of exit with the impact of Covid-19 lasting longer than we originally expected; third is the imbalanced recovery between developed economies and emerging markets and, lastly, the structural divergence between domestic sectors and global sectors.

Looking forward to the second half, as first in and first out, China has now entered the post-pandemic new normal. During this time, we have seen the Chinese economy peaking and subsequently falling into more moderate growth. Over the past year, investors have increased allocations to Chinese equities in their global equity portfolios mainly due to China’s higher economic growth and superior fundamentals.

Last week’s announcement by the People Bank of China (PBOC) to cut the RRR - the amount of cash that banks must hold as reserves - by 50 bps will further boost core domestic demand. We think this easing environment should be constructive for growth and the broader equities market.

CY: Has the recent RRR cut been driven by corporates, especially small and medium enterprises, highlighting the need for more credit? And how concerned are you about inflation?

Dale Nicholls: Economic trends, in general, have been strong, so at a company level there has not been a call for this kind of stimulus. But obviously, this is a positive signal. The biggest impact will be the guidance to banks around lending as we have seen the credit impulse slow down significantly. So greater encouragement to banks to lend more, which is a clear driver of economic growth, is welcome. We now need to see if this target or aim is implemented though by the banks.

In terms of inflation, we are seeing some pricing pressure when we speak to companies, but we expect this to be transitory. The key is the ability of companies to pass this on and this is what we are focused on.

Elsewhere, in less-loved parts of the market such as the materials sector, we have selective exposure to companies that look well placed to benefit from the ‘industry consolidation’ theme. Many industries remain very fragmented compared to industry structures we see in the West, but the process of market consolidation is clearly underway, and it may have accelerated with the disruption from the pandemic. We remain focused on identifying the winners emerging from this process. Looking at pricing power, there are signs that companies in the sector will be successful in getting those price hikes.

One of the sub-sectors that we have found attractive is the paint business, which is characterised by high margins, robust returns on capital and strong cash flows. An example here is SKSHU Paint, one of China’s largest paint manufacturers, which offers products such as exterior architectural coatings, interior household paint products and waterproofing materials.

CY: Is government support in areas such as technology and innovation still core to overall policy?

VM: Last year as part of the Covid-19 relief package, China announced stimulus measures in both traditional infrastructure and new digital infrastructure. The government has already reduced the traditional infrastructure spending this year but has continued to channel money into new digital infrastructure, underlining China’s focus on becoming self-reliant in these strategic areas.

E-commerce has been a deflationary factor as it allows consumers to buy goods at lower prices. So even with greater regulation, we expect ecommerce platforms to continue to grow and become an even more important part of the economy.

CY: How much of a concern is this the latest round of regulatory probes on some of China’s high-profile tech companies?

DN: The core areas of focus are around antitrust and data security. Firstly, regulation of big tech is not just a China phenomenon, it’s happening globally. We are seeing regulation on this in the US as well. Secondly, there’s also an element of catch up here. In terms of establishing regulation, China has lagged both on the antitrust side and in terms of data security.

However, there is an awareness that the tech sector is one of the fastest growing sectors, one of the biggest employers with generally some of the biggest leaders in innovation, which we know is a key priority, so I don't think there's a real intention to hold them back too much.

In terms of the stocks, this is something we need to watch and see how the regulation plays out. It’s fair to assume that the pace of regulation might slow the pace of monetisation for companies. But this is getting priced in very quickly and we are now seeing a significant divergence in the performance of tech in China versus the US.

Looking purely from the investment side and having experienced previous cycles, I believe we have now reached a point where we can potentially look at increasing holdings in some of these companies.

CY: Can you outline the progress China has been making on the sustainability front?

VM: In September last year, China announced that it would aim to reach its carbon peak by 2030 and achieve carbon neutrality by 2060. As a result, a lot of state-owned enterprises and private companies have carried out changes to successfully implement these initiatives.

This has created a lot of opportunities as well as risks. For instance, this month the PBOC announced a new green finance evaluation method and is likely to follow up with a number of policy tools to support this policy.

While loans from banks have slowed of late, it is notable that green loans have seen a sharp rise in the last three years - potentially becoming the new strategic growth driver for many banks as they offer higher profitability and lower default risk.

We are also seeing tremendous opportunities in alternative energies such as wind, solar and the electrical vehicle (EV) space. In EVs, we are seeing opportunities along the entire supply chain - from raw materials to auto parts to the whole electric car itself

But there are also risks. As these initiatives have encouraged banks to think about how to achieve carbon neutrality by supporting the green sector, it has also pushed them to reduce loans to the high carbon industry. As such, the move to sustainability is creating winners and losers and as active investors this provides us with a fertile hunting ground.

CY: We have talked about some of the investment opportunities emerging from the sustainability themes. Looking at EVs for instance - what is your view on the opportunities here?

DN: These are significant trends driving huge change, so we spend a lot of time assessing potential beneficiaries. This can be hard as a lot of the benefits get reflected in stock prices very quickly, so we have to tread carefully.

We have holdings in the trust that are going to benefit from the increasing penetration of EVs. But if you look across the spectrum of producers, you’ve got a number of new players coming into the market, challenging incumbents. We don’t think some of this potential competition has been factored into stock prices.

There are other areas such as renewable energy where you can invest in sectors such as solar or wind where there's a lot of potential. However, investing in solar can be hard as a large part of this is based on commodities, so it comes down to calling the cycle, which can be difficult.

These are big themes and we are very selective about trying to buy companies at the right price that can benefit from these from these structural growth drivers.

Important information

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in small and emerging markets can be more volatile than other more developed markets. Fidelity China Special Situations PLC has the potential of having high volatility due to its composition or portfolio management techniques. It can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and cause investments to experience larger than average price fluctuations. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. A focus on securities of companies which maintain strong environmental, social and governance (“ESG”) credentials may result in a return that at times compares unfavourably to similar products without such focus. No representation nor warranty is made with respect to the fairness, accuracy or completeness of such credentials. The status of a security’s ESG credentials can change over time. Investments in smaller companies can carry a higher risk because their share prices may be more volatile than those of larger companies. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for illustration purposes only.