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Year of the Pig: dig into China’s domestic brands not exporters

11 February 2019

Asia fund managers Mike Kerley and Dale Nicholls believe fears of China's slowing growth are overplayed, although there is no exaggerating the country's long-term rivalry with the US.

Going into the ‘Year of the pig’ managers believe fears around slowing economic growth in China are overplayed, looking to the expansion of its middle class and a refocus to domestic consumer brands.

‘To be honest it’s a function of maths - if the base keeps growing, how can you keep growing at 10%? It’s impossible,’ said Henderson Far East Income (HFEL) manager Mike Kerley who invests nearly a quarter of the investment trust’s assets in China.

‘When was the last time the second largest economy grew at 6%? Some time ago I think.’

The scale effect means that China has recently contributed more to global gross domestic product growth than when its economy was growing at a much higher annual rate of 14% eight years ago, he said.

‘I don’t think we'll see a number less than 5% anytime in the next five years but 5% on an economy of that scale is still quite an impressive performance,’ Kerley added.

While the likes of Apple (APPL.O) and Land Rover blamed recent sales weakness on China’s slowing growth, he said this was more a function of the companies themselves and their products.

This was supported by steady sales growth figures for the likes of Nike (NKE.N) and Coca-Cola (KO.N), among other big international consumer names, over the past year.

Henderson Far East Income saw total shareholder returns, including dividends, drop 3.4% last year, although its underlying net asset value (NAV) did worse sliding 7%, although that was better than the 8.3% fall in the MSCI AC Asia Pacific index. Longer term, the 6% yielder has generated an average total shareholder return of nearly 11% over 10 years, below the benchmark’s 12.9% return. 

Fidelity China Special Situations (FCSS) manager Dale Nicholls agreed China’s GDP growth was ‘enviable’ in a global context and said consumption has continued to grow at a faster rate, supported by an expanding middle class.

‘We have seen a fall in retail sales to high single digits, with high ticket spending seeing a more significant adjustment - as the auto market has seen its first decline in over two decades,’ said Nicholls. ‘However, there have been pockets of strength in the consumer space, with areas like domestic sportswear, baijiu [grain liquors] and e-commerce remaining strong albeit slowing.’

Domestic brands were closing the gap on international competitors, he said, using telecoms business Huawei (2502.SH) and sportswear label Li-Ning (2331.HK) as examples.

Huawei dominated on the basis of continued advancements in its phones at a more competitive price, while Li-Ning’s popularity had grown with there being less stigma around local brands, he said.

Building up his exposure to brokers and insurance companies was part of this play into the growth of China’s middle class.

China Pacific Insurance Group and broker Noah Holdings (NOAH.N) were two examples in the portfolio's top 10, accounting for 4.9% and 2.2% of assets respectively, he said.

‘There is a structural shift from banks to non-banks as individuals reallocate savings - the savings rate in China is huge - to other financial products,’ he said. ‘I currently prefer life insurance companies as penetration is lower, is less developed and is greatly linked to China’s rising wealth.’

Of more concern in the country’s economic slowdown was the Chinese government’s pursuit of deleveraging, in getting rid of the pile of debt it rapidly accumulated, said Nicholls.

‘Tighter lending conditions have had a marked impact on business and consumer confidence as smaller companies have found it difficult to secure funding for investment,’ he explained.

With its near 100% exposure to Greater China (consisting of 35% China, 41% Hong Kong, 19% US-listed Chinese companies and 3% Taiwan), FCSS suffered a far bigger decline last year. The net asset value (NAV) of its investments tumbled 21.6%, while its shares did slightly better with a 18.8% slide, although both were worse than the 13.8% fall in the MSCI China index.

Five-year returns have been better, however, with shareholders receiving an average 15.8% a year compared to 14.2% from the benchmark, according to Morningstar data.

Regardless of the conclusion to the current trade negotiations between the US and China, Kerley argued the US would continue in its attempts to stunt Chinese growth.

‘Trade is a little bit of sideshow, a little bit of starter for the potential traumas that could ensue in the years ahead,’ he said.

This centred around fears about the ‘Made in China 2025’ economic strategy of upgrading domestic manufacturing and the resulting likelihood of it taking over from the US as world’s largest economic power.

This struggle between the two countries was therefore likely to continue over the next five or 10 years, Kerley said.

UK markets ended a six-day rally last Wednesday after US president Donald Trump vowed to stop China’s alleged ‘theft’ of American jobs and wealth, in his State of the Union address.

‘Trying to predict what Trump will do next is almost impossible but for us our exposure to the export sector is something we're not particularly focused on,’ said Kerley. ‘What we do like is Chinese brands in a Chinese context, we're not investing in Chinese brands in the global context. The Chinese consumer we think is still pretty healthy even though when you read some publications, it suggests they're not.’

Huawei was a direct example of the US targeting the China 2025 strategy, as a technology producer at the cutting edge of the country’s development, he said.

The US Department of Justice had charged Huawei with stealing intellectual property from German US-listed firm T-Mobile (TMUS.O). The Chinese phone maker’s chief financial officer Meng Wanzhou remains in custody in Canada, charged with fraud violating US sanctions against Iran.

Kerley said he would not be surprised to see American companies losing market share in China as a result, suggesting this had already happened with Apple and pointed out this had happened when China was involved in a spat with Japan.

‘There were people burning Toyotas in the middle of the street in China. I'm not sure we're going to that far and the Chinese have been very careful so far not to issue any comments about buying American being unnationalistic which is what they did during the Japan debacle,’ he said. 

‘But that's clearly something that could happen. So although Chinese exports could suffer from what we're seeing with the US, American corporate sales to China could potentially be decimated.’

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