The outlook for China

Key points

• Recent months have been very challenging for Chinese equities due to regulatory and economic uncertainty. The relative underperformance of small-cap and growth as a style factor have particularly impacted the trust.
• A lot of the negative newsflow is now reflected in current valuations, which look very attractive relative to other markets and its own history.
• Despite near-term uncertainty, we remain positive on the investment opportunities on offer in China. We have put money to work in areas where we see long-term value and gearing levels have increased.

The current backdrop

The property-induced economic slowdown China experienced towards the end of last year has continued into the opening months of 2022. This has been exacerbated more recently by the strict Covid lockdowns we’ve seen in large cities such as Shanghai. The direction of China’s Covid policy is hard to predict, but I do think we are likely to see a gradual opening up as more antiviral drugs - and perhaps even vaccines - get approved for use. This would clearly be a significant boost for domestic consumption as it would release pent-up demand.

On the regulatory side, the policy tightening we’ve seen over the last 12 months has also significantly impacted investor sentiment. The magnitude of tightening has been greater than what we have seen in the past, but I believe we are now past the peak and approaching the end of this cycle. Looking ahead, we may even start to see some loosening as the government has a lot of room to move, particularly in property, while some fiscal and monetary stimulus will also be required for the government to hit its 5.5% GDP growth target for 2022.

 Against this backdrop, it is unsurprising that corporate earnings have generally been revised down and we have seen this come through in reporting, particularly in consumer discretionary and property-related areas. The current consensus is for around mid-teens earnings growth this year, with a pick-up over the second half of the year as the economic picture improves.

Trust performance

The last 12 months have been very challenging for the trust from both a Net Asset Value (NAV) and share price perspective. We were relatively highly geared heading into the market correction and this had a clear negative impact on performance. The relative underperformance of small-cap and growth as a style factor have also been two major drags on relative returns given the core investment philosophy of the trust. At the sector level, our holdings in technology have detracted as the above-mentioned regulatory tightening has driven broad-based weakness in this space.

Past performance is not a reliable indicator of future returns.

Source: Morningstar as at 31.03.2022, bid-bid, net income reinvested.

©2022 Morningstar Inc. All rights reserved.

Outlook and positioning

Despite recent challenges and ongoing uncertainty, we remain positive on the investment opportunities on offer in China. We believe a lot of the negative newsflow is reflected in current valuations, which look very attractive relative to other markets and its own history. What’s more, a likely looser policy stance is in direct contrast to what we are seeing across other major economies - this backdrop supports the case for China to outperform on a relative basis moving forward.

Our increasingly positive outlook is reflected in current gearing levels, which have increased over the last couple of months with net gearing standing at around 125% today. This is due to a combination of adding to areas where we see significant value and closing the majority of our short positions in the wake of the market correction.

In terms of sector positioning, the trust remains focused on stocks and sectors that appear well positioned to benefit from China’s long-term structural growth drivers. Indeed, despite recent uncertainties, powerful trends like the growth of the middle class and urbanisation provide a long runway for growth.

Following the significant recent falls in technology-related names, we feel that the risk/reward payoff has tipped much more in our favour in these companies. Alibaba, for example, is trading at a mid-single digit multiple and although it does face some competitive challenges, it remains the dominant platform in China and generates very high returns on capital. As is often the case with broad-based corrections, some stocks with lower regulatory risk have also sold-off, presenting some very attractive opportunities. Interestingly, this includes some smaller companies that could actually be beneficiaries of regulatory changes since most of the new reforms focus more on larger companies.

We have also moved to build-up a sizeable position in industrials which now stands at the largest sector position in the trust. The core thesis around industry consolidation remains very much in place as areas like building materials in China are very fragmented relative to what you see in the West. Some of our paint holdings, for example, have underperformed due to property sector concerns, but we maintain a high level of conviction in the long-term story and see significant potential for future upside as sentiment and fundamentals start to improve.

 Finally, a note should also be made on our unlisted positions, which span a wide range of areas and collectively account for around 13% of the overall portfolio. Internet technology ByteDance remains a major holding in this space and the company continues to deliver very strong revenue and profit growth through Douyin in China and Tiktok internationally. Notably, two other unlisted positions - HR management software provider Beisen and auto maintenance platform Tuhu - have filed for an IPO in Hong Kong and should come to the public market over the next few months.

Summary

Investor sentiment towards China has been very weak and this is something that is usually seen at market bottoms. The combination of weak sentiment and low valuations is creating opportunities and we continue to put money to work in areas where we see long-term value.

Important information

Past performance is not a guide to future returns. The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments are subject to currency fluctuations. Fidelity China Special Situations PLC can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. This trust invests more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies and the securities are often less liquid. This Investment Trust invests in emerging markets which can be more volatile than other more developed markets. 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. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

The latest annual reports, key information document (KID) and factsheets can be obtained from our website at www.fidelity.co.uk/its or by calling 0800 41 41 10. The full prospectus may also be obtained from Fidelity. The Alternative Investment Fund Manager (AIFM) of Fidelity Investment Trusts is FIL Investment Services (UK) Limited. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0422/370740/ISSCSO00075/NA