Small Steps Into China

There was little shelter for investors in 2022, in what was both a remarkable and challenging year in the markets.

The environment soured early with inflation, already in the system, exacerbated by Russia’s invasion of Ukraine and the subsequent pressure on energy prices. There were few places to find cover and no asset class was left unscathed.

That said, the trajectory of Chinese equity markets felt different from broader indices. Inflation played less of a role than in the West although the impact of energy prices has certainly been felt. Instead, we have been swimming in choppier waters with the attractive fundamentals of Chinese companies butting heads with a myriad of other headwinds.

Headwinds and perceptions

Perception risk was, and still is, a big issue for China, particularly through the lens of a global investor.

Global tensions over China’s relationship with Taiwan were present through much of 2022, stoked in part by the Ukraine conflict. Additionally, China has been on the receiving end of specific trade restrictions from the U.S, a further escalation of already tensed relations between the two economic powers. Fortunately, talks between the two nations are unfreezing, with President Xi and President Biden meeting in Bali in November.

What has been more challenging, however, has been the impact of China’s zero-COVID policy which has seen swaths of the country plunged into lockdown for weeks at a time. Some areas of the market have proven robust but others have been impacted negatively by the policy. For instance, the real estate sector has endured a difficult period as contracted sales have slumped, further adding woes to developers who are already strapped for cash. Consumption has taken a hit as well, as the strain of mass lockdowns have affected consumers both psychologically and economically. China’s recent lifting of many of its pandemic policies and its firm pivot to living with COVID from zero-COVID is to be welcomed from an economic standpoint though the abrupt manner of the transition will bring challenges in the short term for China’s health services and daily life generally amid an inevitable rise in COVID rates.

Fundamental drivers

Despite the disruptions China’s domestic economy has faced, several allocations within the Matthews Asia Funds China Small Companies Fund have performed over the past year. The portfolio seeks to invest in small innovative and efficient growth companies that stand to benefit from secular growth trends.

In terms of absolute performance, several healthcare names – including those in biotech and medical devices performed well for the strategy given the outlook of less severe price cuts and the longer-term opportunity for healthcare innovation within the country.

"In 2023, in what will be the Year of the Rabbit, we are looking at two key catalysts for China’s equity markets.” Portfolio Manager Winnie Chwang

Some of the Fund’s exposure within the solar tech sector has also been beneficial, and we see this space as a longer-term theme as China reorients towards energy self-sufficiency. Elsewhere, several of our positions which benefit from increased robotics and automation in China’s increasingly modern factories have performed well and remain long-term components of the portfolio.

Our allocation towards real estate, however, has been detrimental to performance, due to the overall suppression of the market in China. We do, however, believe that valuations are too depressed to ignore and the sector will be of net benefit once the policy environment becomes more supportive.

The portfolio also holds some small tech companies based in Taiwan which, despite favorable valuations, have suffered due to the geopolitical tensions between China and the U.S. as well as concerns about global semiconductor cycles. But like Chinese real estate, we think the long-term fundamentals of this sector are intact and will recover as political sentiment as well as more efficient inventory digestion of semiconductor components progress.

Source: Factset Research Systems as of 31/12/2022

Investment catalysts

So in 2023, in what will be the Year of the Rabbit in the Chinese Zodiac, will we see a recovery in the economy? For the Chinese equity markets, we are looking at two key catalysts.

Despite its intentions, zero-COVID has undoubtedly been detrimental to markets and a severe brake to the domestic economy. The lifting of the policy will be welcomed by investors, both in China and internally, as it should unlock the suppressed value hidden behind the mass lockdowns and travel restrictions. 

The second catalyst is China’s refocus on its growth economy, supported by economic easing opportunities. While the U.S. is forecast to continue its monetary tightening into 2023 and Europe faces recession, China is in the unique position to be able to consider easing its monetary policy and targeted stimulus could be possible. Doing so will likely make China unique amidst many of its major peers, which are steadfastly on track for higher interest rates.

Of course, we are mindful that many of the challenges of 2022 have not yet passed. We cannot speculate on the near-term economic impact of the end of China’s zero-COVID policy. Likewise, geopolitics remains difficult to account for, although having borne the brunt of trade restrictions with the U.S., we anticipate that Beijing will deploy a renewed focus on self-sufficiency. Looking forward, China may well seek to limit its reliance on imports from international markets which may in turn provide further opportunities for the portfolio.

We enter the year with optimism. The fundamentals that made China attractive to us throughout 2022 remain in place and the headwinds which have blown against us now appear to be easing. There’s light at the end of the tunnel. With our portfolio positioned to benefit from China’s re-opening, both domestically and internationally, we look forward to the opportunities it may bring.

Winnie Chwang
Portfolio Manager
Matthews Asia