Is it time to look again at China?

Despite the impressive performance of China’s economy its stock markets underperformed many of their emerging market and Asian counterparts during 2009 and 2010. Moving into 2011 however, and there are signs that this trend is beginning to reverse with Chinese shares outperforming broader emerging market and Asian markets over the first three months of the year. At F&C we believe that the reversal is set to continue and have been selectively increasing our Chinese weightings across our portfolios.

Why has China underperformed?

Before outlining China’s attractions it makes sense to remind ourselves of some of the reasons for its relative underperformance. In our view the government’s intervention in the economy has been behind much of the malaise as it attempted to tackle inflation and cool growth. As well as more orthodox approaches, such as increasing interest rates, Chinese policymakers have adopted more micro-management techniques. Among the most notable have been the controls placed on banks including the nine increases to the reserve ratio requirements. For the property sector mandatory deposit down-payment levels were increased and a property tax trialled.

From the government’s perspective the measures were successful. From an investment standpoint however the risk premium associated with the market increased with sometimes dramatic valuation contractions in sectors like those mentioned above.

Inflation has been the second key issue, rising from a low of -1.8 per cent in July 2009 to in excess of 5 per cent. Food prices and housing costs have been among the key drivers of this rise in prices with the former exacerbated by the poor harvests of the second half of 2010. The government moved to stimulate the agricultural sector and less extreme weather conditions have helped ease the pressure on prices which are beginning to fall.

At the same time the government has actively moved to get to grips with the real shortages in housing through targeting 10 million new homes in 2011 and a further 10 million in 2012 – a significant jump from the 2.3 million new builds in 2009. This injection of capacity should help moderate the effect of housing costs on overall inflation.

Growth intact…

Although inflation does look to be easing, economic growth remains healthy with an expansion of 9-9.5 per cent expected for 2011 and 2012. Importantly, China appears to be without many of the significant macro-economic concerns that are so apparent across much of the developed world.

…and an increasing opportunity set

One factor that has seemed to concern many potential investors in Chinese equities is the perceived lack of companies that look attractive from an investment perspective. At F&C we would argue that this situation has really changed for the better. The market has evolved significantly over the last five years becoming less reliant on the oil and commodity sectors.

Additionally there has been a real increase in the number of easily tradable companies orientated towards China’s fast growing domestic economy. The banking sector illustrates this well, becoming the largest sector in the market and demonstrating impressive profits growth.

We also believe that consumer related and property sectors abound with potential opportunities and see selective value within coal and cement.

Mindful of risks

Although we are positive on China we remain mindful of the potential risks to our upbeat assessment. A dramatic acceleration in trade friction with the US is something that we would monitor but the biggest threat remains a stalling of global growth.

Unlike many of its developed counterparts however China would be relatively well positioned. Why? Because it is relatively unique in the fact that its tightening process is drawing to a close, giving the authorities scope to adopt a more accommodative stance should conditions dictate.

This contrasts sharply with the likes of the US, Europe and UK where inflation continues to pressure central banks into raising rates.

Overall attractions

On balance we believe that the positives outweigh any potential negatives when it comes to investing in China and across our portfolios we have been selectively increasing our exposure to Chinese equity markets.

As ever it makes sense to maintain a diversified portfolio meaning that China is not the sole market we are currently favouring. For example, we are overweight Brazil for a number of reasons, including strong momentum in its domestic economy that is not reflected in share prices, many of which remain attractively priced relative to other emerging market economies.

Nigeria is another country where we see opportunities, particularly among the financial sector against a backdrop of major improvements to corporate governance and the regulatory environment. There is also scope for structural improvements in the energy and electricity sectors as a result of upcoming elections.

Closer to home we like Hungary – a country unloved by many others who we would argue are being too bearish on its economic prospects. Many share prices are cheap and its open economy and proximity to Germany mean it is well placed to benefit from the German powerhouse economy.

Mike joined F&C’s Emerging Markets Equity team in February 2011. Previously, Mike had worked for Nevsky Capital as an Asian Fund Manager and was manager of Nevsky’s Emerging Asia fund from its launch in November 2007, and was also latterly responsible for the Asian portion of the Global Emerging Markets fund. Nevsky Capital was created from the Emerging Markets activities of Thames River Capital which Mike had joined in February 2004. Mike was previously a Director of Emerging Markets Equities and Global Resources at Baring Asset Management where he started his career in July 1994. He has a first class BSc in Economics from Southampton University and is AIIMR qualified

F&C, one of Europe's leading investment management companies, is listed on the London Stock Exchange. The company was founded in 1868 and is one of the oldest and largest asset management companies in Europe. Since 1 September 2010 Thames River Capital belongs to the F&C Group. The deal aligns two asset managers with complementary areas of expertise and capabilities, creating one organisation with the scope to deliver a broad range of investment solutions to all clients. The F&C Thames River Group manages a total of €123,5bn assets under management (as at 31.12.10).