Trade negotiations - and the subsequent signed agreement with the US - coupled with slowing headline growth have kept China firmly in the headlines over the opening weeks of 2020. Fidelity China Special Situations PLC’s Dale Nicholls reflects on the issues of the day and discusses what this means for investors in Asia’s largest economy.
- The phase 1 trade agreement between China and the US was welcomed by markets and signals no major escalation for the time being.
- The ebb and flow of trade tensions over recent months has had some knock-on effect on real world activity with 2019 Chinese GDP coming in at 6.1% - the slowest rate of growth in 29 years.
- However, the slowdown has been a glide rather than a steep fall and areas related to domestic consumption continue to grow rapidly.
With US-China trade tensions dominating media headlines and investor sentiment over recent months, markets were able to breath a temporary sigh of relief as the world’s two largest economies agreed a phase 1 deal in the middle of January.
At face value, the agreement signed by US president Donald Trump and China’s vice premier Liu He does avert painful tariffs and signals no major escalation for a few months. To an extent, markets had already begun to factor this into valuations and over the course of 2019 I had maintained that China and the US would arrive at some semblance of a trade deal. A prolonged period of tariffs would have caused significant mutual damage to both sides, including higher prices for US consumers.
However, reading into the details, the phase 1 deal is far from all-encompassing and investors will now look forward to a second round of agreements. I expect this will be a long-drawn process and it would be a positive surprise if round two negotiations reach some fruition over 2020.
Slowing near-term growth but long-term structural opportunities
The trade tariffs we saw imposed over 2019 clearly impacted financial markets and the uncertainty also fed through to real world business sentiment and activity. This was in part one of the factors behind Chinese GDP growth falling to 6.1% last year, which represents the slowest pace in 29 years.
If you scratch below the surface, however, a more nuanced picture presents itself. The slowdown has been more of a glide than a sharp fall and it is important to recognise that the relative rate of growth we see in China is still significant when compared to the West. Moreover, a number of areas related to domestic consumption are still growing rapidly as domestic demand continues to play an increasingly important role in driving overall economic activity in China.
Fidelity China Special Situations PLC remains focused on identifying and investing in those companies that are benefitting from this structural shift. As a result, the portfolio’s holdings are predominantly domestic-focused with around 90% of revenue for the underlying holdings coming from Greater China.
In addition to rising penetration across a range of consumer categories, we are seeing increasing ‘premiumisation’ and trading up which should not be a surprise as incomes rise. While many foreign players occupy strong market positions, we continue to see local players asserting themselves and building strong businesses from sportswear to toothpaste to coffee chains.
The prospects for these domestic companies are robust and I have a high degree of conviction in their ability to grow their earnings over the mid-term, irrespective of the external environment. This should over time reward investors in the form of share price appreciation.
Technological innovation continues to play a key role enabling and creating new business models across a range of areas in the domestic economy. Alibaba and Tencent are key players - their ecosystems continue to expand and will occupy an even greater share of the Chinese economy, including strong growth in financial sectors and cloud infrastructure.
In terms of other opportunities for investors, the healthcare sector, and in particular contract research outsourcing, is emerging as an exciting area of opportunity as China shifts from generics to biologics. Increasing pharmaceutical sales is supporting the potential for a significant increase in R&D spending, which contract research companies such as WuXi AppTec are well placed to capture.
At the market-cap level, it is also notable that a significant valuation gap continues to persist between large and smaller companies versus historical levels. Investors have generally shunned smaller and medium-sized companies and any closing of this gap would likely benefit the portfolio given our small-cap focus.
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Dale Nicholls, portfolio manager of Fidelity China Special Situations PLC, ...
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