2021 was a volatile period for Chinese equities, but we have seen times like this before and most likely will see them again. Although regulatory and broader macro risks have negatively impacted sentiment towards China, history teaches us that these are usually the periods that offer the most attractive investment opportunities. Corporate earnings for the market are forecast to grow over 15% over the next 12 months. Coupled with these solid projected earnings, the overall Chinese equities market is trading on a price earning multiple that is attractive - both relative to history and relative to other global stock markets.

What could surprise markets in 2022?

It is important to continue to focus on the risks in China and to closely follow regulatory developments. However, we are likely to see fewer policy surprises in 2022. Instead, we expect to hear more around the government’s overarching policy aims that have already been announced, including environmental and Common Prosperity reforms.

Developments in the property sector should be closely monitored from both an unexpected positive and negative perspective. This segment has been a significant driver of both economic growth and local government finances, as well as being a major component of the consumer balance sheet.

As we head into 2022, we are at a turning point for the sector - lower levels of activity are a given, but any significant correction in prices could clearly impact the consumer mindset. The impact of higher taxes, including property taxes, are other possibilities that will need to be considered. Having said this, when coming out of a period of tightening there is significant scope for Beijing to adjust its policies.

Positioning for what lies ahead in 2022

As is often the case with broad-based corrections, some stocks and sectors 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 also remain upbeat about the outlook for the unlisted portion of the portfolio and the progress being made in the respective businesses that we are exposed to.

Whilst the goal is to be in sectors aligned with government policies, in some areas, such as those related to climate goals, we are seeing some stocks trade at very steep valuations and the risk/reward equation looks stretched.

Although the long-term strength of the domestic consumer remains very much intact, one of the bigger shifts in the portfolio has been a reduction in holdings in the consumer discretionary sector, mostly because of valuation levels, and an increase in holdings in materials and industrials.

The thesis around industry consolidation in areas like building materials remains very much in place. However, we have trimmed some positions given rising concerns over the residential property slowdown and potential knock-on effects to the industry from the troubled developers in the market.

Following the significant recent correction in technology-related names, we feel that the risk/reward payoff is now tipping much more in our favour in these companies. While there is still risk of new regulation, as we think about what could come next, there is a good chance that we are near or close to a “peak” in terms of news flow.

The government has ambitious long-term goals in areas of economic development and innovation. Clearly, these will be difficult to achieve without a vibrant private sector. At the same time, valuations for many companies have moved to historical lows and look even more compelling when we compare to global peers.

Sustainability considerations

The evaluation of ESG factors are a core part of my investment process and I continue to see progress regarding the level of engagement and transparency with Chinese companies. Sustainability factors are key topics of conversation with corporates and many management teams are looking at ways to generate a more sustainable outcome for their companies.

Although China continues to lag most other major markets in this area, we are encouraged by the fast rates of improvement we are seeing. China’s regulatory commission is engaging with companies to improve the disclosure of ESG metrics to align themselves more with standards in Hong Kong, which is the most sustainable non-European market. Not only is this a good outcome globally, but we also believe progress on better ESG practices could be a key source of alpha for the portfolio over the longer-term.

From my perspective, Fidelity’s proprietary ESG ratings system are far more ‘up to date’ than those of mainstream ratings agencies and also better reflect the result of our direct engagement with the companies that we invest in. Furthermore, I am pleased to highlight that the ratings of the companies within the portfolio are well ahead of the broader market and continue to improve.

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