As investors across the region ushered in the Year of the Dragon last month, hoping for a better year for China’s markets, Dale Nicholls, portfolio manager of Fidelity China Special Situations PLC, outlines why despite the volatility, the overall trend still points to a recovery in growth and highlights the key areas of opportunity still to be found in the world’s second largest economy.

Following its initial reopening in 2023, sentiment towards China has been volatile, largely driven by challenges in the property sector. Policymakers continue to respond with the aim of offsetting downside risks and restoring investor confidence. Because of this we believe there are still opportunities to be found in this Year of the Dragon, which according to tradition is associated with strength wisdom, luck and prosperity.

Macro challenges
Considering the broader context is crucial. China is at a different point in the economic cycle to the West. Unlike Europe or the US, inflation has not been a problem in China and the government is taking measures to stimulate investment and consumption to support the post-Covid recovery. 

Despite sluggish economic activity, the overall trend still points towards a continued recovery in growth. Consumer confidence remains soft, mainly due to a weakened property market, but the government is addressing this by implementing various measures including lower mortgage requirements and support for property developers. Additional measures to boost both supply and demand in the sector may be required, but a substantial amount of household savings - accumulated recently for security - sets the stage for an upswing in consumer spending once confidence is restored.

Going forward, we expect economic activity to pick up with improving business confidence, which has been impacted by regulatory clampdowns. There is cyclicality to regulation and the current policy orientation is shifting towards loosening, with more balance between growth and stability. After all, China’s long-term goal to double GDP per capita relies on a vibrant private sector and sustained growth.

In the face of a problematic property market in China, the refinancing conditions for property developers will likely remain challenging in the near term despite more supportive policies. However, this is not detrimental to all property developers. While we don’t expect a huge property rebound given the structural challenges, home prices are showing signs of resilience, especially in top tier cities.

Ultimately, the existing divergence between various developers could be magnified further. The indiscriminate sell-off has caused some mispricing, which provides an opportunity for active investors that can successfully identify the leading players, who are most likely to benefit from lower funding costs among peers and can gain market share while cash-strapped developers struggle.

Compelling valuations

Given the extent of recent market sell-off, valuations in the Chinese equity market remain compelling both in historical terms and compared with some other major markets. Clearly, a lot of pessimism over the economy appears priced into valuations.

Despite performing effectively in industries with strong growth potential, the stories of exceptional individual companies are often missed because their valuations are dragged down by negative macro headlines and poor sentiment. Given that stock prices tend to follow earnings in the long-term and provided that the forecasted earnings growth for such companies materialises, we believe the upside potential of investing in these companies is significant.

As such, we are continuing to find companies offering compelling long-term growth prospects within China’s industrial sector, driven by rapid innovation and ongoing industry consolidation. Many businesses are also benefitting from the re-orientation of global supply chains and an increasing preference for local suppliers.

Across sectors, companies are sustaining a fast pace of innovation, evident in measures of R&D spend or their share of global patent applications. This is improving their competitive edge and, in areas like robotics for example, domestic players are closing the gap on global peers.

Fragmented industries like building materials, including paint, pipes and waterproofing, are poised for further consolidation, following the trajectory seen in more developed markets. Good quality companies with an edge and scale should profit from gaining market share and are providing attractive investment opportunities.
In emerging sectors such as electric vehicles and renewable energy, we are identifying opportunities among enablers in the EV value chain, particularly those providing key components and services, such as EV battery manufacturers or auto parts suppliers. Healthcare also presents opportunities, especially in areas with low penetration like medical devices or core pharmaceuticals.

The portfolio also retains a significant exposure to the consumer sector as, despite recent challenges, many companies will continue to benefit from China’s long-term shift from export and investment-led growth towards higher quality growth driven by consumption. Urbanisation and a growing middle class persist in strengthening consumer purchasing power, offering notable structural growth for those under-penetrated products and services industries.

Investing for the long-term

Despite ongoing challenges, we are still seeing growth and adaptability in companies and opportunities for investors. Moreover, given our recent discussions with companies on the ground, we have the sense that worst is behind us and over the longer-term, improved corporate earnings could be a key driver for the return of broader investor confidence.
As noted previously, innovation continues to thrive across sectors, reflecting companies’ commitment to building a competitive edge. High-end manufacturing and domestic consumption are central to the government's long-term plan to reduce reliance on investment and property for driving growth.

Equally, while overseas investors may focus on the impact on China of de-globalisation and ‘near-shoring’ of industry, one consequence of this is an increasing preference among Chinese consumers for Chinese brands, resulting in domestic companies taking ever greater market share in what remains one of the world’s largest markets.

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