MSCI China Index decreased by 11.70% in August and 9.53% this year till end of August. Hong Kong stock market has continued to perform poorly over the past 3 months, and Hang Seng Index has fallen to record lows since August 7th. We think there are four main reasons: Firstly, China A-share market continually tumbled in August, so Hong Kong investors were more suspicious about the China economy, A share market and the series of government intervention in the stock market. Secondly, PBOC announced to depreciate RMB by 2% on 11 August, which was for the first time in the past decade. The devaluation was beyond the market’s expectations, so it made equity investors in Hong Kong worry even more about stability of China’s economy and RMB exchange rate. Thirdly, due to the uncertain prospects of economic condition in China as well as in other emerging markets like Brazil, the investors began to doubt the leading roles of emerging markets as the principal driver of global economic growth and thereby threaten global economic stability. Emerging stock markets stumbled in tandem with developed stock markets, so investors have a sharply decreased appetite for risk. Fourthly, the increased uncertainty over if the US Federal Reserve will raise interest rates has raised Hong Kong investor’s concern about capital flows, which further decreasing their risk appetite. Although there have been large corrections in the market in August, growth stocks, especially those in the “new economy” sector, has gained significant excess returns. Some industries in the “new economy” sector have showed the defensive characteristics in the market downturn.
In August, China’s economy has showed a pattern of slowing down growth, and the foundation of a stable economy is not solid yet. To start with, by looking into the leading factor PMI, China’s PMI in August is 49.7, which is below the tipping point. It has been the first time that PMI is below the tipping point in 6 months, which is a sign for a slowdown in economy. According to the data announced by National Bureau of Statistics in August, the industrial value-added in July has decreased month-on-month, putting an end to the continuous growth since April (the added value of industries above a designated scale dropped by 0.8% in July month-on-month). China’s economic growth in the first half of the year was partly contributed by the increase in capital market, but will receive more challenges in the second half of the year due to the fluctuations in stock markets and shrinks in market value. As a result, we’ve seen more proactive monetary policies and fiscal policies. On Aug 26th, PBOC performed a simultaneous cut in RRR and interest rate again to hedge the risks of economic downturn. On Aug 31st, the three Ministries jointly announced to lower the minimum down payment of second house by using public reserve funds from 30% to 20%. Meanwhile, on Sep 1st, the State Council organized a meeting and lowered the capital requirement of fixed assets investment programs in some construction industries. It has been the first time since 2009 that the capital requirement of fixed assets investment programs was lowered. Ministry of Finance has also confirmed to make some investment programs before schedule and the quota of the third-round replacement of local government bonds scheduled in 2016. The measures above can be regarded as the signals that the governments wish more positive functions of monetary policies, construction industry and financial policies in the future.
We hold a positive view on China’s economy in the medium to long run. First of all, Chinese economy is in the worst case over the past 10 years with both electricity output and domestic consumption data unfavorable, indeed slower than the average growth rate over the last decade. However, the potential economic growth rate is still higher than most countries compared to the rest of the world. The golden era of resources- and labor-arbitrage opportunities in China has come to a halt, but demographically consumptive dividend will come from huge population, demographically intelligent asset will come from education and social activities, and institutional dividend will release from the reforms instead. The overall structure of China’s economy has improved a lot throughout the past three years as economic reforms occurred and overcapacity along with leverage eliminated in every industry and sector. It provides China a new impetus for economic development. Meanwhile, the structuring reforms and adjustments of China’s economy remains a work in progress, which can be considered as the largest institutional dividend for China’s economic development. We believe that China, the world’s second-largest economy, will successfully overcome the middle-income trap and break through the bottleneck of resources, environment, and slowing population growth. In fact, such processes will not go smoothly, and institutional reforms will also be difficult because of special interest groups. The challenges in Chinese economy this year is an epitome of difficulties in restructuring the economy. However, it provides inspiration and strength as the nation cope with challenges and it sometimes help the implementation of policy reform. China’s economic development has reached a critical point.
In terms of the operations, the investment team actively managed the positions based on market conditions. The fund rarely has such position adjustment, because we always believe the fund’s long-term excess returns come from our manager’s investment choice through in-depth industry and stock analysis. However, the market is in a very special situation in the second half of 2015, and since the increasing correlation between H share and A share markets, the fluctuations in A share markets also have a significant influence on the H share, which is viewed as irrational in the short run. Under the current market circumstances, we have to adjust the fund position in response to the market actively, mitigate the risk of market downturns for investors, and create short-term excess returns. On the other hand, we continue to focus on the booming “new economy” sector during the market correction, and grasp investment opportunities when the market declines. Currently, the H share “new economy” appears to be a very attractive investment sector in terms of future growth potential and valuation level, so we will increase the equity allocations for these potential companies accordingly.
In terms of macroeconomics, we believe that we’ve seen Chinese government’s policy direction in the second half of the year, which is hedging the risk of economic downturn by boosting infrastructure investment. Next, we may expect to see a series of positive monetary and fiscal policies in supporting the economy. Meanwhile, it is probable that we will see more implements of structural adjustment and detailed reform policies, such as a basket of SOE top-level design reforms. With the effectiveness of these policies, we believe the investors’ appetites for risk will rise, and the current negative market sentiment will be relieved gradually. The bull market in China A share that began last year is not only due to capital allocation to equity market from residential real estate and savings, but also because of the investor expectation for further China reforms. With that being said, we will expect positive changes in market expectation and market condition that brought by the actual effectiveness of reforms. The “Fifth Congress” in October may have reform measures released. Therefore, we do not believe that the China’s economy will crush in the medium- to long-run, there is a huge potential for both economic growth and capital markets development.
From the market perspective, the recent fluctuation in China mainland A-share market led to temporary government interventions, including China Securities Finance Corporation acted as “stabilization fund” to direct buy stocks in the market. These policies were necessary when market was lack of liquidity and facing tendency stampede drop in order to avoid systematic risk. As the market gradually recovered and leverage rate sharply decreased, the possibility of systematic crisis has been lowered down significantly, and these temporary measures may gradually exit so that investors can make rational judgment on valuation of the market and the companies without much interference. We saw that the mainland securities regulator has clarified that CSFC will no longer make direct executions, and will not cut positions of the stocks bought previously in a relatively long period of time. In the meantime, the mainland securities regulator has introduced various laws and regulations, in order to clarify the timetable for OTC lending and umbrella trust funds to exit and strictly prohibit the future inflows of OTC lending and umbrella trust funds into the Chinese stock market, which will fundamentally block the inflow channel of bank funds and control the market leverage. With the decline in A-share market, the overall market valuation has dropped to a relatively reasonable level. The valuation of Hong Kong stock market has been pushed to the lowest level and almost the lowest globally, with P/E ratio of both MSCI China Index and Hang Seng Index back to 7x and many blue chip names getting close to historic lows. Hence it has little room for further decrease.
For the concerns about the interest rate hike by the US Fed, we believe that the Fed will keep close communication to the market before and after any large monetary policy change, for example the Fed has communicated to the market about this round rate hike for more than three years, so that the market has gotten enough expectations of the direction and time for the rate rise. Therefore, when the Fed hikes interest rate, we think that it will not hit the market substantially. Simultaneously, the US rate hike will be relatively slow and gradual so that its impact on capital flow of Hong Kong market will be minimal. The recent strength of Hong Kong currency against US dollar also reflects the same trend. We will continue to achieve excess returns for the fund investors through our in-depth research and survey.