The gathering clouds over China’s economy are weighing on investor sentiment. The MSCI China Index has fallen 5.3% year-to-date (in US dollar terms) and the Hang Seng Index has fallen by 7.3%. In contrast, the US blue chip S&P 500 has risen 15.9%, boosted by its leading tech stocks and speculation around generative artificial intelligence (AI), which also has propelled the Nasdaq up 37.7%. The China market, as measured by the Hang Seng Index below trades at a multi-decade low relative to the MSCI ACW Index, back at discounted levels not seen since the Asia crisis of 1998.1
The Federated Hermes Asia ex-Japan Fund has 44.0% invested in China (including Hong Kong) versus the benchmark MSCI AC Asia ex-Japan IM Index weight of 38%, a relative overweight position of 600bps (as of 31 July 2023).
The fund has no direct exposure to real estate developers, to the Country Garden Group, or Zhongzhi Enterprises Group, the holding company for the Zhongrong Trust.2 Our only exposure to the real estate sector is indirect, via commodity and cement companies for instance.
The China valuation discount
We like China from a bottom-up basis and are overweight c.6%. We would be inclined to be more overweight were it not for two key risks:
- Geopolitical tensions with the US. It’s possible the situation may improve. The whole world presumes it will only get worse. Pragmatically, we don’t expect to see a complete rapprochement between the US and China over the next decade, and therefore we expect our China overweight will always be limited on a go-forward basis.
- Domestic challenges. Given the prices on offer, we believe China is a risk worth taking but it is a risk, which is why we have tempered our overweight. We have an approx. +15% overweight in South Korea. We are unlikely to stretch to that in China, no matter how optically attractive the market, given our assessment that there are a few more potential ‘black swan’ events that could happen in the country.
The second risk people are concerned about in China is the mood on the ground. We have witnessed this rise in discontent during visits to the country. Chinese people are not worried about geopolitical risk, they worry about the property market and their jobs and the rising unemployment rate which is acute for the youth cohort (approx. 23%). The market has been talking as if China has stopped growing. Growth has structurally slowed down, but we think this is normal cycle.
Scope for contagion?
A credit event for Country Garden would have a negative impact on the property, banking and insurance sectors. We own less than 2% combined in Chinese cement and building material companies which might be affected – although valuations remain attractive, at price-to-earnings (PE) multiples of around 5x and 4x respectively. We also own a small position in an insurance company that might be impacted, however, the company trades on a PE of 5x and offers a dividend yield of 6% which we believe is an attractive proposition.
Country Garden’s liquidity situation may remain challenged in the near term given its exposure to lower-tier cities. However, in our view, it is likely that the Beijing government will do all it can to prevent contagion as it prioritises stability above almost everything.
In our portfolio, we hold no Chinese banks with most of our financials exposure invested in South Korea.
1 Bloomberg as at 16 August 2023.
2 Country Garden, China’s largest private property developer, missed bond payments this month, and one of China’s biggest shadow banks, Zhongrong Trust, skipped payments on several investment products, adding to concerns that the property slump is spreading to the financial sector.