Newsletter commentary Oct 2022

In October, our portfolio underperformed. A notable drop was from Chinese equities listed overseas. Despite the CSI small cap 500 and CSI 1000 indexes rose 1.6% and 2.7% respectively, the SSE 50, the CSI 300, the Hang Seng China Enterprise Index, and KWEB lost 12.0%, 7.8%, 16.5%, and 22.1%. The market performance reflected that foreign investors have concerns over Chinese assets but interest in industries that will receive policy support in the future.

At the same time, the U.S market rebounded with an eased expectation on rate hike in December, driving the Dow Jones index up by 14% and the Nasdaq by 4%. We think the market is still focusing on inflation expectations.

On the other hand, Chinese assets have fallen to an unprecedentedly low level, and valuations have reached a point that deviates from two standard deviations. Based on experience, it is highly probable that it has reached the bottom. Are we missing the trough? We want to address a few reasons causing the deep drop.

We believe that the economic cycle, industry regulation, industrial structure adjustment, the impact of the epidemic, and investors’ risk aversion have all accounted in. 

Firstly, from the perspective of the economic cycle, since the epidemic, we have experienced long-term economic growth that is lower than the potential growth rate, which has considerably squeezed most companies' profits. Although a significant number of counter-cyclical measures have been issued, the actual effects were limited due to on and off outbreaks.

Secondly from industry regulation perspective, companies' boundaries and means of expansion need rethinking and redefining under the prevention of disorder capital expansion requirements. This has affected the valuation and profitability and was reflected on stock prices.

Thirdly, ongoing contraction of real estate-related industries and expansion of some emerging industries have been the most significant initiatives reflecting the industrial structure adjustment. Export-linked industries has returned to normal from high-speed growth. 

Also, the epidemic has not yet ended. The long-lasting situation has had a more significant impact on expectations and caused increasing fatigue. 

Lastly, investors have been avoiding risks related to external factors such as suppression of China’s semiconductor industry by the U.S.

Looking forward, the epidemic will be a vital variable affecting investors sentiment. Not only has it actually affected business activities, but if it persists for too long, it may hurt the potential economic growth. With the change of virus over time, there will be room for finding a better balance between epidemic control and economic growth, which will impact short-term sentiment and medium to long-term financial expectations significantly.

It is also expected that industries such as Internet will continue to develop after regulation. Judging from the decline of nearly 70% in META, valuation drop will be significant once a high growth company losses its growth momentum while not demonstrating a second growth curve. However, relevant companies in China have already priced in.

Real estate industry has been for long on the slide. It is difficult to say whether a new equilibrium point has been reached, but the rapid decline during the past few years is gradually dwindling. With the population issue becomes dominant, the future development of real estate industry will always be limited by total population problem. High-quality development that has been repeatedly emphasized in government repots is to adapt to changes in population structure, and though science and education able to be promoted from demographic dividend that will still last for another 20 years. This obviously differs from the previous economic driving force. 

It requires the economic development performance to change investors’ risk appetite and to reverse investors’ pessimistic expectations.

In general, the problems of the current stock market have both cyclical factors and due to structural changes such as changes of development model and room of some industries, of the population structure, of the external environment, and the impact of the long-lasting epidemic on the growth potential. Another point is that the most prolonged sustained decline itself confirms the expected weakening.

The power of economic cycles still exists, and epidemic control will continue to be optimized. Although it’s hard to predict the exact time and specific steps, we believe in room for optimization in view of a dynamic combination of virus toxicity, preparation work, and economic development Economic development is still the top priority. At the same time, the world is seeking a foundation for security, and development is a vital security source.

The market might be too pessimistic toward the structural changes. For instance, China's current number of college students is approximately 100 million. By 2030 and 2040, it will reach around 200 million and 300 million, respectively. The potential of so many highly educated populations in a single market is worthwhile anticipating.

Times are changing, as well as the mix of supply and demand that drives economic development. It will be bumpy on the road of the “major changes unseen in a century”, but we still see the potential. The changes need to be reflected in our portfolio, in the duration of our investment expectations and in the choices of investment directions. By avoiding some value traps, the extremely low valuation of the overall market will work out in the end because the power of the market cycle has remained. Under current circumstances, investors may only focus on negative structural factors while neglecting some positive ones.

In the short term, we can observe the changes in the RMB exchange rate, which reflects China’s determination to maintain an independent domestic monetary and financial policy. At the same time, we can also closely watch the optimization of epidemic control measures and its impact on the economy. It always happens in the trough that rise is easily triggered by any good news. We will persistently try to explore and find new growth while avoiding crowded places.