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China - from macro to micro

Dale Nicholls

Dale Nicholls - Portfolio Manager, Fidelity China Special Situations PLC

The daily newsflow on US-China trade negotiations has continued to drive gyrations in financial markets in the first half of the year. Unsurprisingly, Chinese equities have been at the centre of these sentiment shifts with the most recent development post-June’s G20 seemingly taking us back to expectations of an amicable outcome.

China - from macro to micro

I think it seems reasonable to expect this noisy macroeconomic and geopolitical environment to persist for the time being as negotiations continue. Longer-term I ultimately think that a trade deal being agreed remains the most desirable outcome due to the mutual damage a prolonged and full-blown trade war would bring to both economies - starting with higher prices for US consumers.

While some parts of the negotiation will be complex and difficult to reach full consensus, particularly around issues such as government support in strategic sectors, we believe both sides will be increasingly incentivised to reach agreement. For China, we may see negotiations push towards a more open economy.

Against this backdrop, the trust remains focused on those areas that are exposed to China’s structural shift towards a domestic consumption-driven economic model, with around 90% of the portfolio's total revenues coming from Greater China, including Hong Kong and Macau. In these so-called “New China” consumer-related areas, the underlying growth drivers are strong, innovation levels high and new players are emerging.

Technology as an enabler

The technology sector continues to play a key role enabling and creating new business models. Alibaba and Tencent are core positions - their ecosystems continue to expand and will occupy an even greater share of the Chinese economy - although the portfolio also has significant exposure to other players outside of these household names.

One such example is Secoo, a leader in luxury e-commerce that is building strong relationships with well-known global brands, yet it trades at a significant discount to global peers. Elsewhere, Kingsoft is set to benefit from a recovery in online game approvals, reduced losses in its cloud business as the market consolidates, and from continued strong growth in its software business.

The unlisted space

I continue to utilise the enhanced investment powers the trust structure provides to invest in unlisteds with more than 5% of the portfolio invested in this space. Notably, two holdings - Meituan Dianping and Aurora Mobile (known as Jiguang pre-listing) - came to market last year in Hong Kong and New York respectively. I continue to hold Aurora for its strong potential for continued growth by leveraging its access to the broadest data set. Meituan was sold due to the perceived risks relating to increased competition across a range of online services.

More recently, three new unlisted holdings have been added to the portfolio: DJI International, a drone manufacturing company; Sensetime, China’s leading AI company focused on computer vision and deep learning; and ByteDance, which operates various content platforms globally including Toutiao in China, the leading news aggregator, and Douyin, a strongly growing short video platform, which is also growing strongly overseas under the name TikTok.

Rising middle class also supports selected financials

Finally, a note should also be made on non-banking financials given the trust’s significant exposure to insurers like China Pacific Insurance, China Life Insurance and China Taiping Insurance. The insurance sector was badly hit in the 2018 bear market amid concerns for their investment book, moving valuations to historically low levels in many cases, and levels that compare favourably with other global insurers despite far better growth prospects.

The long-term opportunity remains attractive as the insurance industry is still in its infancy; it is tied closely to the rise of the middle class and their propensity to protect wealth. Indeed, this is an overarching theme supporting consumption, which remains the biggest driver of growth in China.

In addition to rising penetration across a range of categories, we are seeing increasing ‘premiumisation’ and trading up which should not be a surprise as incomes rise. While many foreign players occupy strong market positions, we continue to see local players asserting themselves and building strong businesses from sportswear to toothpaste to coffee chains.

As growth levels between the old and new parts of the economy diverges - and with aggregate valuations relatively undemanding - China is a fertile hunting ground for stockpicking. Although an uncertain macro environment has contributed to earnings growth expectations moderating over recent months, the companies in the portfolio still have robust prospects and I have a high degree of conviction in their ability to grow their earnings over the mid-term. This should over time reward investors in the form of share price appreciation.

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