The Chinese dragon: powered by consumers

On the short side, we don’t like government-initiated sectors that rely on quotas and are not directly influenced by market demand. For example, we have been very sceptical about the business models of anti-pollution environmental companies. Although China clearly needs to invest to combat pollution, we think that businesses are more likely to spend the money on becoming greener if there are laws and/or government subsidies. Such sectors are therefore very vulnerable to any changes in government policy and tend to have low cash flow.

We are also cautious about companies in the old economy – the manufacturing giants who have not adapted to changing demand and continue to produce low-end goods that are now available cheaper elsewhere.

There are, of course, a number of clouds on the horizon, not least US foreign policy. We expect an escalation of tensions between the US and China should Donald Trump implement his campaign promises on trade. He has been very vocal in calling for an end to cheap imports from China and campaigning for manufacturing jobs to be brought back to the US. We don’t know whether this is just rhetoric, but we do know that some of the people chosen for his new administration are hostile to China. In such an environment, it would make sense to avoid – or even short – companies that export a lot to the US and would thus be vulnerable to trade restrictions.

However, the consequences of any protectionist policies wouldn’t be fully positive for the US either. If Trump delivers on his pledge to impose a 45 per cent import tax on Chinese goods, it would have a knock-on impact on US inflation and affordability. Although he is taking a hard line, we hope he will reach a compromise with China and avoid an outright trade war, which would be a 'lose-lose' scenario for both countries.

The other major concern is China’s debt burden – especially private debt. China’s overall debt to GDP ratio is 250 per cent – high, but not as high as, for example, Japan at over 350 per cent. The worry is that, unlike in Japan, Chinese debt is mostly corporate. If the economy slows down, companies will struggle to repay loans and be forced out of business. That is one reason why Chinese banks are currently on such cheap valuations – investors are concerned about the scale of their non-performing loans (NPLs).

The onus is on the government to step in and resolve this situation. After all, most of China’s banks are government-owned, and roughly two-thirds of the outstanding corporate debt is held by state-owned enterprises (SOEs).

We believe that 2017 could be the year of reckoning on the debt front – and potentially of great opportunity. Famously, the Chinese word for “crisis” is made up of one character meaning “danger” and another “opportunity”. If the debt crisis is resolved, then we could see a very good year in Chinese equity markets, especially as corporate profits and industrial activity are showing signs of improvement.

In order for that to happen, we would need to see the government taking on some of the corporate debts, alongside continued monetary stimulus – but not so much as to cause inflation problems. For now, however, the debt situation remains a risk.

To sidestep some of the risks and position for a possible boom, we have built a barbell portfolio. On the one hand, we are investing in the new economy, in sectors such as the Internet where companies are typically debt-free, cash-rich and enjoying structural growth. These stocks should do well regardless of what happens to the corporate debt pile.

We also have some beleaguered industrial companies and ports, which are at the bottom of their earnings cycles. If there are reforms, then these battered industrial companies should benefit. We think the risk reward is quite good – the potential for investment gains is considerable while the scope for a further fall in their share price is limited because they have already fallen so much. These are our call options on the possibility of reform.

At the same time, managing risk is top of our agenda. We constantly monitor overall market and macroeconomic risks and stand ready to adjust the net exposure of the portfolio to take advantage of opportunities or mitigate losses in down markets. The flexibility of being able to actively shift our positioning helped the portfolio over the past year – both during the sell-off in early 2016 and the rally in the third quarter.

Many people are understandably sceptical on China because they cannot understand how a country whose corporate debt burden has exploded can avoid a blow-up. We agree that there are some challenges – albeit ones that intelligent government intervention could effectively disperse. At the same time, however, China is an economy with close to 1.4 billion consumers whose disposable income is growing every year.

Correctly identifying the stocks that are likely to perform well or lose out amid the economic transformation, can be especially attractive in Greater China where the median returns dispersion of stocks in the MSCI Golden Dragon over the past 20 years stands at 19.5 compared with 13.5 for the S&P 500.⁵ We believe that all adds up to create very fertile ground for bottom-up investment opportunities for long/short strategies.