The 19th national congress of the Communist Party of China has begun and represents one of the most important political events this year. President Xi Jinping is expected to cement his position by having his allies promoted into positions of power in the party and the government.

The congress, which began this year on 18 October, takes place every five years. As well as positions being given out, it also reviews past policies and hands out new ones.

Xi’s keynote speech is likely to concern pollution and anti-corruption. There may also be an update on his plans to reform state-owned enterprises (SOEs). He wants to make changes to shareholder structures and increase M&A activity as well as measures to improve ‘operational efficiency’.

Investors around the world will be studying the event closely for signs of how China plans to drive its economy in the future. Economic growth has been slowing in recent years, yet the pace remains considerably ahead of most major markets in the world.

We explore the congress and China’s economic activities in this article, as well as talking to several fund managers about whether investors should increase exposure to the country as part of a diversified portfolio.

Growth slowdown

China’s GDP growth rate was consistently in double-digits or close by for a number of years. In previous congress meetings, a high GDP growth rate was set and aggressively pursued.

The leadership is now accepting that growth rates are slowing although the economy continues to expand.

In a nutshell, China is attempting to move its economy towards being consumer driven and away from being export led, fuelled by low cost manufacturing.

The emerging consumer-based economy in China is home to some of the most innovative companies on earth. There are plenty of ways for UK investors to obtain exposure to the potential winners of China’s economic push.

Companies like e-commerce giant Alibaba, internet company Baidu, and tech firm Tencent have a vast domestic market and some are listed on stock exchanges in other parts of the world. These stocks are likely to appear in many China-themed funds owned by UK investors.

The vast majority of larger Chinese companies are listed on the Hong Kong Exchange, although Alibaba has a New York Stock Exchange listing, indicating the global reach and appeal of these burgeoning Chinese enterprises.

While Chinese companies will also be listed on a domestic exchange such as the Shanghai Composite Index there have been restrictions with access to these markets. However, accessing Chinese A-shares (domestic Chinese equities) has been getting easier in recent times.

In 2014, the Hong Kong Shanghai Stock Connect enabled investors to access A-shares via the Hong Kong exchange. It also allowed Chinese investors access to the Hong Kong market. Towards the end of last year, the Hong Kong Shenzhen Stock Connect was opened as well, giving investors access to China’s more tech heavy exchange.

It’s also possible to use exchange-traded funds to gain exposure to Chinese stocks. If you were seeking exposure to some of the largest stocks on both the Shanghai and Shenzhen exchanges, CSOP Source FTSE China A50 UCITS ETF (CHNA) is an example of a UK-listed ETF providing relevant exposure. It tracks the performance of 50 companies.

For those seeking greater diversity through a passive vehicle like an ETF, a relevant product is Lyxor CSI 300 A-Share UCITS ETF (CSIA). This ETF tracks 300 stocks in the China A-shares range by market cap.

Investor sentiment

Investors’ enthusiasm for China shifts from one year to the next. But fears of an economic slowdown and its growing debt burden seem to
be lessening, so many are revisiting China.

You’d have to have been living in a cave for over a decade not to be aware of China’s growing equity markets. In recent years they have come to the fore in the news but not always for the right reasons.

In 2015 the Shanghai’s Composite Index lost a third of its value in just under a month and on the opening day’s trading of 2016, the market was suspended twice due to wild price movements.

Charlie Awdry, portfolio manager of Henderson China Opportunities Fund (GB00B5T7PM36) comments: ‘We always say to people that this is a niche asset class at the far end of the risk spectrum and that anything can happen in China.’

Volatility vs risk

Jan Dehn, head of research at emerging markets asset manager Ashmore (ASHM), says it’s important to make a distinction between volatility and risk in the Chinese market.

Dehn explains that while China’s equity markets are well developed, its fixed income or bond markets are less so. He says this leaves Chinese investors, who according to him save 50% of their wages a month, with just equities and property to invest in.

If China’s entering a bear market there’s little option for domestic investors but to short the stocks, namely betting that they will fall in value. That can cause the market to be volatile, raising the potential for wild swings in share prices.

Volatility doesn’t necessarily translate to risk. For example, a company in danger of going bankrupt is a risk.

What's China's share of global economic growth?

China accounted for 28% of global economic growth in 2016. This is a greater share than the US, Europe and Japan combined.

With China’s A-shares finally being included into MSCI’s emerging markets index from next year, an emerging market ETF will track China’s equities but only 222 Chinese stocks are being included. These companies are also the large cap, SOE companies.

We think the best way to capture China’s potential upside is through actively-managed investment funds and there are a lot of products covering different parts of this high growth market.

Smaller company opportunities

Some China-focused funds will concentrate on parts of the market where they see value, such as smaller companies which are overlooked and possibly mispriced by the market.

Tiffany Hsiao, lead manager on Matthews Asia Funds China Small Companies (LU0721876364), says small-cap companies in China are at the forefront of the country’s economic shift away from fixed asset investments toward innovation, consumption and services.

However, a recent note by Matthew Hodge, senior equity analyst at Morningstar, says ‘China’s increasing reliance on fixed asset investment to drive economic growth has the unwelcome impact of growing debt, declining productivity and a diminishing pool of projects worthy of investment’.

The debate on China transitioning from an infrastructure investment hub to more of a consumer led economy is ongoing and vital for investors. Hsiao’s fund contains a lot of consumer staple stocks which if China is moving towards a consumption economy could do very well.

The fund’s top holding Silergy Corp makes up for 6.2% of assets and is listed on the Taiwan Exchange. The company is a tech stock and has returned 52.2% year to date.

The fund’s second largest holding Genscript Biotech has returned a whopping 122% year to date.

Future tech leader 

When it comes to technology. Dehn at Ashmore says China is investing more in tech than the US and Europe combined and says it could emerge as a global tech leader.

Hsiao says her fund focuses on innovative, efficient and sustainable growth companies, with an emphasis on firms oriented toward domestic demand and rising income levels.

‘Small-cap companies tend to thrive in productivity and value-enhancing industries such as automation, health care, e-commerce and education,’ says Hsiao, adding that this is reflected by the constituents of the fund portfolio.

She also believes that not only are Chinese small caps at the forefront of the country’s shift to a consumer-based economy but also that the smaller companies are less volatile than large cap SOEs as they are likely to carry less debt.

‘We believe that small caps in China offer very attractive risk-adjusted return potential compared with equity markets globally.’

Larger company opportunities

Henderson’s China Opportunities Fund focuses more on the larger Chinese companies, most of which are listed on the Hong Kong exchange.

This is where Chinese companies have tended to list, using the ‘one country, two systems’ principle since Britain passed the territory back to Beijing in 1997.

Henderson fund manager Charlie Awdry says one of the more unusual companies his fund owns is Kweichow Moutai which makes a Chinese spirit. ‘They’re like the Diageo of China,’ he says. The stock has returned 62.8% year to date.

‘China comes and goes out of favour. In 2007 investors were in love with China then fell out of love with it. Now people who were trying to ignore it, can’t,’ says Awdry.

He’s a proponent of China’s successful move into a consumer based economy. He claims that companies in the Henderson China Opportunities Fund should do well whether debt goes up or down or if there’s a cyclical wobble in the economy.

That’s because Awdry’s holdings are driven by consumer demand and typically have good cash flow. His two top holdings, Alibaba and Tencent, both have over 9% of the fund’s assets invested
in them.

Henderson is not alone in having big stakes in these tech giants. Both Fidelity China Special Situations (FCSS) and Baillie Gifford Greater China Fund (GB00B39RMM81) have these companies as their top two holdings.

‘Alibaba and Tencent are kings of mobile payment,’ says Gary Monaghan, investment director at Fidelity. Mobile payment is a much more popular way to pay than credit cards in China.

While China’s GDP growth may be slowing, its large consumer stocks are not. Alibaba has been growing at 50% a year for the last five years in revenue terms. Shares in Alibaba and Tencent have returned 110% and 87% year to date respectively; so it is not surprising that they are popular with fund managers.

Other sectors of interest

While China’s burgeoning tech sector is highly attractive, there is also interest in some of the more traditional sectors like banking. Henderson’s Awdry has positions in two of the largest state-owned banks, China Construction Bank and the Bank of China.

Shares in China Construction Bank have returned 16.8% year to date while Bank of China has gained 18%. While those figures aren’t as impressive as the consumer stocks, they are still good returns in investment terms and they also offer dividend yields in the region of 4.5% to 4.7%.

Ashmore’s Dehn says there’s going to be a ‘dramatic structural change in Chinese banks in the next decade’. He believes they are becoming more like Western banks and offloading non-performing loans from their balance sheets.

Once these loans are turned into tradable bonds they can be sold into a growing mutual fund industry.

This could mean that Chinese banks, used primarily for long term lending to local government vehicles to build infrastructure, would now be able to offer asset management services to the burgeoning middle classes.

One of President Xi’s aims for SOEs is to reform financial institutions so exposure to the large Chinese banks could well pay off for investors.

The negative view on banks

Banks aren’t for everyone though. Mike Gush, investment manager on Baillie Gifford’s Greater China Fund, says his fund hasn’t held a Chinese bank for a long time. He’s concerned about the level of growth they can achieve especially if capital requirements become more stringent.

However, he does hold China Taiping Insurance, a state-owned enterprise. He believes there are long term growth prospects for the insurance industry in China. The fund also has a significant holding in Ping An Insurance.

Both the Fidelity and Henderson experts like the insurance sector, with the latter having 4% of his fund’s assets in Ping An while Fidelity invests in two state owned insurers, China Pacific and China Life.

The attractiveness of insurance companies in China is a consequence of the rise of middle classes and their need for the companies’ services. Year to date, shares in China Pacific have returned 32%, China Life 19.6% and Ping An 64.8%. For the insurance sector, this is phenomenal performance compared to their developed market counterparts.

Is this the end for infrastructure investments?

Given the potential returns available from both consumer stocks and financial institutions it would seem investors with exposure to China do not need to rely on the country’s large scale infrastructure investments that epitomised the country for so many years.

However, China’s ‘One Belt, One Road’ (OBOR) plan announced in 2013 by President Xi is one of the most ambitious infrastructure projects to date.

Dubbed by some as a modern-day Marshall Plan, China’s initiative will build roads, ports and railway tracks along ancient trading routes to Asia, Europe, the Middle East and Africa.

That should support long-term growth and development in the economies involved through better connectivity and help cement China’s global influence.

While difficult to quantify the level of investment needed at this stage, China Development Bank alone has reserved $890bn for over 900 projects, highlighting the magnitude of this undertaking.

The scale of the project is unlike anything seen in the modern era, hence the comparison to the Marshall Plan. However, economic think tank Oxford Economics estimates that by 2050 the OBOR region will contribute 80% of global GDP growth, with China’s share remaining broadly stable at around 40%.

What does this mean for the mining sector?

Fears that Xi’s reforms would negatively impact mining companies seem unfounded if this huge undertaking is to move forward.

Investec analyst Hunter Hillcoat comments: ‘The 19th Communist Party national congress has cast a pall of uncertainty over the country’s commodity demand. However, we expect incumbent president, Xi Jinping, to emerge in a stronger political position and this should allow more infrastructure investment (both conventional and smart grid) and a strong emphasis on energy sustainability with increasing focus on renewables.

‘We expect China’s policies to underpin demand prospects for most base metals, carbon steel making raw materials and precious metals with predominantly industrial uses, such as palladium and rhodium’.

The global connectivity initiative, aiming at creating a better infrastructure network spanning 65 countries covering 60% of the global population and about one third of global GDP is daunting.

Its success will show that while China can transition its economy towards being consumer based, it will still need the vast amounts of raw materials that for so long was the hallmark of the Chinese economy.

Longer-term appeal 

China has its doubters, as you might imagine. American investment manager Jim Chanos famously shorted the country when he realised that it was building enough office space for every man, woman and child in China.

But with its financial reforms and global leaders in the tech space, it’s a country with as much investment potential as anywhere in the world.

Given the many different routes to access Chinese markets such as passive ETFs, investment funds and trusts all helped by initiatives such as the Hong Kong Stock Connects, now is the perfect time to invest in China, in our view.

With President Xi’s mandate most probably being strengthened after congress finishes, hopefully the volatility that has plagued the country’s equity markets may die down. (DS)

The expert's view on the China Congress

All eyes are now on Beijing and the political and economic policy shifts that will take place in what should be a highly informative week. Providing President Xi Jinping can maintain control, markets could warm to the prospect of reforms and sustainable growth.

If his influence is diminished and Party apparatchiks establish a more committee-led leadership style, China could press the accelerator when it comes to fiscal stimulus and GDP growth. That could bring a near-term sugar rush but leave investors with a debt-fuelled hangover and greater risks further down the line.

The 63-year old Xi Jinping looks like a shoo-in for a second term as General Secretary of the Communist Party and President of the People’s Republic of China. The real interest may lie in who makes it onto the Politburo, as the majority of the 25-man body will be stepping down this time around, and particularly the seven-man Politburo Standing Committee, since five of its members are due to retire.

This reshuffle will open the way for others to step up and stake a claim for even higher office in 2022 – Xi Jinping and Premier Li Keqiang both made it onto the Politburo Standing Committee in 2007 on their route to the very top.

It will therefore be important to see who is promoted and whether they lean toward Xi’s market-pleasing agenda or not.

President Xi wants to keep cracking down on corruption and stop debt spiralling while keeping growth on track and the currency strong.

This is a difficult juggling act. Reducing debt could mean slower growth, albeit growth with more reliable long-term foundations.

If Xi’s influence is in any way diluted by the changed composition of the Politburo after the showpiece conference in Beijing there is a chance that the Party will embrace greater debts in exchange for faster growth in the short term and wobblier foundations in the long term.

Russ Mould, investment director, AJ Bell

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