However, these funds came bounding back in 2024, with IA China becoming the fifth-best performing Investment Association sector of the year as returns leapt 13.8%.

This strong performance contrasted with prior years, with eleven funds making total returns upwards of 20%, and only two portfolios – Guinness China A Share and Fidelity China – reporting losses.

See also: Is China at a turning point, or will it disappoint yet again?

It begs the question: should investors be re-considering an allocation to China funds within their portfolios? Those with a sturdy risk appetite should certainly be eyeing up the sector, according to Chelsea Financial Services managing director Darius McDermott, who said China has some of the highest return potential on the market this year.

Bold stimulus plans from the People’s Bank of China (PBoC) are what propelled Chinese equities in 2024, and further measures to revive China’s economy and stabilise its property market are expected in the months ahead. These new stimulus announcements could again push China funds to new heights, according to McDermott.

See also: Chinese markets soar following announcement of ‘aggressive’ stimulus package

Yet the readjustment last year was sharp and fast, making it easy to miss. The IA China sector shot up 20.7% in the week following the PBoC’s announcement in September before levelling out, where it has stayed ever since. Investors who want to bank on another round of stimulus plans stimulating the market should act fast, or risk being left behind, McDermott warned.

“It shot up in a very short period of time, so if you’re waiting for another stimulus announcement, be ready to pull the trigger, because it won’t wait for you,” he added.

Tariffs could extinguish hopes for growth

There is one overbearing factor that could turn China’s outlook from hopeful to grim – tariffs. Trump’s proposed 60% tariff on Chinese imports to the US could offset the positive sentiment injected by upcoming stimulus announcements and plunge China funds’ returns back into the red, according to McDermott.

See also: How will Trump’s tariffs impact markets?

Until further details are shared on the extent of tariffs and stimulus plans, the potential outcomes for China funds remains stark. Investors stand to make some high returns from the Chinese market in 2025, but could equally lose just as much, according to McDermott.

“You can’t have a low risk way of investing in China. If you’re investing in China, you are seeking superior returns, and for that you must expect superior risk,” he added.

“If Chinese equities went up 40% this year I wouldn’t be surprised – but equally if they went down 40% I also wouldn’t be surprised. When you’ve got such a wide spread of potential outcomes, it really shows the inherent volatility in that market.

See also: China’s AI breakthrough causes US tech stock tumble

“There is more stimulus to come after the tariff position is understood, and that could be a catalyst as it was last year for a sharp upward tick. But the lingering threat of course is China’s interest in Taiwan – that question mark refuses to go away.

“And with the Communist Party of China becoming more authoritarian under Xi Jinping, all those question marks still have people feeling uncomfortable about investing in the region.”

Despite investors’ hesitancy to reallocate to China, Ben Yearsley, director of Shore Financial Planning, said China funds are “cheap and fascinating”. Share prices in the region have dropped sizably amid the downturn of the past few years, presenting an appealing entry point for those with the right risk tolerance.

See also: A World Of Higher Inflation 2025

Yearsley is continuing to buy funds such as Fidelity China Special Situations and Matthews China Discovery, which are up 18.1% and 16.6% respectively over the past year.

The former is trading at a 12.7% discount to its net asset value (NAV), which could provide investors with a slight buffer should returns tumble.

As the Chinese zodiac turns to the Year of the Snake, investors are left wondering what the new year holds for its equity markets.

Traditionally associated with wisdom, strategy, and adaptability, the snake offers a fitting metaphor for navigating the twists and turns of China’s economic landscape and geopolitical environment.

Trade war with Trump

China’s growth paradigm since late 2020 has been a two-speed model – a very strong export machine with poor domestic consumer demand. Its trade surplus hit a record high of about $1trn in 2024, while its 10-year government bond yield hit a record low of 1.6% with its economy trapped in a deflationary cycle with weak consumer confidence.

President Trump’s re-election and the prospect of a new trade war will threaten the sustainability of export growth, as exports to the US account for about 3% of China’s GDP.

How the forthcoming trade war is fought matters a great deal. A modest and gradual increase in tariffs is unlikely to derail export growth, but a strong and swift tariff increase scenario would put considerable pressure on economic growth in the foreseeable future.

The range of outcomes is very wide, and the path to the end game is highly uncertain. Investors need to stay agile and prepared for volatility and opportunities.

Bolder fiscal stimulus

The narrative changed significantly after the critical policy pivot in the last week of September 2024. While this was seen as an inflection point in stimulus policy, the follow-through so far has fallen short of investors’ expectations.

A crucial reason for the lack of a big bazooka so far is that policymakers don’t yet know which one to bring out. The size of the bazooka is dependent on the severity of the trade war.

As Trump prepares to fire his initial shots after being formally sworn in, they will assess and adjust the size of the stimulus accordingly, and the National People’s Congress in March will offer a timely occasion for them to do so.

Much bolder fiscal stimulus focusing on boosting domestic consumption would improve consumer confidence and rekindle the animal spirits.

Capital market reform

One policy directive that investors have not paid enough attention to are Beijing’s plans to “invigorate the capital market” by “using the capital market as a lever (to boost economic recovery)”. A better and more efficient capital market serves to achieve two important goals. 

Chinese households firstly need a new avenue to store, invest, and grow wealth. This role was previously fulfilled by the property market.

House ownership is high, and 60% of household assets sit in property. The best days of the property cycle are behind us, and the negative wealth effect of the property downturn is hurting consumers’ willingness to spend.

A deep, efficient and transparent domestic capital market with a strong pool of high-quality public companies that can deliver good long-term shareholder return is a very convincing and much needed alternative.

Another important problem that needs fixing is the state-owned banks’ ineffective and wasteful lending driven model, which is no longer fit for purpose in a technology and innovation driven stage of growth.

The bank lending model works fine when growth is driven by funding manufacturers with tangible plants and equipment. However, when the new sources of growth are mostly in innovative industries with more intellectual property and intangible assets, a deep capital market with sophisticated risk takers from venture capital, private credit and equity, and patient long-term institutional investors plays a much more important role in allocating capital efficiently.

China’s efforts to reform its capital market would improve corporate governance, raise the quality of listed companies, and in turn, boost shareholder return.

Stimulus policy is more important than trade war

Trump’s recent re-election brings the trade war narrative back to the forefront of many investors’ minds. The Year of the Snake is going to be a tug-of-war between domestic policy stimulus and the trade war, which will bring plenty of good investment opportunities that may come with some manageable volatility.

How policymakers will apply  stimulus policy tools to boost consumer confidence to fight deflationary pressures, and respond to the trade war and its impact on export growth is the most critical driver of equity market returns in China.

The policy pivot at the end of September 2024 was a critical turning point. It signalled that at long last, the policymakers acknowledged the long-term damage of the deflationary pressure and poor consumer confidence and signalled their willingness to fight.

In essence, this put a floor on economic growth and asset prices. What remains to be seen is whether the policy goal is to merely arrest the downturn or to get the economic engine humming again.

A trade war would undoubtedly put pressure on external demand growth, but it could also serve as a much-needed final kick that policymakers need for unorthodox and bolder reflationary stimulus policies, which is a more important driver for asset prices in China.

Claus Born, senior client portfolio manager, Franklin Templeton

Despite the recent correction, the valuation level of the Indian equity market remains high. The MSCI India index is trading at 24 times expected earnings, which is slightly above the level of the S&P 500 at around 23 times.

The valuation level of MSCI India is about 10-15% above the average of the past 10 years. This can be explained to a large extent by a lower cost of capital and stronger earnings growth in the Indian market. We therefore see hardly any significant overvaluation in the large-cap segment.

However, the situation is different for mid caps – this market segment currently has a valuation level that is around 100% above the 10-year average. For small caps, the valuation level is still 50% higher than the average.

In these two market segments, higher valuations were justified due to higher earnings growth.

However, we are now seeing a tendency towards an adjustment in earnings momentum. This creates the risk the valuation premiums for many small and mid caps will not be sustainable over time.

Are the outflows in India related to China’s stimulus-driven economic policy? There have certainly been investors who have tactically repositioned themselves in response to the Chinese government’s announcements.

In October, there were strong inflows into ETFs investing in Chinese equities, among other things. Until then, positioning in China had been rather weak. The announcement of economic stimulus measures has brightened investor sentiment on the country, both abroad and in China itself. But overall, the market also experienced a correction in October.

With regard to the role played by the central bank’s current policy, in October, the Indian central bank left the reference interest rate unchanged at 6.5%. Interest rate cuts are still expected over the next few quarters. The timing of these depends on how quickly seasonal inflation in food prices subsides over the next few months.

The strategist’s view

Mohammed Zaidi, investment director, Nikko Asset Management

These two markets could not be further apart in starting points and valuations. While the September-October reversal of this trend was abrupt, many things would likely need to change for sustained, long-term improvement in Chinese versus Indian equities.

India is one of the richest sources of sustainable returns and fundamental change, but finding these opportunities at a good price is the challenge. Fortunately for patient investors, such an opportunity may be emerging. Narendra Modi’s re-election to rule by coalition rather than majority likely limits his ability to implement more significant structural reforms.

Compared with other Asian economies, the Reserve Bank of India and Securities and Exchange Board of India have been proactively regulating their markets, likely curtailing growth in some areas. Additionally, the digitisation of the economy is profoundly impacting traditional distribution and brand moats –something several companies benefited from for decades.

Given its lofty starting point, some consolidation in local equity markets would be welcome. Despite some short-term reservations, India remains one of Asia’s most compelling long-term investment opportunities.

For China, our attention shifts west. US president elect Donald Trump successfully campaigned on protectionism, with China as a key target. However, assumptions this is net negative for emerging and Asian markets is uncertain. During Trump’s first term, Chinese equities outperformed the S&P 500 and all perceived China beneficiaries.

The key takeaway is Trump is not the only fundamental change. In China’s case, domestic policy is paramount. We believe Chinese equities already factor in a much higher risk premium for trade disruptions.

While China’s policy shift is towards stabilisation and addressing key financial systemic risks, sustained improvement in Chinese equities is likely contingent on greater promotion of both consumption and services – areas that would stimulate job creation, innovation and consumer confidence.

The wealth manager’s view

Kamal Warraich, head of fund research, Canaccord Wealth

In October, there was the largest monthly outflow of capital from Indian equity funds – over $10bn (£7.9bn) – since the pandemic. This was down to a combination of global and domestic factors.

Investors were taking advantage of China’s economic stimulus measures and relatively low Chinese equity valuations, which prompted a shift in capital from India to China. The Hang Seng’s price-to-earnings ratio was notably lower than India’s Nifty 50, making Chinese markets more appealing.

Another contributory factor was the overvaluation of Indian equities, with the Nifty 50 trading at high price-to-earnings multiples versus other emerging markets, meaning a sell-off was likely.

Rising US bond yields was another factor, leading to reduced expectations for aggressive Federal Reserve rate cuts, which encouraged investors to redirect funds to US assets, seen to be safer.

There have also been geopolitical concerns, with ongoing tensions in the Middle East and Ukraine. This contributes to the narrative of a cautious outlook on global growth, meaning investors want less exposure to emerging markets like India. And the picture for Indian markets has been a little bleak, with a lacklustre Indian corporate earnings season dampening investor confidence.

At Canaccord Wealth, we are still marginally overweight India and underweight China within our emerging market allocation. We do not allocate on a country-specific basis across emerging markets, which is a bottom-up result of our broader equity strategy that seeks to maintain a bias towards high-quality funds and companies.

Although China’s appeal to some foreign investors might be growing, we remain cautious. The Chinese stockmarket is still frowned upon by a lot of global investors due to the political overhang, which cannot be overstated.

Of course, we are aware of the considerable discount many Chinese companies trade on and are keeping watch.

The fund selector’s view

James Sullivan, head of partnerships, Tyndall Investment Management

China and India, the two principal protagonists of the emerging market index, are hard to ignore, and a little like that famous yeast extract, investors tend to love or hate them depending on the economic cycle.

There is little doubt that the emerging markets index is both absolutely and relatively cheap, but that is more to do with China than it is India.

India trades at 22x trailing earnings compared with the index at less than 14x. India has eased back a little in terms of valuation, but the valuation remains one that is closer to fully priced than opportunistic.

Despite the Chinese equity market appearing to offer good value, it is still too reliant on policy measures akin to a defibrillator bringing a patient back to life; until the Chinese equity market is discharged from hospital, it remains ‘touch and go’ as to whether it will be able to sustainably support itself any time soon.

All things considered, not least the direction of travel for the US dollar, for the same or better risk premium, we’d rather have any excess allocation to cheap developed markets than emerging markets at this moment in time.

This leaves us with a position that is typically ‘in line’ with our benchmarks, using a blend of active and index funds to source the exposure we require. Vanguard is currently our preferred index fund in this space, paired with broader Asia Pacific active funds such as Stewart Asia Pacific Leaders and Jupiter Asian Income where a higher yield is required.

This article first appeared in the December issue of Portfolio Adviser magazine

China’s latest Ministry of Finance press conference may have lacked specific measures to directly support consumption, but the unexpectedly large size of China’s fiscal stimulus package has done a great deal to boost investor confidence in the struggling Chinese economy.

The measures announced, including new tools for China’s central bank to help companies buy back shares using refinanced bank loans, prompted a rush into Chinese equities in September. Stocks on the Shanghai exchange rose, with turnover reaching $101bn.

Initially, the exchange experienced glitches in order processing and delays, before stocks in China finally recorded their best day in 16 years on the last day of September.

See also: Is China at a turning point, or will it disappoint yet again?

Following China’s latest interest rate cuts, we now see the world’s second-largest economy potentially taking a more targeted route to economic revival. The country’s renewed efforts are designed to help securities firms, insurers and other institutional investors raise funds by clearing their balance sheets.

We view the immediate market reaction to these moves as a strong indicator of not only investors’ appetite for value, but also a sense of FOMO (fear of missing out) that we believe could continue to fuel the market rally.

Short covering may also have played a role in the recent rally. Traders who have suffered heavy losses may be unwilling or unable to bet against the government again anytime soon, which could lend stability to the current rally.

See also: Chinese markets soar following announcement of ‘aggressive’ stimulus package

However, with weak domestic consumption, a troubled property sector and other structural problems still weighing on the Chinese economy, quick fixes seem unrealistic. There is a long way to go, still.

That said, the signal that these measures are sending to the market is the strongest it has been in at least three years and has laid the foundation for a better perception of the Chinese equity market.

External geopolitical risks has created uncertainty, especially in the run-up to the US presidential elections. Talk of a possible trade war between the US and China also continues.

See also: Macro matters: Why managers are buying China again

Yet investors may take some comfort from the fact that, as in recent decades, the US is still likely to have a divided Congress – which may limit far-reaching changes to legislation.

All of this is not to say that we are not encouraged by the Chinese leadership’s new determination to stabilise markets. The measures have already pushed emerging market equities to highs not seen in more than two years.

The Brazilian and South Korean stock markets, both of which hit their year-to-date lows in August, have since rebounded. The same is true for the Mexican market, where equities rebounded after a dip in early September.

See also: Fairview’s Yearsley: China becomes ‘story of September’

However, this may be a reminder that there are long-term global market opportunities.

While the market focus this week may be on China, and while the long-term case for an allocation to Chinese equities has likely improved with the recent announcements, we cannot overstate the importance of diversification.

Asia and emerging Asia is becoming increasingly bifurcated, a trend we believe will continue. With the global interest rate cycle, the US election and geopolitical fragmentation all adding layers of complexity, we believe that investors should prioritise flexibility and agility in this economic climate.

See also: Fidelity’s Dale Nicholls remains ‘cautiously optimistic’ on China

We see China’s concerted comeback effort in global markets as a positive signal for the country and the broader region. Long-term trends such as technology leadership, attractive valuations and the expansion of production capacity offer ample opportunities for investors along the risk spectrum.

The road ahead will certainly not be smooth, but the biggest risk for investors could indeed be to ignore Asian markets in their allocation decisions.

Will the new measures aimed at bringing economic growth back to its 5% target mark an inflection point for China and pave the way for high returns, or will it fizzle out and disappoint as it has done so many times before?

Here, Portfolio Adviser speaks to two fund managers with very different views on the future of China.

China will do everything it takes to jumpstart the economy

While the Western world has encouraged its population to spend over the past ten years, which has powered its markets through an agitated economic landscape, the name of the game in China has been to save.

As a result, China has put its economy in a somewhat opposing position, waging a battle on deflation as the Federal Reserve and Bank of England attempt to lower to 2%. In an effort to not add onto debt, China has opted to hold strong on interest rates to prioritize currency stability.

Yet as China takes its own route through a period of economic turmoil, it also is facing the end of two long-term economic cycles. On a global scale, the country contends with a divergence from trade integration that has dominated the past 20 years. And within China, it faces the end of a 10-year economic cycle that has relied heavily on investing in the supply side of the economy to stimulate growth.

See also: Chinese markets soar following announcement of ‘aggressive’ stimulus package

Andrew Swan, head of Asia ex-Japan equities at Man Group, said: “You’ve got a combination of these things happening together, and as a result, you get a very weak economy. And the problem China has is overcapacity with weak demand, and that creates deflation, which then exacerbates the problem. So we’re kind of at that important point in time where China needs to come up with something new.”

But now, the global economy is shifting, and China has taken its queue as the value of its currency increases. Less than a week following the Federal Reserve’s pivot towards interest rate cuts, the People’s Bank of China and Chinese regulators announced a 50 basis point cut to its reserve requirement ratio and a decrease of benchmark interest rates.

“The currency has started appreciating almost to the day that it looked like the Fed was almost guaranteed to cut rates. They’re facing now a strong currency, so they can loosen as much as they want on monetary policy to stimulate the economy,” Swan said.

“The economy has been facing big, long term headwinds. But in the short term, China has been running monetary policy which is totally contrary to the way you should be doing things. But we’ve just reached an inflection point in that.”

Swan believes that the “jolt” needed for the Chinese economy has started with this week’s announcement.

“The government came out today saying ‘line in the sand here, we are going to do what it takes’. They haven’t said it explicitly, but I think effectively, that’s where we are,” Swan said.

“They understand the problems. They understand the risk of not turning this around. And what you really need now is a direction from the top to tell people now is the time to change. You need that Draghi moment. And I think they’re kind of almost there.

“If you think about what Draghi did in 2011, he saved the world by saying, ‘We will do whatever it takes’. They didn’t actually do anything, but at the end of the day, it’s that commitment that gets the private sector to do the public sector work. And that’s what China’s about to try and do. Give it the commitment to say we’ll do what it takes, but that signal line will mean the private sector does it.”

See also: Macro matters: Why managers are buying China again

While this week’s announcements could be the start of “doing what it takes”, Swan said the changes in policy on the horizon for China go much further. While these movements address some of the symptoms of the issues, Swan said China is also going after the cause. This will largely come down to incentivizing the population to spend, not save.

“Up until now, they’ve been focused on the supply in the economy, like self-sufficiency in high tech areas and new renewables. But now they have to put that focus on the demand in the economy. And if they can get more demand in the economy, you break this death spiral of prices falling,” Swan said.

“You start to get a bit of pricing power back. That means you break this deflationary cycle. It doesn’t really matter to me how significant it is, but it’s the direction of change which is most important, because if you can rebuild expectations of prices increasing into the mindset, then people will start consuming today. The biggest problem with deflation is people think prices will be cheaper in the future. So they save today, because they can get things cheaper in the future.”

But in an economy that has been conditioned to save, what causes people to start spending?

Swan believes this will begin with changes to China’s Hukou system, which currently means that social benefits are linked to one’s birthplace, not where they currently reside. Changes to this program could mean the removal of property ownership restrictions in places like Beijing and Shanghai. It could also mean placing monetary values on the plots of land given to families, which could allow for more flexibility of funds and urbanisation.

“This is not a quick fix, but it’s a change in direction from where we’ve been which I don’t think the market is fully appreciating, but I think we’re on the doorstep of this happening. It’s a really long-term, positive, incremental change,” Swan said.

“It won’t be the old China, but it certainly would be better than what we’re seeing today.”

A rally in Chinese equities never lasts

There will always been commentors singing China’s praises and proclaiming that an elusive rebound is nearing, but the truth is in the numbers. After decades of false starts and no returns to show for it, those false claims become background noise, according to Jupiter Asian Income manager Jason Pidcock.

“The pattern is that every now and then there’s a flurry of excitement around Chinese equities which is followed by a sharp move up, but then fairly quickly they go back again. And that has happened more times than I can remember over the last 30 years.

“There’s always been people saying things like ‘it looks relatively cheap’ and ‘it’s due a period of outperformance’ but I’ve learned to ignore those kind of messages.

“And you hear messages like that all the time. Every now and then Chinese equities do have a bounce and they’ll say ‘oh look I’m right,’ but every rally over the past 30 years has petered out fairly quickly.”

This happened in most recent memory when China lifted its Zero-Covid measures in late 2022. Disillusioned investors piled into Chinese equities after being promised that it was a turning point for the long-beleaguered market, but by the end of 2023, the MSCI China index had lost them another 16.2% throughout the year.

And this has happened time and again over the past decade. An investor who bought in at the peak of the 2014/15 rally – which was fuelled by a double whammy of government reform and the launch of the Shanghai-Hong Kong Stock Connect that spurred global enthusiasm – would still be down 7.3 percentage points to this day.

Investors who are being told that a resurgence in China is forthcoming would do well to take it with a pinch of salt, according to Pidcock. Especially considering that the market’s outlook today is worse than it has been in decades.

“I began investing in this region towards the end of 1993 and in that whole time Chinese equities have been pretty much the worst performing in the world,” Pidcock said. “And that was over three decades when its growth rate was one of the highest in the world.

“They started that period with low levels of debt – now they’ve got a lot of debt. And it was a period where foreign direct investment was piling into China – now it’s coming out of China. So if China was ever going to outperform, it would have been over the last 30 years.”

Despite having all these drivers behind it – ones it has now lost – the Shanghai Composite index is up roughly 50% since the start of Pidcock’s 30-year career. “That is a truly abysmal return,” he said. “I can’t find a market that’s done worse than that.”

While decisions made by the People’s Bank of China in recent days have attempted to solve some of the nation’s economic woes, the market is still littered with “so many different challenges” beyond that, according to Pidcock.

China is tackling a rapidly aging population over the long-term, with over a quarter (28%) consisting of over 60s by 2040 according to the World Health Organization, making it the fastest growing aging population in the world.

In addition to this, China is plagued by political volatility and policy uncertainty, which has turned foreign direct investment negative for the first time in decades, according to the International Monetary Fund.

See also: Fidelity’s Dale Nicholls remains ‘cautiously optimistic’ on China

After being burnt by one too many false dawns and with little to look forward to in the region, Pidcock cut China out of his £2bn Jupiter Asian Income fund in 2022. And performance has been all the better for it.

Pidcock’s fund is up 24% over the past two years whilst the average IA Asia Pacific ex Japan fund trails far behind at 4.9%.

It was the Chinese government’s crackdown on private education and technology in late 2021 that initially made Pidcock question his holdings in the region, and the more hostile signalling that ensued was the final nail in the coffin. With the situation only having worsened since, Pidcock has not looked back.

“We felt that we had to take heed of that warning, and I don’t think anyone else had. I’m not aware of any other Asia Pacific funds that reduced their China weighting so dramatically, let alone go to zero. But it has very much helped our relative performance, and the messaging has only worsened since then,” he said.

“I still have 100% conviction that was the right thing to do. I’m highly unlikely to invest in a Chinese business for years rather than months.

“Ultimately, I try to minimize unnecessary risk in everything I do, and I see investing in China as an unnecessary risk when there are much safer markets.”

With 2024 an intensely busy year for elections, it is worth examining the possible implications for investors in what is a highly topical region for the US presidential election – China.

Election outcomes may not be clear in advance – the US presidential election is proving difficult to predict with only months to go – and it can be hard to gauge the impact of potential policies.

Instead, we focus on what is known, the scenarios which could play out and what is already priced in, taking a view on what that all means for valuations.

Democrat or Republican – will it really matter to China?

The major issue between China and America is trade tariffs. China’s exports to the US fell 13% between 2018 and 2019 following the implementation of trade tariffs of up to 25% by then President Donald Trump.

His 2024 campaign pledges include baseline tariffs on all imported foreign goods to America as well as to “end reliance on China” with a range of trade barriers.

Vice president Kamala Harris is taking a more targeted approach, with her an president Joe Biden imposing tariffs on a range of imports from China in May including electric vehicles, solar panels and semi-conductors.

See also: Macro matters: Why managers are buying China again

Trump has been quite vocal about retaliating against Chinese economic policies, with Harris more guarded, but there is probably less between the two than rhetoric suggests.

China has responded to these ongoing tariffs by diversifying its trade links, signing bilateral agreements with emerging economies across Asia, Africa and South America. These will temper and offset the impact of any further tariff action by the next US government.

In data terms, in 2022 Asia accounted for close to half of Chinese exports, contrasting with 22% to Europe, and the US amounting to just under 20%. The US is important for China, but not as important as it once was.

It is also worth noting that any further tariffs on Chinese imports to America could create an inflationary headache for the US, disrupting its economic recovery. This is a known risk and is to some extent already priced in.

Looking at China in a new light

China is a very different market and investment proposition compared to ten or even five years ago. It is no longer a copycat mass manufacturer and exporter relying on foreign expertise and dominated by government-controlled entities, banks and property developers.

The Chinese economy is now fast paced and innovative with many businesses generating above average returns.

Foreign companies are now lining up to partner with leading Chinese private firms because they have often created more advanced technology and manufacturing processes than those operating in the developed West.

See also: Is there any point investing in the US actively?

China has also faced a number of well-documented challenges over recent years – including an extended covid lockdown and an overheated property market – which have seen valuations fall. As a result, these factors and risks are now priced in, and our analysis identifies valuation opportunities for investors.

One example of this is the high proportion of Chinese companies with a MOAT rating. This is a concept pioneered by Morningstar, based on Warren Buffet’s notion of companies building a competitive edge which protects them and their position from competitors.

Almost half of Chinese companies have a MOAT rating, just behind the US. It is a strong indicator of being able to grow faster and more profitably.

Detecting where value opportunities exist

Overall, China offers attractively priced high-quality companies experiencing improving profitability, at a time when US and several other markets are trading at high valuation levels.

We currently hold more than we usually do in our portfolios, but less than in other markets, reflecting the unique nature and risks of investing in China.

Our focus is on domestic companies, particularly in the technology and communication services sectors, where they are principally serving the local market rather than competing with US companies.

In-depth investment research, analysis and insights are key here to pinpoint good opportunities in China, as well as identifying the challenges to steer around when the next US presidential term commences.

This year has an unprecedented number of global elections, with more than 60 countries holding an election, covering approximately half of the world’s population.

Perhaps most significant amongst these elections is the US presidential election this coming November. Whilst creating many hours of television footage and newspaper column inches, what is the likely impact for investors?

Going back as far as 1933, stock markets have tended to rise no matter which political party has been in power in the US. In fact, there have only been two presidential terms where the US market has ended lower than where it began.

This was under Richard Nixon and George W Bush, who suffered market reactions after the Watergate scandal and the terrible events of 11 September 2001, rather than economic policy.

Whilst data suggests that returns have been higher in years when Democrats how won the presidency, the following year returns have been stronger during Republican presidencies. But in truth, there has been no strong correlations that are helpful for investors.

What has tended to matter more are the level of stock market valuations and the strength of the economy. That is not to say that policy do not have an impact, it is just very difficult to predict ahead of the event.

To cloud the issue yet further, in certain areas there has been much greater policy alignment than the political party’s rhetoric suggests.

Take China for example – President Biden has not only maintained the Trump-era tariffs but has recently announced measures to escalate them further ahead of the election in a bid to protect US jobs.

Should Trump win in November, his ability to repeal policies such as the Inflation Reduction Act will also be heavily influenced by whether the Republicans manage to win both the Senate and the House of Representatives. Our ability to second guess policy changes ahead of the event is arguably no better than the flip of a coin.

For us, valuation is the starting point. The price you pay matters foremost, followed by a thorough analysis of the economic fundamentals.

When we invest our clients’ money, we prefer to focus on those things that are knowable, assessing the likelihood of potential outcomes rather than betting on a single outcome.

Although Chinese equities today are deeply unloved and investors are fearful of a more belligerent approach from the US, we believe much of this has already been reflected in the price. Valuations continue to trade towards the very bottom of their range.

This has been driven by a deterioration in corporate profitability brought on by a combination of harsh Covid-19 lockdowns and the communist parties crusade against private sector companies that were deemed to be operating within a quasi-monopoly or against consumers best interests. Most notably, big internet tech companies and property developers.

Since the end of the lockdowns, the Chinese government has pivoted towards a pro-economic recovery, even if it has not matched global investors expectations.

Corporate profitability we think can normalise from the current cyclical trough. Given the low sentiment, any news that is less negative, can have an outsized impact on returns.

Whilst we do not rule out further tariffs should President Trump triumph in November, we think the upside potential from here is in our favour versus the risks.

We like the more domestically orientated sectors, such as communication services and consumer discretionary stocks, where the investment case is much more about a recovery in China than their ability to compete internationally. Many of these companies are not only well managed but also dominant franchises exhibiting strong competitive advantages.

Similarly, the UK is expected to hold an election by early 2025.  Given the indebtedness of the country and the weak growth, most commentators do not believe that politics will have much of an impact on the economy.

However, what we notice is that UK equities have derated ever since the result of the EU referendum was announced, with the valuation gap only widening during Covid. This has not been helped by the domestic pension fund sector steadily and consistently divesting from the asset class since the 1990s.

Whilst the UK market has benefitted from a higher rate environment, the valuation gap has remained consistently wide. Our analysis shows that the UK is a market of global stocks, not a market of UK domestic companies, with only 19% of revenues coming from sales to the UK, with many being global market leaders.

In recent years, the UK stock market has had to contend with a collapse in the perception of stability as the governing party has fought with itself over how to capitalise on the benefits of Brexit.

Similarly to China, the bar has been set low, and any recovery in perceptions can only serve to improve sentiment from international investors, whilst in the meantime, we own a basket of globally facing companies, many of whom are world class if not leaders.

In conclusion, whilst we do not dispute that elections can impact markets, trying to second guess market moves is very hard, if not impossible.

It is very early days, but over the past month, the IA China/Greater China sector is up 3.5%. This compares to a decline in the India sector of 3.5%. This suggests that some parts of the country’s stockmarket are starting to fire up. There are other tentative signs of a shift. Net retail sales from the sector dwindled to £25m in February, less than half of January’s levels. Discount levels on investment trusts have also moved in from historically wide levels.

There appear to be some signs of improvement in the country’s economy. The country’s GDP figure grew faster than expected in first quarter of 2024, rising 5.3% versus a Reuters’ poll showing consensus expectations of 4.6%.  The government has brought in selected stimulus measures, which are driving growth, even if the hoped-for ‘big bazooka’ remains elusive.

Fund managers also appear increasingly optimistic, given low valuations and stronger growth prospects. James Donald, head of emerging markets, Lazard Asset Management, says: “I don’t want to sidestep some of the risks, such as China’s relationship with Taiwan. However, if it doesn’t materialise, there is every chance that China will be one of the best stockmarkets in the next five to 10 years.

“We’re now in a position where the Chinese market is probably the most hated in the world. There are some highly profitable, fantastic businesses that we couldn’t get close to buying three or four years ago, now they’re value stocks.” Across the Lazard funds, it is the first time they’ve had index-level exposure in recent history.  

Dale Nicholls, manager of the Fidelity China Special Situations fund, says he has dialled up the gearing on the trust and it now sits at over 20%. “At a time when the market is cheap, sentiment is bad and there’s lots of opportunity, gearing will be higher. That’s where we are now.”

Ongoing problems

That said, no-one downplays the very real challenges that the Chinese economy faces. Xavier Hovasse, head of emerging equities at Carmignac, says: “The top down story for China is quite ugly. The property market is a disaster; they have over-built and inventories are very high. The population is shrinking; while data is difficult to obtain, it seems that the number of babies born has shrunk from 18 million to 10-11 million.”

Donald says the real estate sector is still six or seven years away from being a contributor to the economy. Foreign direct investment is likely to be weak, given ongoing geopolitical tensions. He adds: “It comes down to the consumer. The consumer has a lot in the bank, but they’re very pessimistic.”

There are some signs of life for the consumer. Domestic travel is improving, for example. During the Chinese New Year festival in mid-February, the country’s Ministry of Culture and Tourism reported an estimated 474 million domestic travel trips. This was a 34% increase over the previous year and is a first step for Chinese consumers in starting to spend again. However, few managers are expecting consumer spending to reignite with any vigour.

Valuation anomalies

The real appeal in the Chinese market remains the low valuations. Hovasse says: “It’s the most inefficient market. There are constant booms and busts.” He says he continues to find all sorts of anomalies in the Chinese market, including an education company where the shares dropped 95% because the government said it couldn’t make a profit on one of its businesses. “It was worth a third of its net cash and its other two businesses were still contributing to cash flow. This is deep, deep, deep value.”

Nicholls also highlights these sorts of opportunities. One of his portfolio companies paid out 70% of its market capitalisation as a special dividend in 2023. He points out that net issuance has been a drag on returns from the Chinese market, creating excess supply that has needed to be digested, but Chinese companies are learning their lessons: “That mindset around capital return to shareholders is really changing. That dilution will improve and could go negative in 2024.”

He believes that many companies have prioritised ‘land grab’, but clearer market structures are now emerging, giving more capacity to pay money back to shareholders. They are encouraging management teams to adopt buybacks: “We’re focused on our engagement with company. If we’re not going to get paid by the market, we’d like to be paid by the companies.”

Geopolitics

Geopolitics has been a major factor in China’s weakness and this remains a concern in spite of thawing relations with the US. The US election is likely to bring continued rhetoric on China, with both Democrats and Republicans talking tough.

However, in general, fund managers do not see a confrontation over Taiwan as a key risk. Hovasse says the Chinese government has shown restraint over Taiwan. It had been assumed that China would support Putin in its invasion of Ukraine, he says, but that support has not materialised to any significant degree. He adds: “The reaction of the Western world was not expected to be that harsh. Putin wouldn’t have bought hundreds of millions of US and European bonds if had anticipated the response. Even if Jinping thought about invading Taiwan, the reaction of the west to Russia probably makes it less likely. It would be irrational and a disaster for the domestic economy.”

All fund managers recognise that there are still some difficult areas of the market. The auto space, for example, is a difficult area. Real estate remains tough. Hovasse and Nicholls both say it is vitally important to have a capable analyst team to sieve through the markets. There are still plenty of companies that are only quasi private and investors need to be careful that their interests are being looked after.

It has been a long and difficult road for the Chinese market. Any turnaround is unlikely to be instant or linear. However, the valuation anomalies seen in Chinese markets, some thawing on geopolitics, and marginally stronger growth may be the start of a shift.

The year of the Dragon has started with investors split between those abandoning Chinese equities and those seeing contrarian opportunities.

This sums up the key questions facing investors after a three-year bear market in the world’s second largest economy – will the future be like the past? And is China simply uninvestible because of its political regime?

Let’s start with the first of these questions – the outlook.

Hero to zero

Here, the challenge is to set aside behavioural biases and construct realistic potential outcomes based on the data, then estimate how much weight to put on each scenario. This starts by recognising that our behavioural instinct is to give way too much importance to recent experiences – in this case disappointment – when thinking about what could happen.

The evidence from our Morningstar flows data is that these biases lead investors to make bad timing decisions that detract value. In our latest ‘mind the gap’ study, returns were lower when flows were taken into account versus the underlying fund return.

To put the facts about China today into perspective, we need to look back at the last 3 years.  In early 2021, China was a market darling and clocking up two years of high returns.  IMF studies show the dramatic rise in the number and value of listed Chinese companies. By the end of 2020, China comprised approximately 40% of Global Emerging Market indices and foreign ownership at between 3.5% to 4% – both historic peak levels.

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Investors overlooked many of today’s concerns that were evident back then: residential property overbuilding, US trade restrictions, high debt levels, and periodic pendulum swings in government policy from reigning in the private sector, to supporting its growth.

Since then, economic growth has disappointed, impacted by stringent COVID lockdowns, the drop in inbound investment, and the fall-out from the residential property boom and bust. Corporate profits were also hit by the “common prosperity” regulatory crackdown in late 2021 that added severe restrictions on gaming companies and private education companies, and sanctioned high profile powerful corporate executives. Foreign investors swung from bulls in 2021 to bears by 2023, dramatically scaling back their exposure.

A changing future

So where has three years of a bear market left us today? Well, here are five current facts that paint a very different picture from when the market peaked.

First, profit margins are at the low end of their historic range and rising.  Second, valuation measures are at the low end of their historic ranges too. Third, measures of sentiment point toward pessimism, including profits expectations, net flows and positioning. Fourth, government micro economic and macroeconomic policies have eased to be more supportive of the economy and companies in general, including gaming.  Fifth, the market composition has changed.

Many major companies are dominant franchises with low levels of debt, while the banking sector and property development sectors are much smaller parts of the market than in the past. 

These five factors tell us that China is a pariah market, one that has priced in greater risks, weaker growth and discounted any eventual cyclical recovery. These are typically the hallmarks of a good investment opportunity.

By comparison most other equity markets are trading at levels at or above fair value, and there are increasing signs of extreme optimism in several leading US stock market companies.

Is authoritarianism a concern?

That still leaves the issue of how much to allocate to an increasingly totalitarian, communist state. Sizing exposure comes down to both the margin of safety embedded in current share prices, as well the degree of uncertainty – in other words randomness that makes it virtually impossible to estimate probabilities.

China’s most striking difference is its one-party state, which under Xi Jinping has taken a greater degree of control over everything, including more entrepreneurial listed companies.

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For this reason, we believe fair value is lower vs comparable assets in countries which do have independent rule of law, strong shareholder rights, and greater predictability and transparency of government regulation.

It is also why portfolio exposure should be considerably lower, even when opportunities are brightest. We thus constrain our direct exposure to China and hold less than we would for many other large markets that are similarly attractive. 

Should China exposure be zero?

Well, around the world all governments have become far more interventionist.  Covid ushered in much larger government spending and regulation. Policies to reduce emissions and incentivise onshoring, such as the US’ Inflation Reduction Act and Chips and Science Act, have had huge impacts on businesses, as does the rise in military spending.

In other words, no matter which equity market you invest in, the fate of companies is heavily influenced by governments via fiscal policy, monetary policy, regulation, trade, the military and direct government investment. A productive and active private sector is recognised as playing a key role in supporting political stability via employment and the shift to high productivity industries, where the private sector has been the key driver.

So, we do not see a convincing case for excluding Chinese equities from a well-diversified portfolio, given the quality of leading listed private companies and their strategic importance for China.

The real problem has been that investors closed their eyes to all the known risks and invested too much at peak prices. The painful ride has taken its toll, but today these risks are priced-in and an appropriately sized exposure is warranted.

In fact, our own research shows that prospective risk adjusted returns are higher than usual in absolute terms and vs other markets, so we hold more than usual in our Morningstar multi asset funds and managed portfolios.

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The China bear story has been well documented by now. A troubled property market, problematic and high local government debt, collapsing birth rates, and demographic challenges all led to low business and market confidence, and significantly derated China assets.

Looking at the asset prices, it is hard not to wonder whether the China growth story has ended. However, after having just spent three weeks in a dozen cities, from the glitzy Shanghai to the sleepy backwater town of Fanchang that has just welcomed its first Starbucks, it is clear that the China growth story is not ending, but changing.

Rise of the Chinese multinationals

Internationalisation is the buzzword in corporate China. For some, it is a reactive and defensive move in response to the impact of rising geopolitical tensions in global supply chains, inadequate domestic demand and, thus, excess capacity.

However, for some aspiring entrepreneurs and companies, internationalisation is a natural evolution from domestic dominance to global prominence.

Export and global growth are not new, nor are they the same as that of yesteryear when iPhones and Nike shoes were made with cheap and efficient labour. This new phase of internationalisation is different – it is the export of expertise, technology, innovation, and brands. From ‘made in China’ to ‘branded and marketed by China’, we will see the rise of Chinese multinationals.

Chinese EVs are coming to a place near you

Commenting on its Chinese competitors during his company’s most recent earnings call, Tesla CEO Elon Musk said: “If there are no trade barriers established, they will pretty much demolish most other car companies in the world. They’re extremely good.”

In fact, it is already happening. With its technology, scale and leadership in the production of electric vehicles (EVs) and a more successful go-to-market strategy, China’s car exports overtook Germany and Japan in extraordinary fashion in just two years.

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A substantial part of this success is rooted in their competitiveness and popularity in other emerging markets. In an increasingly multipolar world, this trend of rising Chinese multinational brands in the global south is very likely to continue. While it will take more time and effort to win the hearts and wallets of richer and pickier European consumers, Chinese car makers have a compelling value proposition for a world fast transitioning towards EVs. The winning formula of better and cheaper will prevail.

However, it is not just about selling cars globally – Chinese brands are also making their supply chains international, bringing their best partners with them.

Hongfa, the world’s largest relay manufacturer with a dominant market share in high voltage DC relays for EVs, is constructing its first European production site in Germany after building a thriving Indonesia production base servicing its global clients . Developing local supply chains in Europe is also necessary and critical to managing rising trade barriers and tension.

Your margin is my opportunity – should Amazon be afraid?

While it will take time for Chinese EVs to conquer Western consumers, Chinese digital consumer platforms are already making significant inroads. Temu, Pinduoduo’s international e-commerce superstore, and Shein, a global e-commerce fashion retailer, are both able to boast more than 150 million monthly active international users and $30-$40bn annualised gross transaction sales. Both are already very popular with US and European consumers, especially younger digital natives.

Temu sells the same products as Amazon at discounts of 30-40%, with many consumers willing to trade convenience and wait the two week delivery period, especially given the current cost of living crisis. Amazon even reduced its seller fee last year in an attempt to compete against these fast growing new entrants.

The ubiquitous three and the convergence of two Chinas

What struck us most when visiting many small towns in China is the ‘ubiquitous three’ – a name given to three companies that seem to be everywhere throughout the country.

Luckin Coffee brings tolerable $1.50 per cup coffee to the masses; Tastien Chinese Burger localises Western fast food at lower price points; Mixue peddles sub-$1 fruity and creamy tea drinks on an industrial scale. Looking at the ubiquitous three, it is hard to reconcile them with the narrative of weak consumption.

The answer lies in the convergence of two Chinas. There is the developed China with about 200 million middle-class consumers clustering around four megacities – the China that everyone was visiting and focusing on.

But in contrast, there is another emerging China characterised by wet markets, cheap knockoffs and unbranded consumer goods. Instead of the Shanghai middle class drinking more Starbucks or pricey artisanal coffee, the main consumption story now revolves around the other hundreds of millions of lower/middle-income families trying decent coffee and burgers for the first time – and often at more affordable prices.

China’s growth has slowed after decades of urbanisation and investment-led explosive growth, but it is far from over. Rather, the growth drivers are transitioning.

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We have now entered the year of the dragon in the Chinese zodiac – a magnificent and mystical creature symbolising supernatural power and prosperity. As the most auspicious of all zodiac signs in Chinese culture, could the year of the dragon bring a change of fortune for China?

We believe 2024 is likely to remain an uphill battle for the Chinese economy and its markets.

To avoid being overwhelmingly pessimistic on China, let’s think about the potential positive developments in 2024.

The authorities have stepped up stimulus measures and are increasingly pre-emptive and targeted in nature. At some point, they may well develop a “whatever it takes” attitude.

For example, in an unprecedented move, China’s central bank announced an impending cut in the reserve requirement ratio (the percentage of deposits that a commercial bank must hold in reserve) ahead of its official meeting date. There is also a clear signal of further easing measures to come. Consideration of a stock market stabilisation fund shows the authorities will not turn a blind eye to the haemorrhage in Chinese stocks.

China has also backtracked on measures aimed at deterring online gaming companies, which shows increased consideration for how regulatory changes can impact market sentiment. The risks of a regulatory crackdown remain, but the worst is probably behind us.

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The external demand picture for China may look brighter too, with interest rates likely to be cut and an increased probability of a soft-landing in major economies in 2024.

Low Chinese asset valuations due to the depressed sentiment around China could also pique investors’ interest – could “be greedy only when others are fearful” apply to how investors view China?

The problem with the investment philosophy widely celebrated in the West is that it is not always applicable in China. The reason why? China is still a centrally directed economy and the state has tightened its grip on private companies in recent years.

Being a shareholder may not equate to participation in the future success of a company, for example. Instead, shareholder capital may be used to serve the policy goals of the Chinese government and underwrite the risk in the process.

True, there are some secular bright spots in relation to industrial upgrades, artificial intelligence (AI) and de-carbonisation. Electric vehicles (EV) and solar panel production are booming, and China will be a key player in the world’s transition to renewable energy. Progress has been swift, perhaps best seen in BYD (Build Your Dreams) overtaking Tesla as the world’s biggest EV producer in 2023.

However, investors exposed to a broad equity index in China may find it difficult to benefit from these themes. The top ten constituents of the CSI 300 Index are dominated by state-owned banks and insurance companies, whereas the Hang Seng China Enterprise Index has a heavy weighting to Chinese technology giants, which remain under scrutiny due to national security.

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Even if you target the companies that may benefit from secular tailwinds, many Chinese companies that produce and supply to the world’s renewable energy sector are heavily state-subsidised and are not necessarily profitable. These industries may also be challenged by the increasingly protectionist stance of the West, which may become a focal issue for the China hawks in the upcoming US election. During the US-China trade war under Donald Trump’s presidency, Chinese equities significantly underperformed those in the US.

Simply put, economic confidence in China will be steered by the property sector in 2024. The liquidation order of Evergrande will be complicated and investors will have to wait years to retrieve assets. Crucial to sentiment recovering will be whether unfinished residential units are completed for homebuyers who have already paid. Chinese authorities and Evergrande have made this a priority but it is worth watching how this one unfolds.

While there are goals to channel more funding into the property sector, it is hard to anticipate a major recovery in 2024, as banks have remained cautious and selective in their lending. Not helping matters is the expectation that refinancing pressures will remain high for property developers in 2024 and 2025, according to Moody’s.

Unless there is a revival in the property market, consumers’ appetite to spend may be limited, especially given around 70% of Chinese household wealth is tied to property. The property crisis also highlights the wider difficulty in rebalancing China’s economy from one driven by fixed investments to an economy deriving growth from consumption.

Against this backdrop, it is unsurprising that Chinese equities have become very cheap. After falling in seven of the past 10 years, it is unlikely to see further big drawdowns in 2024. That said, for markets, it is going to take a lot more than the prospect of easing and better economic data to turn their entrenched negativity around. China could really do with the year of the dragon living up to its name.

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These include the country’s protracted property crisis, the massive accumulation of local government debt, the deflationary pressures that indicate the apparent shift to consumer-driven growth is failing and China’s ageing population.

The CSI 300 index, which measures the top 300 companies on the Shanghai and Shenzhen stock exchanges, plunged 44% (in US dollar terms) during the past three years and Hong Kong’s Heng Seng index (HIS) – which also lists the shares of major Chinese companies – fell around 40% in the same period, according to FE Fundinfo data.

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In contrast, the MSCI World index posted a positive 23% return, and the S&P 500 soared 32.7%. Last year alone, the CSI 300 and the HIS lost 10.9% and 13.8%, respectively, while investors turned to a renascent Japan, whose market was up 20.8%, and to the alternative emerging giant, India, where the MSCI India index surged 21.3%, according to FE Fundinfo.

“A positive outlook for India is reinforced by weakening investor confidence in China, which puts India in a favourable position as a viable alternative to China in the eyes of global investors. For China, we remain on the sidelines, as we wait for the bottoming process to unfold,” Bhaskar Laxminarayan, CIO and head of investment management Asia, Julius Baer, told a recent roundtable in Hong Kong.

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Yet, dozens of funds available to Hong Kong and Singapore retail investors with a broader Asia-Pacific ex Japan mandate also ailed as China stocks comprise 31% and Hong Kong 5.8% of the MSCI benchmark, which excludes Japan and allocates only 20% to India.

The index generated an unimpressive 7.7%, while the average return by mutual funds benchmarked to the MSCI Asia ex Japan was a dire 3.6%. Asian investors would have been better buying units in an average US equity fund and reaping a 25.6% return last year – or placing their cash in time deposits.

To read more visit the February edition of Portfolio Adviser Magazine