News analysis: Riding China’s cyclical rally

If you agree with First State’s Asian equity fund manager Angus Tulloch, owning the riskiest stocks in China could, perversely, now be the only way to protect yourself in one of the world’s most volatile markets.

It may also be a subtle hint that his funds’ recent outperformance is about to be undermined by short-term market forces.

Last week Mr Tulloch, who runs the £6.7bn First State Asia Pacific Leaders fund, voiced his concerns that a sudden rally in cyclical stocks was on the horizon, as investors realise that “a lot of steady-growth consumer staples companies are fully priced”.

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This paradoxical situation – in which the riskiest, or most volatile, ‘cyclical’ Chinese stocks could become the safest bet – marks China as a contrarian investor’s paradise.

Indeed, Aberdeen multi-manager Scott Spencer believes just this, as Asian managers have “almost a consensus underweight” in China.

But this consensus may be turning, if a straw poll of emerging markets managers conducted by Investment Adviser last week holds true.

Several managers now seem to concur with Mr Tulloch’s assessment and are positioning their portfolios accordingly.

The managers said that a combination of hedge funds covering short positions on cyclical stocks and economic data releases that had not been as weak as expected would give rise to a resurgence in lower-quality names.

Cyclical stocks have taken a battering in recent months, with miners suffering from a lack of demand in the region and Chinese banks being hit particularly hard as investors fear a crackdown on then country’s so-called ‘shadow banking’sector.

In the year to August 30 the Hang Seng Financials index underperformed the main Hang Seng index by 6.9 percentage points, according to data from FE Analytics.

Wider Asian indices indicate a similar divergence. Although FTSE indices show industrials, oil and gas providers and mining companies to have made gains in the past five years, sectors such as healthcare and consumer goods have doubled in value.

Mark Fleming, who manages the Tiburon Taipan fund, argues that the cyclicals rally has already started – although he admits having been “a bit early” in anticipating the upturn.

Shipping and construction companies have performed well in recent weeks, Mr Fleming says, and he also tips Chinese retailers and banks as potential beneficiaries of the rally. But he also warns that many such companies are facing bigger issues to attract long-term investors, such as suffering from bad debts on their balance sheets or – in the case of many Chinese banks – having too much state interference.

“We are participating in the China rally- we are bullish – but there is a limit to what we are prepared to buy,” Mr Fleming says.

JPMorgan Asset Management’s Claire Peck is also embracing the cyclicals rally, including banks, saying compelling valuations in the region are making cyclical sectors worth their volatility.

“People have been willing to pay a premium for certainty which ultimately limits their returns. Cyclicality is cheap and certainty is expensive,” Ms Peck points out.