InvestmentsAug 19 2013

News analysis: Riding China’s cyclical rally

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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”.

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.

The bulls have plenty of data on their side. Chinese economic growth has yet to plummet as many people feared last year, although it is still showing signs of slowing down. Indicators such as car sales are ticking up and investors are being cheered by a government crackdown on corruption. And when banks such as Bank of China are trading at book value, as Ms Peck says, there is a compelling argument for buying in while there is limited downside.

Mr Fleming is investing in what he calls ‘high quality’ cyclicals, including a state-owned railway, as well as holding on to commodities-related companies through recent volatility as they remain cheap and have a new focus on returning cash to shareholders.

But simply buying a basket of miners, industrials and other economically sensitive stocks is unlikely to help investors ride this cyclical upswing. If Fidelity’s Anthony Bolton is finding China as hard as he is, there is not going to be a straightforward solution.

Aberdeen’s Kathy Xu, a manager within the group’s China and Hong Kong equities team, indicated her team would be content to sit out any short-term rally even if it means short-term underperformance.

She also suggests the cyclical rally could be driven partly by hedge funds, which are closing out or covering “overpunished” short positions in cyclical stocks, designed to benefit when stock prices fall. Ms Xu also reminds investors that equities “can be rallying with no fundamental improvement”.

Ms Xu’s stance is telling, and indicates what we are likely to see from defensive managers such as Mr Tulloch and Aberdeen’s Asian equities star Hugh Young. The pair have mastered the art of protecting investors’ money during downturns and are unlikely to suddenly throw caution to the wind simply to try and stay on top of the performance pile.