In November the fund gained 2.7%. This was again led by Taiwanese technology (+175bp) but we also had solid performance from financials which boosted our returns from Brazil (+86bp), South Korea (+69bp) and Poland. The laggard continues to be China which was down 97bp.
One of the biggest surprises of the year has been the lethargic and piecemeal policy response to China’s clear economic problems in the real estate sector, weak export demand and local government financing. With deflation increasingly entrenched, businesses are naturally less willing to invest which is now compounding the problem.
The irony is that whilst policy rates have been easing since H2 2021, they haven’t fallen as fast as inflation and hence real rates have actually increased. This has pressured debt service levels for leveraged companies and local governments struggling to meet fiscal obligations following the collapse in land sale revenues. It’s also eroded consumer sentiment which has been a roller-coaster ride this year, spiking post re-opening but now back to pandemic lows given the weak real estate market and deteriorating employment outlook.
To be fair, an effective policy response first requires identifying the problem and its size. Both are extremely difficult in China given opaque structures that go beyond traditional bank lending and bond markets. The tip of the iceberg is over-levered real estate developers, where there’s been numerous directives for policy banks to support those that are viable with new credit lines. The difficulty comes further below the surface in the long tail of smaller developers and more poorly capitalized and provisioned city and rural banks. These are disproportionally impacted by declining net interest margins, especially in mortgages where spreads are still high by global standards.
All of this feeds into the most visible problem which is sold but unfinished apartments. Estimates for the size of this housing stock vary considerably, the research firm BCA believes it could be as high as 65 million units which may take over 8 years to clear. Given the impact on bank balance sheets and consumer sentiment, this appears to be one of the more urgent policy priorities, the big question is how.
Earlier this autumn borrowing targets were increased to raise capital for a support facility that could target such measures, similar to Hank Paulson’s TARP (Troubled Asset Relief Program) in the GFC and the original economic ‘bazooka’. As the name suggests, the initial focus was impaired assets, but it soon became clear it was hopelessly dwarfed by their size.
Eventually this fund was used to support bank recapitalizations (the liability side), and only then did we start to see a more positive feedback loop where losses could be absorbed, and entities could consolidate. A similar watershed needs to occur in China’s approach to real-estate developers and LGFVs, and it’s not clear if we’ve reached this point yet. They at least now have a bazooka, it’s out the box, they’re just not sure where to point it.
Combined this all points to lower rates, a weaker currency and more policy support measures as unemployment could become a social issue. This year in terms of allocation, we’ve focused on the consumer and SOEs that have clear alignment with shareholders (both minorities and the state) and a track record of putting shareholder returns above value destructive capital allocation. Unfortunately, there are very few of these but the ones we still hold have all made positive returns this year. We will continue to hold these names whilst fading our interest in the consumer.
We still have a strong preference for Hong Kong where the more open economy is able to reprice and recycle more efficiently and being more directly influenced by US rates than Chinese rates, if recent policy statements offer any guidance, should be supportive into next year.