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A Year of Contras

As we have noted recently 2023 has been the year of the contras where swings in major macro trends have caught consensus positioning and beliefs offside. From a behavioural perspective it is important to remember that price itself can drive fundamentals by affecting perceptions of risk and the required rate of return. Or put another way price action can drive narratives or the prevailing bias. Narratives or as we describe it – consensus beliefs – will often skew positioning and lead to opportunities for contrarian investors. Of course, being the black sheep is often deeply uncomfortable.

As we noted again recently, the Economist cover is often an excellent contrarian indicator. Another is the Bank of America Fund Manager Survey. In the latest survey the ratio of investors “concerned” about China’s housing sector more than doubled to 33% from 15% last month. At the same time 8% of investors polled named China’s a potential real estate “bust” as the biggest tail risk. A net zero percent of investors expect stronger economic growth for China in the next 12 months, down from 78% in February this year. Overall, the “avoid China” narrative is a widely held consensus belief.

Of course, new residential floor space under construction is already down 74% from peak and the listed real estate sector is down by 70% since 2018 (chart 1). Most of the developers’ bonds are already trading at cents in the dollar and in default. To be fair, it is hard to have “mean reversion” when the real asset value is close to zero in bankruptcy. While the real estate bust and the consequences for Chinese growth are a legitimate crisis given real estate has historically contributed 25% to GDP, the crisis is already well priced and appreciated in directly affected assets. In contrast, and ironically investors now “love Japan.” (it is ironic because Japan has been a consensus underweight for most of the past 30 years).

The big picture question is whether China is a genuine value trap? While there have been a range of policy measures announced by the authorities over the past few weeks, so far, the initiatives have stopped short of comprehensive restructuring, addressing the key structural issues and large fiscal/monetary stimulus to support growth. As we have noted, policy is probably constrained by the magnitude of total debt-to-GDP, and the potential for negative interest rate differentials to encourage capital outflow pressure on the currency. Indeed, rate differentials still probably warrant further downside in the CNY relative to the US dollar (chart 2). The currency picture has been complicated by weakness in trade competitors, especially Japan.

From a tactical point of view, the recent rally in spot iron ore might suggest that more aggressive policy support is coming (chart 3). However, that is not supported by the reopening basket or the Goldman Sachs basket of “fiscal impulse” beneficiaries. Nonetheless, what we do know is that “avoid China” is a widely held consensus belief and valuations are extremely depressed in outright and relative terms on Chinese equities.

Our preferred exposure is the large platform companies that have exposure to China’s consumer and technology. In contrast, US tech is probably crowded from a positioning, beliefs and valuation perspective among large managers and hedge funds. When everyone agrees, typically something else tends to happen. Some sectors of China’s equity market are a legitimate value trap; however, we can find companies with 25%+ compound EPS growth, net cash on single digit multiples. The recent bear-porn on China makes me so bullish I can’t walk.

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