The US is unlikely to start a trade war with China despite widespread market fears, according to Liontrust’s Mark Williams and Carolyn Chan, who also believe there are several drivers which make Chinese equities particularly attractive.
As such, the duo – who head up the four crown-rated Liontrust Asia Income fund – have a 40 per cent regional weighting to China, which is 15 percentage points more than that of the MSCI AC Asia Pacific ex Japan index.
“We think we can find lots of opportunities in China and we’re happy that a number of growth drivers are going to continue into the medium term,” Williams said. “But at the same time, as long as things aren’t very extreme, China is not going to be derailed by a lot of changes which have to go on in China for us to remain positive.”
The managers admit the country is not without its issues. For instance, they say China will have to completely overhaul its financial system, following extensive lending to state-owned manufacturing enterprises in the immediate aftermath of the financial crisis.
They say the country’s level of indebtedness was further increased by a simultaneous push for government-funded infrastructure projects in a bid to bolster growth and employment levels.
Performance of indices since 2008
Source: FE Analytics
“There was a huge increase in debt but that has to stop, so we want the economy to slow down,” Chan said.
“It is slowing down; the fact that predicted growth numbers are being allowed to come down is a real positive and, for us, the most positive base case is you see growth slow down to around 6 per cent and become more sustainable in terms of the type of growth.”
“Now, the country’s growth is more domestic consumption-driven and less the result of overinvestment in the lemming production of exports.”
China’s infrastructure-led investment drive after the crisis has also led to production overcapacity, which is another common concern investors have when it comes to having exposure to the region.
However, the managers point out that this is steadily reducing and that, last year, China exceeded its capacity removal targets across problematic sectors such as steel production.
“China shut down more than 10 per cent of its overall steel capacity which, given it produces more than half of the world’s steel; is a significant global amount,” Williams explained.
“It’s a global problem so, yes, a lot of the overcapacity lies in China and that’s talked about, but it’s something we have to be very careful of throughout the Asia Pacific region.
“These aren’t the issues we are trying to catch bounces in; we are looking for more longer term, steady areas of growth. They are reducing some of that overcapacity in China and, equally, the investment in some of these areas is reducing. It’s heading in the right direction.”
One of the more recent headwinds to come to light regarding China is US president Donald Trump’s proposed trade tariffs on the country which, if implemented, would lead to a hefty 45 per cent tax on all goods imported from China.
In fact, following the election of Trump last November, the Shanghai Composite index has lost 5.62 per cent in sterling terms while the MSCI AC World index is up 5.98 per cent.
Performance of indices since 2016 US election
Source: FE Analytics
“Our view is that it’s quite unlikely you’re going to get a trade war,” Chan said. “The reason for that is because we don’t think, if you have a trade war, you’re really going to get a significant number of jobs coming back to the States.
“There’s already movement in some of the companies we invest in away from Chinese manufacturing to other areas where labour is much cheaper. China has increased its minimum wage by 12 per cent every year since the turn of the century on average and that’s had an impact.
“It’s the reason why the currency has been able to stay relatively weak rather than being allowed to appreciate, it’s because they’ve taken the pressure internally through rising asset prices and also through wages.”
The managers say China is now at a level where other countries are taking on the mantle as the low-end producers, such as Vietnam, Indonesia and Bangladesh. They believe this shows the country’s economy is developing and evolving, which is another positive driver for China.
“We think the chances are that, if you get punitive anti-China tariffs, the production would just move to other centres rather than just going back to the US in general,” Williams explained.
“Equally, if you saw broader tariffs it would have an inflationary impact for all of the domestic consumers in the States.”
They use the manufacturing process of the 32GB iPhone 7 as an example of this. Contrary to popular belief, most major components of the phone are created in other countries such as Taiwan and even the US, while only the final assembly is carried out in China.
That said, if the final assembly of the phone was carried out in the US, it would add between $30 and $40 to the production cost, which currently stands at an estimated $225.
Given that the US retail price for an iPhone 7 is approximately $640, the managers say that moving this area of production to the US would have a significant inflationary impact on the product’s end price.
“That would certainly be inflationary. We used the iPhone as an example, but that would obviously span across all electronics. It’s a key component, not just for individuals, but also for businesses in the States,” Chan said.
“I think that following last week when Xi Jinping met up with Trump, the rhetoric has calmed down a lot. China has conceded a few things, they’ve allowed US beef imports to come through again to China having been banned since 2013, they’ve also said they will allow more Hollywood movies to come back into China.
“Those may be soft or small changes, but I think it shows some headway in terms of calming the situation down.”
Overall, the managers don’t believe China will be subject to a trade war or that it will endure a domestic financial crisis.
While they believe the country is undergoing a slow and difficult process to reduce overcapacity and to overhaul their dependence on manufacturing, they say there are a number of attractive and relatively low-risk investment opportunities available which pay out steady streams of income.
For instance, the duo’s largest weighting is in double-glazing manufacturer Xinyi Glass Holdings, which is set to benefit from increased environmental awareness.
They also hold Lite-On Technology, a computer storage devices company, which could benefit from the consumption boom and rising middle class in China.
“China is 40 per cent of our portfolio, there is 60 per cent elsewhere. We talk about it a lot and it’s very important; it’s going to influence most of our holdings. But at the same time, we’re not a China portfolio,” Williams concluded.
“We also don’t expect China’s transformation to be achieved in the next year or two. However, as long as the rebalancing continues, we can look to the areas which are trying to avoid potential negatives – such as non-performing loans – and generate sustainable growth over the medium term.”
Since the £80m Liontrust Asia Income fund’s launch in 2012, it has returned 65.78 per cent compared to its average peer’s return of 52.55 per cent.
Performance of fund vs sector since launch
Source: FE Analytics
Had an investor placed £10,000 into the fund at launch, they would have received £2,541.99 in income alone.
The fund has a clean ongoing charges figure of 0.97 per cent and a historic yield of 4.82 per cent.