What Happened in May
After pausing in April, the offshore China equity market resumed strong momentum in May with the MSCI China Index returning 5.3% in USD terms. This was partly helped by easing concerns over an economic slowdown in the latter part of 2017. Macro-economic data was supportive – China’s manufacturing purchasing managers' index (PMI) stabilised at 51.2 in May, and remained in expansion mode. The China real estate sector rebounded strongly despite the tightening regulatory environment but, however, this rally was more stock-specific than sector-wide. We believe that in some cases stock performances have outpaced improvement in physical markets. We have repeatedly seen in the past that strong sales in lower-tier cities generally signal the peak of the cycle. Therefore, we remain cautious on the sector and prefer high quality names with exposure to higher-tier cities. China A-Shares continued to lag their offshore counterparts in May, resulting in a year-to-date (YTD) underperformance of more than 20%. In particular, small and mid cap companies were the clear underperformers when compared to blue chips.
The Fund underperformed the benchmark in May. The main area of detraction came from stock selection in IT sector. In addition, our positions in less well-known IT names have yet to compensate as investors herded to mega caps.
Outlook and Strategy
Unlike previous environments when small and mid cap names outperformed in a rising market, the current rally in China equities has been firmly dominated by large cap stocks. For example, 7 out of the top 10 benchmark names have outperformed the benchmark over the past one year. This phenomenon continued in May, when investors herded to the benchmark heavyweights with strong momentum and positive earnings announcements, especially the internet stocks. Such a market environment is particularly tough for active managers, where the focus is typically on market mispricing and growth opportunities more commonly found outside large index constituents.
Currently, China small and mid cap stocks are trading at similar valuations compared to their large caps peers, which is almost unseen over the past five years. As a result, a number of our existing positions have been ignored by investors though the fundamental growth outlook remains intact. We see catch up potential once the market mean-reverses. Our experience tells us that such recovery is generally more powerful than many have expected and these turnaround situations have repeatedly contributed to portfolio performance in the past.