China was a key story for emerging market investors throughout 2023. The excitement of stimulus, unlocking of supply chains, and the re-opening in late 2022 and into early 2023, quickly faded as the Chinese government did not provide stimulus levels that other developed economies had provided for their citizens and thus dampened sentiment and constrained economic growth. Further, geopolitical tensions ran high earlier in the year prior to softening towards the end of 2023. Chinese stocks have traded at a discount to their emerging market peers for the last few years as China suffered its third consecutive year of underperformance (see Chart below).

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In hindsight, we recognize that our move from an underweight position to an overweight position approximately 18 months ago was early. However, following our bottom-up value discipline, we sold stocks that had performed strongly and invested in new stocks that were on trough valuations, many in China. We recognize that this has put pressure on our performance in 2023, but as we continue to see improvements in the fundamentals of most of these holdings, we are confident that changes in sentiment will create a strong backdrop for outperformance.

One of the primary pressures on the Chinese market since 2022 has been the property sector and those industries that touch this space. This part of the market has historically been a key driver to economic growth. The Chinese government‘s transition to shift from old growth drivers (property, infrastructure, export, etc.) to new growth drivers (manufacturing, AI, digitalization, energy transition, domestic consumption, etc.) has been temporarily stalled due to COVID lockdowns, geopolitical tensions, and a real estate downturn which dampened consumer confidence, ultimately pressuring economic growth. However, as the shift to new growth gradually continues on its path, we should see an increase in consumption, better balance between demand and supply, and a continued move up in the manufacturing and technology value chain, providing more durable economic growth. We believe as we assess the bottom-up fundamentals for each of our holdings, investing on the right side of these government initiatives should provide downside protection while participating in future growth.

Further, we remain positive on China, as on the margin we are beginning to see improvements at both the geopolitical/regulatory and fundamental levels. On the regulatory front, post the announcement for more restrictive online gaming and the fall in stocks last December, China quickly reversed course and moderated its regulation while also removing the individual responsible for the announcement from their position. This was in direct response to the negative market reaction and suggests that China may be caring more about equity investors. On the geopolitical front, though it is early, there does not appear to be heightened cross-strait rhetoric post Taiwan’s elections and the current status quo is likely to be maintained. And for the all-important U.S./China relationship, there also appears to be a desire to maintain the relative peace and dial down tensions post the Asia-Pacific Economic Cooperation summit between the countries’ leaders in November. Finally, within the China economy we are seeing a gradual recovery in retail sales, growing auto car sales (especially EVs), record box office sales, strong internal tourism, back to 2019 levels, etc. Combined with these improving fundaments, we might be seeing peak pessimism in China, with foreign purchases of China stocks hitting an eight year low in 2023. With valuation levels at 9x P/E, incremental positives on China may prove rewarding for investors.

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