Why are economic activities in China weaker than expected in the first few months of 2018?

Economic indicators fell short of market expectation in previous months. The manufacturing Purchasing Managers’ Index (PMI) in April was 51.4%, which experienced a 0.1% fallback from March1. Indeed, the figure was recorded at 50.3% in February, which was the lowest in the past 19 months1. The anxiety of investors on the potential slowdown of industrial economy has suppressed market sentiments in a certain extent, whereas cyclical stocks have been plagued in particular.

Our observation on the ground leads us to think that there has been a mini-destocking cycle happening in China, which led to the marginally weaker economic data-points. On the supply side, as 2017 was a great year for China corporates, they were expecting strong domestic demand in 2018 and decided to stock up on inventories starting in in late 2017 before the prices of raw materials and commodity rose further. However, the start of 2018 was met with weaker demand caused by the mild slowdown in production and investment, and in some cases, over stringent enforcement of environmental directives. A few “one-off” factors have contributed to softer production and investment growth in March, such as a late Chinese New Year which affected the number of effective working days in March and the longest “Two Sessions” – the annual meetings of the national legislature and the top political advisory body – in history (traditionally economic activities soften during these major meetings because of policy uncertainty and environmental considerations), and colder weather in the north also dampened construction in March. The above resulted in an imbalance of supply and demand in some sectors, which were expressed through weaker economic figures.

However, we have noticed that the destocking cycle of some industries is nearing the end. For instance, the total rebar stock and hot-rolled steel coil stock have been declining since late-March2. We expect that the stocks stacked up last year are likely to be fully digested around June to July this year. As a matter of fact, our viewpoint that the mini-destocking cycle is coming to an end has been supported by the economic data in May. May NBS manufacturing PMI recovered to 51.9% from 51.4 in April, slightly higher than the market consensus3. New Orders Index picked up to 53.8% from 52.9%3. Meanwhile, high-frequency data showed stronger price momentum in raw material prices such as coal and oil in May3.

Finally, a transformation in the nature of cyclical industries has been taking place in recent years. In the past, corporates tend to increase capacity in good times. Excess capacity then caused raw materials prices to drop, leading to constant and vigorous fluctuations in corporate profits. Since the implementation of supply-side reform, the phenomenon of unconstrained capacity expansion has rarely occurred. Up-stream prices have been stabilized in general, whereas profits have been steadily improving. Corporates in cyclical industries will not spend excessively on capital expenditure. Hence, profits for these corporates will no longer fluctuate as wildly as before, and it is expected that their balance sheets will show improvements in two years’ time, accompanying a higher chance of dividend payout and higher dividend yield. We believe cyclical stocks will likely undergo a re-rating in the near future.

[1] Source: The Wall Street Journal, as of May 2018
[2] Source: Bloomberg, as of May 2018
[3] Source: CICC Research, as of May 2018

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document and are subject to change without notice.

Investments involve risks. You may lose part or all of your investment. You should not make an investment decision solely based on this information. If you have any queries, please contact your financial advisor and seek professional advice. This document is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Zeal Asset Management Wins Two Awards in 2017 BENCHMARK Fund of the Year Awards – Fund Manager Q&A

“Our emphasis is to capture long and short opportunities while proactively reduce the downside risk against market beta.”

We are honored to announce that Zeal Asset Management Limited won “Best-in-Class House Award” under the category of Alternatives-Long/Short Equity1 and our CIO, Jacky Choi was named “Manager of the Year” under Greater China Equity Category2 in 2017 BENCHMARK Fund of the Year Awards (Hong Kong).

Jacky Choi sat down with us and answered two frequently asked questions about Zeal’s investment approach and strategy, as well as where the China market is heading next.

Q1: A highly-concentrated investment approach calls for high conviction ideas. How do you generate these ideas? Can you tell us your stop loss policy?

Yes, since we place a substantial part of our fund’s capital into each investment, it is very important for us to conduct deep dive research into all the positions to back up our high conviction. At any point in time, there are over 200 stocks that are closely and actively monitored by the investment team and we know the business and management of these companies thoroughly. Our conviction is built upon continuous coverage on these companies over many years and will invest in them when we deem the prices to be attractive. To find new ideas yet to be under our coverage, we perform quantitative screening regularly, parameters including balance sheet items, P/L items and market related items, e.g. sudden price movement or volume pick-up, etc. Finally, we also use qualitative methods to source ideas. For example, since we conduct more than 1,000 on-the-ground company research visits annually, when we meet with corporate management, investment ideas may arise when we are discussing about their clients, competitors, suppliers, and distributors. When we find initially interesting ideas, we will usually first conduct desk research, looking over annual reports of the company, followed by onsite visit to the company, and then we do our own financial modelling. After all this, if we have high conviction that the stock is vastly over or under-valued, it will go into our stock idea pool for our PMs put into the funds at their discretion.

As the portfolio is concentrated, it is important for us to have loss alerts. However, we do not have hard stop loss rules. The reason is due to the fact that we are operating in a volatile market and our experience tells us that having hard stop loss limit would sometimes result in getting out of a position at the worst time. Each alert will trigger an independent review of the investment case for the position in question by the original idea generator and another member of the investment team, and appropriate actions will be taken afterward. In practice, because the number of positions in the portfolio are not numerous, the investment team will easily spot if any position moves against us well before hitting the loss alert.

Q2: Would you say that your long/short strategy places greater emphasis on downside protection than capturing upside potentials? What is the rationale behind this strategy?

Not exactly, we would say that our emphasis is to capture the opportunities on both the long and the short sides while taking a more pro-active approach in downside risk reduction against market beta, and as a result, achieve risk adjusted returns. So it’s about the balance of upside potential with downside risk reduction and both are equally important. For our long/short strategy, we aim to provide our investors with a relatively stable return stream year after year.

The rationale behind the strategy is that as China is a relatively inefficient market and because a large disparity exists between the returns of the best and worst performing companies, we are able to seek alpha on both long side and short side. Most of our trades are not meant to be pair trades to capture relative returns but to generate positive alpha on both the long and short books. Through looking at the fundamentals of companies, we aim to find corporates that have a high visibility to deliver a steady or growing earnings over multiple years for the long book. On the other hand, for the short book, companies that will face structural difficulties in their businesses or have been so richly valued that any disappointment may cause a major correction. The Chinese markets have had periods of immense volatility and the short book has helped to reduce the magnitude of the ups and downs and also generate returns during very difficult years. At that the same time, the long book has been the major driver of returns in the portfolio and so the importance of which cannot be overstated, hence, the balance of upside potential and downside risk reduction is what makes the strategy successful in our view.

Q3: In the China market, what tailwinds and headwinds should we expect in 2018?

Some tailwinds that we expect is China will speed up reforms of state-owned enterprises (SOEs) in 2018 and beyond. We believe that SOE reform will gradually make SOEs become more profit-oriented rather than scale or top line-oriented. If SOE reform picks up the momentum, both Hang Seng China Enterprises Index and Shanghai Stock Exchange Composite Index will enjoy further re-rating since their valuations look undemanding. Besides SOE reform, we believe that the supply-side reform will continue on the back of seeing initial rewards. China’s economy has been reflating since late 2016 and we believe that supply-side reform has played a major role in this. Due to the fact that corporates are enjoying better profitability, banking assets are improving, and the public is enjoying better air quality through the cutting of overcapacity, supply-side reform enjoys wide public support and this will lead to continue robust nominal growth recovery into 2018.

Unlike last year where the market experienced exceptionally low volatility, we believe that the market will experience more volatility although we think the full year performance of the Chinese market will still be decent. Volatility will likely come from news surrounding US inflation and interest rates. While China’s CPI has mostly surprised investors on the upside over the past 2 years, CPI inflation in the US has mostly surprised on the downside. This is a curious situation since US imports a lot from China and should be importing China’s inflation, but this transmission seemed to have been severed in the past 2 years. We tend to believe that the transmission is only delayed but not severed and when the US sees more CPI inflation perhaps this year, expectations on the US rising rates would accelerate and this is generally negative for China. However, we would like to note that China has in part preempted the rise of US rates through the rise of its bond yield starting in late 2017. Therefore, the yield differential between China and US remains quite large and any initial rise in US rates should not materially decrease the yield differential although it would potentially still be negative for investor sentiment.

On top of that, lingering trade frictions could still be a near-term headwind, but its impact should not be exaggerated. We’ve noticed China’s policymakers have made economic stability one of their top priorities, re-emphasizing the need to maintain accommodative fiscal policy, neutral monetary policy, boost domestic demand and lower financial cost, amid mounting trade tensions with the US. We’ll continue to closely watch China’s policy developments and possible response measures.

1 Source: BENCHMARK House Awards is based on the qualitative methodology and tools determined by BENCHMARK, and reflects the performance data between 1 October 2016 to 30 September 2017.

2 Source: BENCHMARK Manager of the Year Awards is based on the fund manager’s ability in leading the team to outstanding performances over the consistency of three-year and five-year performance, against the benchmark and their peers. The award reflects the assessment by BENCHMARK with data between 1 October 2016 to 30 September 2017.


All comments, opinions or estimates contained in this Fund Manager Q&A are entirely fund manager’s judgement as of the date of this report and are subject to change without notice. In preparing this report, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice.