For the year ending December 31, 2015, the Matthews China Fund (Trades, Portfolio) returned 2.41% (Investor Class) while its benchmark, the MSCI China Index, returned -7.62%. For the fourth quarter of the year, the Fund returned 10.33% (Investor Class) versus 4.03% for the Index.
Market Environment:
After a strong start to the year, associated with a rally in mainland indices, China’s equity market environment turned extremely negative. The heavy-handed approach used by authorities in attempting to stabilize this decline also prompted investor concern. Amid this turmoil, Chinese authorities, to the dismay of global markets, suddenly adjusted the mechanism for the daily setting of exchange rates. This change was not well-communicated and created much confusion. However, we ultimately consider the move to be a long-term positive development. The confusion regarding the currency intensified during the year as fears of capital flight reappeared. Onshore foreign exchange deposits in China have not increased with any significance, which may suggest a healthy adjustment is taking place. Another thing to note is that most of the foreign exchange reserve depletion occurred during the third quarter, and the run rate since has narrowed, which perhaps implies that a one-off balance sheet adjustment, rather than consistent capital outflows, is taking place. We believe the initial loss in reserves is a U.S. dollar adjustment in working capital by Chinese corporates, both onshore and offshore. Finally, China is receiving a US$500 to US$600 billion trade surplus annually. As commodity prices weaken, this should provide a buffer for continued outflows. We anticipate flows to moderate significantly. On the economic front, the lack of sequential growth momentum in China continues due to a decline in property market investment, and a slowing of the fixed asset investment in manufacturing. Our central case is that 2016 will be similar to 2015 in that we believe the economy should continue to shed excess capacity in some industries and associated nonperforming loans will be recognized. So far, this adjustment has been orderly, and we believe this will continue to be the case. The end of this down-cycle will be indicated by a moderation of write-offs at Chinese banks, and we are watching for this. The timing of this moderation, we feel, is uncertain and may well be a 2017 event. Meanwhile, the government refrains from launching large-scale stimulus programs to spur short-term economic growth, instead continuing with its approach to help stimulate only targeted areas and continue with structural long-term reform.
Performance Contributors and Detractors:
During the year, the health care sector was among the biggest contributors to relative Fund performance. Health care companies overall reported strong earnings, showing continued growth momentum. The year ahead will be more difficult for these companies as more intense pricing pressure and competition increases. Among our health care holdings, Jiangsu Hengrui Medicine was a top contributor to Fund performance, and the drug maker is typical of health care companies we favor as it has a strong diversified product pipeline and is committed to moving up the value chain, away from pure generics.
During the fourth quarter, financials sector holdings also contributed to Fund performance. Tier one property developers continue to take market share in a consolidating industry where overall trends are flat at best. In particular, China Vanke (SZSE:000002, Financial) and China Resources Land contributed outsized returns. The Internet space was also another bright spot for the Fund. NetEase (NTES, Financial), a gaming company that develops most of its games in-house, further enhanced its mobile gaming platform and was a strong performer. ANTA Sports Products (HKSE:02020, Financial), a branded sportswear company that has benefited from an improvement in brand perception through focused advertisement, also did well. It has shown prowess in managing its inventory cycle in recent years.
Performance in the industrial space was among the biggest detractors to Fund performance. Among our industrials holdings Air China (SHSE:601111, Financial), despite weak oil prices, was a poor performer. Sentiment around excessive RMB depreciation on Air China’s USD debt offset the strong consumer travel story.
It must be highlighted that being thorough in our bottom-up approach helped the Fund in tough conditions during 2015. Minimizing stock selection mistakes and staying away from companies where the outlook was particularly uncertain ensured the Fund had a good year relative to its benchmark.
Notable Portfolio Changes:
During the quarter, we increased our positions in the life insurance industry, which significantly boosted our financials weighting. Although life insurers are classified within the financials sector, we tend to view such businesses as consumer discretionary holdings in China. Sales of life insurance policies are showing very positive operating trends as companies continue to penetrate China’s untapped regions. We believe Chinese life insurance policy design and the reduction in the interest rate environment in China have boosted the appetite for such sales. Our holdings here include AIA, Ping An and China Life. The insurance industry has strong competitive dynamics in which the big companies dominate and there is real strength in economies of scale in the ability to attract agency workforce.
During the year, we exited instant noodle producer Tingyi (HKSE:00322, Financial) as we believed the barriers to entry and competition in its core noodle business continued unabated. We also sold Golden Eagle,Tsingtao Brewery, Sun Art Retail and Belle, the women’s shoe retail store operator, as over-supply and Internet channels continue to pose margin and sales issues in the traditional retail space. The quarter saw unusually high turnover as market conditions allowed us to re-evaluate every position and identify opportunities in stocks that were previously too expensive. Turnover in the Fund was unusually high last year, and we would expect this to moderate significantly this year as we finished restructuring the portfolio by the third quarter of 2015.
Outlook:
Looking forward, we expect the central government to continue to achieve a balance between non-intervention and major stimulus programs. Targeted accommodative policies have been adopted to prevent the economy from further slowing. The government has been making efforts to accelerate the reform process by encouraging and supporting the private sector economy, and increasing the role of market forces. Capital market reform is also high on the agenda. This area of reform should not be underestimated, and we anticipate seeing further reforms over the next 12 months. In particular, capital account reforms in relation to the currency and opening up of equity and bond markets will provide short-term volatility as the market tends to react negatively to big changes and uncertainty of outcome. The government, we believe, has the firepower to manage this transition. The last point to note on capital account reform is it is massively underrepresented in Chinese assets, bonds, equity and cash. Any signs of an improvement in the underlying nature of the Chinese economy could facilitate a sizable reallocation into a market that remains underrepresented in global portfolios. At current valuations, we see the risk-to-reward ratio as extremely attractive, despite the skepticism on China’s growth transition away from heavy industry. We believe the determination of the government to achieve this objective is clear. Despite valuations being cheap, we expect volatility should present us with attractive alpha-generating ideas. The reform agenda in place may be slower than the market would like, but it must be remembered that the changes taking place are very significant and something we have not seen since China’s World Trade Organization deal was signed.
The views and opinions in this commentary were current as of December 31, 2015. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund’s future investment intent.
Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.
As of 12/31/2015, the securities mentioned comprised the Matthews China Fund (Trades, Portfolio) in the following percentages: Jiangsu Hengrui Medicine Co., Ltd. 1.8%, China Vanke Co., Ltd. 2.8%, China Resources Land, Ltd. 3.3%, NetEase, Inc. 2.8%, ANTA Sports Products, Ltd. 2.4%, Air China, Ltd. 1.8%, AIA Group, Ltd. 2.5%, Ping An Insurance Group Co. of China, Ltd. 5.5%, and China Life Insurance Co., Ltd. 3.6%. The Fund held no positions in Tingyi (Cayman Islands) Holding Corp., Golden Eagle Retail Group, Ltd., Tsingtao Brewery Co., Ltd., Sun Art Retail Group, Ltd. or Belle International Holdings, Ltd. Current and future portfolio holdings are subject to risk.
