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End of Q4 2023

Performance

Asian equities gained in the fourth quarter as hopes that US interest rates may have peaked led to renewed investor appetite for risk assets across the region. Most markets ended the period in positive territory apart from China, where weaker economic growth and a lack of major stimulus measures remain key overhangs. Against this backdrop, the portfolio rose, and outperformed the reference regional index during the period. At the regional level, our large underweight in China and overweight in Taiwan were the key contributors to relative performance.  On the other hand, stock selection in Hong Kong and Korea also added to performance.  From a sector perspective, our exposure in technology, as well as selection within industrial and consumer names were among the key areas of performance contribution.

At the individual stock level, signs of recovery in the semiconductor cycle in 2024 and the ongoing optimism around generative AI being a long-term growth driver saw our select Taiwanese foundry and fabless IC design holdings, including Mediatek and TSMC, trading higher over the quarter. Korea’s Samsung Electronics also saw strong share price gains on the back of the commencement of mass production for low-latency wide DRAM, along with stabilisation of shipment growth and upward revisions in ASP. In the Chinese Ecommerce space, our nil exposure to Meituan and underweight exposure to internet name, Alibaba, both added to relative returns as stock prices declined on consumption downgrade in China and higher industry competition intensity.  In Australia, medical device maker Cochlear saw share price gains on the back of its strong growth expectation given its dominant positioning in the growing implant market globally.  Its superior product quality and R&D capabilities should also further enhance the company’s competitive positioning.

On the negative side, ongoing investor concerns around macro challenges in China saw our consumption-related stocks among the key detractors during the quarter. These included restaurant chain operator Yum China and Macau casino operator Galaxy Entertainment, which traded lower amid softer macro performance in China and weaker recovery.  Elsewhere in China, our pharmaceutical exposure to Wuxi Biologics traded lower amid unexpected downgrade in revenue growth and margin for 2023 due to biotech funding weakness, CMO project deferral and a high base from last year’s large Covid contribution. Meanwhile, our nil exposure to Chinese ecommerce name Pinduoduo has hurt performance as its shares gained as the company continued to expand market share in the domestic market.  The faster-than-expected growth of its US-based platform Temu also bolstered investor optimism around the stock and supported share price performance. In Taiwan, precision electronics testing instrument manufacturer, Chroma ATE, was another key detractor following disappointment in recent sequential decline of revenue numbers due to softness in the EV related business.

Outlook

The last two months of 2023 brought a welcome rally in Asian stock markets which generally followed global stock markets upwards primarily on hopes that US interest rates had peaked.  In a remarkable twist that fueled the Santa Claus rally, the Federal Reserve delivered an unexpected gift to the markets, stoking hopes for a US Goldilocks scenario with a shift towards earlier-than-expected rate cuts following Powell's speech at the December FOMC.  Economists promptly recalibrated their predictions, with the majority now anticipating total cuts surpassing 150 basis points in 2024, with the initial cut kicking off in March 2024.  This news spurred a rally in global equities, a dip in bond yields, and a softening of commodity prices.  Consequently, the Asian market ended the year on a positive note, registering an overall gain for CY2023, although the weakness in China also meant that the Asia region has trailed the global equity market (as proxied by MSCI AC World) which saw a rally of over 20% for the year.

As we go into 2024, we will use the opportunity to highlight some of our key findings following our month-long trip in Asia which had proven both fascinating and fruitful for our investment in the region.  Many meetings had taken place while we were in the region, including c.50 one-on-one corporate meetings which threw up some interesting new investment ideas and also some interesting bigger picture thoughts.

Our first observation reviewing our company visit notes is that inflation is not an issue in the places we visited in Asia.   Nearly all companies we saw instead discussed weak end demand, selective discounting, increasing promotions and incentives, the need to pass on falling raw material costs, disruption, and oversupply and irrational competition from China.  This applied whether it was e-commerce in Taiwan, DIY stores in Thailand, technology companies, battery manufacturers, convenience stores, bicycle manufacturers, Indonesian paint suppliers or consumer staple companies.   The picture across the region was quite consistent with very few companies talking about putting up prices or claiming to have pricing power.  For stock markets this is clearly a double-edged sword – falling inflation is likely to be positive for market sentiment but clearly pricing pressure is a headwind for earnings unless companies can eke out cost savings.

The other factor that came out of our visits was that oversupply from China in certain industries is very real and poses a threat to those companies competing with Chinese ones.  This applies to multiple industries with China’s economic slowdown very clearly STRUCTRUAL and likely to be prolonged given the extent of the excesses particularly in the property and financial sectors. It looks to us that with weak demand at home China will be exporting its excess capacity whether this is electric vehicles, batteries, semiconductors, solar panels, wind turbines, pharmaceuticals, medical equipment, construction machinery, etc.   It is also evident that the Chinese export prices are showing sharp deceleration during the year with little signs of abating.  The Chinese domestic slowdown and continued build out of overcapacity in many industries is also likely to be deflationary.  In particular, the EV and solar industries have seen huge capacity build-out and this is being replicated across sectors that are considered “strategic” by the CCP.

The second observation from our extended trip was how very visibly demographics in Asia is changing.  In Hong Kong we did not get in a taxi where the driver looked under 70 years old, and whilst out hiking the many workers clearing up after the typhoons and thunderstorms that hit the city at the time all looked well past the age that they should be wielding chainsaws.  Restaurants in Taiwan meanwhile were full of robot servers, and Taiwanese convenience stores are increasingly unmanned (shoplifting is less of an issue in law abiding Taipei!) whilst at Bangkok airport we were literally run over by a robot cleaner whilst not looking where he was going (rather embarrassingly, I should add).  With many Asian countries facing a rapidly ageing demographic this will throw up some interesting structural dynamics particularly in Korea, Taiwan, Hong Kong, China, and Thailand – it is an area we are doing some more work on.   We remain convinced that ageing demographics in Asia at least will be profoundly deflationary.

The third observation from our trip was how supply chains in Asia are rapidly adapting to our new geo-political world.   Most export related companies we met indicated they are moving some of their production facilities out of China with favoured destinations usually Vietnam, India, and a lesser extent Indonesia.   US end clients increasingly want all final goods whether technology products, semiconductors, window blinds, auto parts, textiles out of China – whilst European clients are happier with China plus one (or de-risking of supply chains) strategies.

The question for investors then is the trade realignment good or bad news for corporate earnings – and for end consumers is it likely to be inflationary as manufacturing outside China is likely to be higher cost?  The evidence here is interesting and certainly not yet conclusive.  

For some technology companies where the threat of Chinese competition decreases due to sanctions that work (bans on access to semiconductor equipment and key skill sets) it increases their moats or competitive positioning.  This would be the case for companies like TSMC, Hynix and Samsung Electronics and other specialist Taiwanese and Korean technology companies with genuinely high levels of intellectual property.

For other industries however where we see companies adding large capacity outside of China, whilst Chinese competitors continue to expand their domestic facilities in China, we are likely to see very significant oversupply and large-scale price pressure.  Areas we would be particularly worried about would be EV batteries and the related supply chains, auto parts, commodity semiconductors etc. – basically anything under the American IRA act.

The other point to note around the movement in supply chains is this is not currently a wholesale exit from China.  The production moving to India, Mexico and Vietnam is often just final assembly whereas all the components and higher value-added parts still come from China.   For the moment this is not a massive realignment.   Recent data shows that China’s manufactured goods surplus remains large and rising – what in reality is happening is that Mexican exports to USA are booming but Mexican imports from China are similarly booming.   We suspect in Vietnam the picture could be similar.

So, our initial conclusions after many company meetings in Asia and surveying evidence on the ground is that the movement of supply chains is optically real, but not necessarily fundamentally significant.   By creating more capacity in many industries, particularly commodity ones we think “deglobalisation” currently may be disruptive and deflationary.   This is quite contrary to what appears the consensus belief amongst some top-down economists in the West.

What struck us after our month travelling is that we may be seeing the return of the 4Ds, in Asia at least.  The 4Ds was a presentation we used to regularly give 10 years ago.  It highlighted that deflationary forces were likely structural.  These forces were Disruption (and overcapacity), Demographics (i.e., aging societies), Debt (too much debt in China and the West), and Disparity in Income (middle class incomes squeezed whilst rich do better but the rich save more of their income thus depressing overall consumption).   As it stands today, we do not see evidence of inflationary forces or “higher for longer” in Asia (quite the opposite in fact in China which is now clearly a significant global deflationary force!).

On a more positive note, we were also struck how financially healthy most of the companies we met were during our trip in Asia.   Nearly all companies we hold in the portfolio are net cash and nearly all committed in our meetings to maintaining dividends whether in absolute terms or percentage payout ratios.   We see plenty of opportunities to make positive returns in Asia even if some of the return would come principally from dividends for some companies.  It is particularly heartening to see increasing numbers of Asian companies like Swire Pacific announcing very large buybacks.  Another positive note that came from our meetings is that in most industries the painful process of running down the excess inventories built up post COVID is almost complete (homewares, textiles, mobile handsets) or is well underway (semiconductors, bicycles).   This means, whilst the outlook for end demand in 2024 is uncertain and visibility low, at least the double headwind of weak end demand and inventory clearing has gone.   This left us feeling more upbeat about select export businesses in the region.

Overall, following the trip in Asia we left more upbeat on prospective Asian stock market returns as we enter 2024.  We believe inflation will increasingly be less of a headwind and outside of China the economic picture in Asia looks reasonable.  Company balance sheets are generally in good shape and whilst the earnings outlook is uncertain, valuations and market sentiment in the main more than reflect this in our view.

What are the risks?

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. 

Investors in the emerging markets and Asia should be aware that this involves a high degree of risk and should be seen as long term in nature. Less developed markets are generally less well regulated than the UK, they may be less liquid and may have less reliable arrangements for trading and settlement of the underlying holdings. 

The Company holds investments denominated in currencies other than sterling, investors should note that exchange rates may cause the value of these investments, and the income from them, to rise or fall. 

The Company invests in smaller companies that may be less liquid than in larger companies and price swings may therefore be greater than investment companies that invest in larger companies. 

The Company may borrow money to invest in further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so. 

Investments such as warrants, participation certificates, guaranteed bonds, etc. will expose the fund to the risk of the issuer of these instruments defaulting on paying the capital back to the Company 

The fund can use derivatives to protect the capital value of the portfolio and reduce volatility, or for efficient portfolio management. 

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Please remember that the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

Issued by Schroder Unit Trusts Limited, 1 London Wall Place, London EC2Y 5AU. Registered Number 4191730 England.

For illustrative purposes only and does not constitute a recommendation to invest in the above-mentioned security / sector / country.

Schroder Unit Trusts Limited is an authorised corporate director, authorised unit trust manager and an ISA plan manager, and is authorised and regulated by the Financial Conduct Authority.

On 17 September 2018 our remaining dual priced funds converted to single pricing and a list of the funds affected can be found in our Changes to Funds.

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