The gloom surrounding Chinese equities and the economy has lifted and growth is returning, albeit tentatively, after three years of the economic malaise caused by the Covid-19 pandemic.

Optimism was in short supply as the Company’s financial year got underway. The central government’s strict zero-Covid policy weighed heavily on share prices for much of 2022 and disrupted swathes of the economy. Yet throughout stock market history, patient investors who have been prepared to sit tight during periods of volatility have often been rewarded. The turning point for China came at the start of November 2022, the very beginning of the reporting Period. Share prices surged after the government unexpectedly announced that it was abandoning its seemingly steadfast commitment to its controversial zero-Covid policy. Increased liquidity support for the struggling property sector from the government and state-owned banks also improved investor sentiment. Share prices rallied further in December as the prospect of an economic reopening became a reality. All social distancing measures were lifted and Covid-19 cases surged as a result, but China responded by encouraging herd immunity. China’s Center for Disease Control and Prevention stated in January 2023 that the current wave of infections was “coming to an end”.

Investor spirits, buoyed by hopes of a rebound in economic growth, drove the market higher and, with a strong rebound in share prices from November onwards, February’s profit-taking was perhaps inevitable. However, share prices resumed their upward trajectory in March. Investors chased short-term “hot themes”, including those relating to ChatGPT, wider artificial intelligence (“AI”) opportunities and state-owned enterprise reforms, rotating out of previous winners in the process. April saw the AI hype dissipate somewhat as investors refocused on fundamentals.

Turning to broader economic themes, one of the most eye-catching statistics of the Period was the reported GDP for the first quarter of 2023. It showed 4.5% year-on-year growth, up from 2.9% in Q4 2022, and easily surpassed market estimates of 4% annual growth. However, other data, such as an unexpected decline in the Caixin Manufacturing Purchasing Managers’ Index, generally considered a reliable indicator of the strength of the Chinese economy, declined from 51.6 in February to 50 in March, suggesting the recovery remains patchy.

The concerns over the speed and strength of the economic recovery after the easing of the zero-Covid policy has been reflected in company earnings. First-quarter results from A-share companies largely pointed to recovery, although the rebound is not yet proving to be as robust and broad-based as expected. Based on our conversations with company management teams, we believe that growth and recovery will be more pronounced as we move into the second half of 2023.

Portfolio Performance

During the Period the Company’s net asset value (“NAV”) total return was 14.0%, which compares with the MSCI China All Shares Index, the Company’s Reference Index’s, return of 16.7%. The Ordinary share price total return was 11.5%, as the discount to NAV at which the Company’s Ordinary shares trade widened to 14.4% from 12.5% at the start of the financial year.

The portfolio initially performed strongly after the re-opening of the Chinese economy. The market recognised our high-quality holdings and the opportunity for them to benefit from the return to normal economic activity after three years of stifled growth. However, profit-taking affected the portfolio in February. Our limited exposure to artificial AI-related stocks also negatively impacted performance as investors chased this “hot” trend in March. We do not believe this trend is sustainable as we expect that investors will find earnings delivery does not match their expectations, forcing them to refocus on fundamentals. We have already seen this to a degree, as AI-related stocks suffered a dip in April.

Stock-selection accounted for the Company’s modest underperformance versus the Reference Index. Our consumer discretionary holdings were the main source of underperformance, although our information technology holdings also had a negative impact on overall portfolio returns. Our financials and healthcare holdings partially offset the rest of the portfolio’s negative performance.

China Merchants Bank (CMB) and Tencent were the top two performers. CMB rallied on the economic reopening while Tencent benefited from a recovery in sentiment as regulation towards the internet sector eased. Elsewhere, Kweichow Moutai benefited from strong initial interest in consumer stocks after the re-opening. The company’s special dividend and proposed capacity expansion also boosted sentiment. Other holdings also benefited from the improved investor confidence in consumption, including sportswear firm Li-Ning and electrical appliance manufacturer Midea Group. Other beneficiaries of China’s re-opening included pan-Asian life insurer AIA and the Hong Kong Stock Exchange.

Turning to the laggards, LONGi Green Energy, Yunnan Energy New Material and Sungrow Power Supply were all affected by the weakness in renewable energy-related stocks. Starpower Semiconductor suffered from softening semiconductor prices. Not owning Ping An Insurance also hurt relative performance, given its strong first-quarter results. Holding JD.com was unhelpful based on market concerns over rising competition in e-commerce. This may weigh on the stock over the near term, but we remain positive on the company's long-term competitiveness.

Portfolio Activity

We believe our bottom-up stock-picking approach, grounded in fundamental research and local expertise, provides an advantage in finding the best quality companies in which to invest. We engage collaboratively with companies, prior to investment as well as part of our ongoing due diligence, with the aim of sharing expectations and encouraging best practices. Please see the Case Studies of Engagement Activity for examples of the work we have been doing in this area. We continue to construct and manage the Company’s portfolio based on the themes of Aspiration, Digital, Green, Health and Wealth. Whilst this approach will not prevent us from investing in stocks where we see fundamental value, we would expect most of our holdings to align to these key themes.

During the Period the Company received regulatory approval for a Qualified Foreign Investor (“QFI”) licence status, which provides access to the broader Chinese equity market. As a result of this, we purchased two new stocks: Centre Testing International and OPT Machine Vision. Centre Testing International is a leading third-party testing company that enjoys stable and diversified growth. OPT Machine Vision is a leading machine vision company with good growth prospects, driven by the upgrade of automation manufacturing in China.

We also initiated a position in PDD, owner of popular shopping app Pinduoduo. It is gaining market share within China's ecommerce sector. We added to our existing position in Alibaba Group in January, based on its attractive valuation, easing regulatory pressures and an improving outlook thanks to the earlier than expected reopening of the economy.

We exited positions in Anhui Conch Cement and GDS due to weakening conviction and in view of better opportunities elsewhere.

Revenue Account

The loss for the Period was £1.1m compared to a loss of £0.221m for the same period last year. While investment income was up almost 34% to £0.604m, the prior year numbers benefited from a waiver of the management fee for the first six months following the completion of the combination with Aberdeen New Thai Investment Trust in November 2021. As a result, the current year management fee charge is more representative of the ongoing expense than the prior year.

In 2022 90% of the income in the year was generated in the second half of the Company’s financial year and we expect that the split is likely to be similar in the current year.

Outlook

The past three years have undeniably been challenging for China and those who are invested in the country. Stringent social curbs and onerous travel restrictions placed a great burden on the population. Now is the time for optimism, however, even if there has not been a ‘V’ shaped economic rebound as some had expected.

We see the Chinese consumer at the heart of the recovery. After a very long period of widespread lockdowns, there is considerable pent-up consumer demand. Furthermore, elevated household savings should provide a powerful tailwind for consumer spending. As jobs and income prospects improve, we expect consumers to spend their savings across different sectors, including tourism, travel, healthcare and property.

The policy environment is another reason for optimism. Many Western economies are still wrestling with stubbornly high inflation, resorting to repeated interest-rate rises in a bid to manage the problem, with varying degrees of success. In contrast, the inflation picture in China remains benign. This has given the authorities the freedom to introduce accommodative monetary and fiscal policies to support economic growth. In late April the central government acknowledged the need to sustain the economic recovery at a meeting of the Politburo. Policy guidance is therefore likely to remain supportive. With growth in many developed Western economies set to slow as higher interest rates bite, China represents a real counter-cyclical opportunity.

Finally, but crucially, valuations in China remain highly attractive. We believe that quality companies — the type our investment process favours — are still discounted by the market, but their prospects have improved significantly and we believe that the market will recognise this valuation discrepancy over time.

Across our five themes of Aspiration, Digital, Green, Healthcare and Wealth, companies are still trading below historical valuations. These companies have weathered the pandemic storm and continue to exhibit solid fundamentals. We believe this is a great opportunity to invest in quality companies at compelling valuations.

Nicholas Yeo and Elizabeth Kwik
abrdn Hong Kong Limited
27 June 2023

Discrete performance (%)

Total return; NAV to NAV, gross income reinvested, GBP. Share price total return is on a mid-to-mid basis. Dividend calculations are to reinvest as at the ex-dividend date. NAV returns based on NAVs with debt valued at fair value.

Source: abrdn Investments Limited, Lipper and Morningstar.

Past performance is not a guide to future results.

Note on change of investment strategy Prior to 26 October 2021, the Company's investment policy was to invest in emerging market funds of funds. Please note that performance data for time periods prior to 26 October 2021 relate to an investment objective and strategy that no longer applies.

Important information

Risk factors you should consider prior to investing:

• The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• Emerging markets or less developed countries may face more political, economic or structural challenges than developed countries. This may mean your money is at greater risk.
• The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
• The Company invests into other funds which themselves invest in assets such as bonds, company shares, cash and currencies. The objectives and risk profiles of these underlying funds may not be fully in line with those of this Company

Other important information:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

Find out more at www.abrdnchina.co.uk or by registering for updates. You can also follow us on social media: Twitter and LinkedIn.