Bolton’s five China challenges and four top stocks

Speaking to investors today following the six-month results of his Fidelity China Special Situations trust, Anthony Bolton explained why the trust has struggled, with net asset value falling 29% over the six months to 30 September.

“I make no excuses but to say it has been very disappointing, especially the three months to the half-year end,” he said. The manager blamed the trust’s exposure to volatile small caps, as well as its level of gearing, for the underperformance.

“As the market goes down, gearing goes up. We went from gearing in the high 20s down to the low 20s, and intend to keep it near to where it is today, at 24.4%.” The gearing is split across $100m of bank debt and $100m of credit default swaps, Bolton added.

He recently removed a put option he had had on Korea as insurance against the possibility of conflict between North and South Korea, which had detracted from performance. “I was very concerned about the situation between North and South Korea, but I became less so in the late summer as talks with the US restarted. In September I closed the KOSPI put option position at a significant profit.”

Bolton said the Chinese market has been much worse than he was expecting over the last six months. “I have never seen such brutal markets as during the September sell-off,” he said, adding he remains optimistic about China’s prospects for future growth.

Here Bolton highlights five of the major challenges facing China. “The key thing about it is that in a world full of problems, China has its challenges but also its solutions,” he said.

1. Inflation

"Inflation remains high but is showing signs of peaking. China will have to adapt to structurally higher inflation over the long term, but in the short term it is starting to come down.

"Although food inflation remains volatile and difficult to predict, I believe China should be experiencing significantly lower official inflation in future months (even though real inflation is above official figures). This is one area where weakness in the rest of the world is helpful because of falls in commodity prices.

"This better environment should allow the Chinese authorities to stop their monetary tightening and this may have already taken place. Whether they now loosen will depend partially on how the domestic situation develops from here and whether the developed world returns to recession.

"I still think GDP growth is headed back to around 8% (above the Five-Year Plan target of 7%). If the world goes into an economic downturn I would need to revise this down to, say, 5%-6%.

"One should remember that, although exports are important to China relative to many other Asian economies, China is less exposed to exports to the rest of the world. The destiny of its economy is more in its own hands."

2. Bad bank debt

"I remain of the view that there are real issues due to lending via the Local Government Finance Vehicles in the credit expansion period. We could see up to 20% of this debt below water.

"However, I remain of the view that this is more of a 2013-2014 problem than an immediate one and, in any case, the central government has ample resources to solve this problem and debts could be rolled over.

"In the past the government has generally taken bad debts off the banks' balance sheets at face value and guaranteed them. I expect something similar to happen again in two or three years' time when the new political leadership will be able to blame its predecessors.

"A newer worry for investors is the growth of the unofficial loan market in China. This market has always been there but during the tightening phase over the last 12 months or so it has grown at a very fast rate as banks restricted loans to borrowers and these borrowers have had to look elsewhere for funds.

"There have been a number of conduits for this lending including entrusted loans, trust products, peer to peer lending and so on.

"With bank deposit rates controlling lending at very high rates, the unofficial market has appeared attractive for those with surplus funds. Although most loans are secured, the big expansion in volumes and the monetary tightening means there is the potential for loan losses which could impact some lenders particularly in certain cities.

"I do not believe, however, that this is a major national problem that will have a big impact on the economy."