Will Year of Dragon cause burnt fingers?

After a punishing year for Asian markets, most experts think the worst is over, says Jeff Salway

CHINA’S economic growth has been the investment story of the last decade and is expected to power the global economy for years to come.

But as China prepares to enter the Year of the Dragon – with New Year celebrations starting tomorrow – investors are being warned to tread carefully, as growth eases off and concerns linger over the implications of the western economic slowdown.

After years of stratospheric growth in China, recent months have brought investors down to earth with a bump.

Those hit by Chinese market volatility include legendary fund manager Anthony Bolton, who last year lost more than £1 million of his own money in the £570m Fidelity China Special Situations trust he manages. A share price fall of more than a third has seen investors in the trust also suffer losses.

It was not the only fund to suffer, as investors were given a reminder of the inherent risks of putting their faith in China.

Hong Kong’s Hang Seng Index fell 20 per cent in 2011 and the Shanghai Composite Index is down by a similar amount over the last year, reflecting concerns over a property bubble, inflation and the repercussions of the global slowdown. China’s growth has fallen for three successive quarters, and economists are suggesting that in 2012 it could drop below 9 per cent for the first time in more than a decade.

Andrew Gillan, manager of Aberdeen Asset Management’s Edinburgh Dragon Trust, said: “Slower land sales and souring loan books are evidence that the property boom is over. Battered export markets make the slowdown worse. While Beijing has room to stimulate if need be, the climate for earnings has worsened and mainland valuations are not compelling, unlike those in Hong Kong, where we find value.”

So can we expect the slowdown to continue? Or should investors look forward to China roaring back in the Year of the Dragon?

Most experts are relatively optimistic, albeit with a degree of caution.

Haig Bathgate, investment director at Turcan Connell in Edinburgh, believes forecasts of a hard landing in China are overblown.

“The one thing that was really worrying us last year was elevated inflation rates in China, which were having a disproportionate impact on food prices and therefore increase the probability of social unrest,” he said.

“When there is significant inflation this means that the Chinese central bank is much less able to stimulate the economy through interest rate decreases – those inflationary pressures have started to subside from the peaks and that means that the Chinese central banks have more tools at their disposal to stimulate the economy.”

Nothing has changed as far as the long-term growth story in China and other emerging markets is concerned, says David Thomson, chief investment officer at VWM Wealth Management in Glasgow.

“Compared to the West, China enjoys faster economic growth, a younger population and a wealth of natural resources. China is now the world’s second largest economy and has large reserves of foreign currency which it can use to stimulate its own economy without having to worry about slowdown in the West.

“It also has the benefit of a very controlled economy where resources can be switched from the production of consumer goods to infrastructure, goods and services for domestic consumption.”

Other pundits are more cautious about prospects for China over the coming months, with concerns lingering over the impact that a worsening of the eurozone crisis would have on Asian economies.

Adrian Lowcock, senior investment adviser at Bestinvest, said: “Despite huge domestic investment in Chinese equities, there is still a correlation with the western risk trade, so when western investors become risk-averse they take money out of regions such as China and other emerging markets.”

Yet, even with that in mind, China will continue to grow strongly, said Gillan.

“Its share of world demand in everything from commodities to capital goods is so large that other economies’ dependency on it will only increase.”

But what does this mean for investors? Do the risks of investing in China no longer reflect the potential rewards? Or should the world’s second largest economy have a presence in most portfolios?

One big problem for investors is that the rate of economic growth in China has not necessarily been reflected in big returns. And while there is potential for strong investment growth, it comes hand in hand with enhanced risk and volatility.

Lowcock said: “The rule of thumb with regards to China is that the economy and the stock market are not necessarily correlated, so whilst the economy has continued to grow at high single digits, the stock market has not.”

Exactly how to invest in China is an issue for debate. Investing directly in funds with a specific China mandate is not necessarily the best approach, with many advisers preferring to gain exposure through funds for which China is just one element, such as Asian or emerging markets vehicles.

Global growth funds can also be a way into China, with many holding western companies that have sizeable operations in emerging markets.

“China remains a volatile investment market and direct investment may not always be the most appropriate way to invest,” said Thomson. “We prefer to invest indirectly in those areas that China (and other emerging markets) needs, such as commodities, brands and technology.”

He uses the JPM Global Consumer Trends and M&G Global Basics funds, among others, when looking at ways of tapping into China’s growth.

“The key is to invest on weakness, and given the continued uncertainty we prefer exposure through a global emerging market fund where a manager can strategically asset-allocate to China or remove exposure,” said Lowcock.

“We like Aberdeen Emerging Markets, which has 16 per cent in China.”

Patrick Connolly, certified financial planner at AWD Chase de Vere, agreed, claiming that “broad-based” emerging markets funds are the best way for investors to access China.

He singled out the Aberdeen fund plus the emerging markets funds run by Schroders and JPM.

“If China does go from strength to strength then investors will benefit through these funds and other investments they hold which aim to piggyback on the Chinese growth story,” said Connolly.

“However, if Chinese stock markets perform badly, as they did in 2011, then investors will be thankful they have spread their risks and aren’t over-exposed to the region.”