Stock market environment (July-September)

The greater China equities market experienced the worst quarterly decline in three years since the last global financial crisis in the 3Q of 2008, with the MSCI Greater China index plunging 23% in the 3Q of 2011. The European debt crisis, the fear of a double-dip US economic recession and the S&P downgrade of the US sovereign credit rating led to a rapid decline in global investor risk appetite for emerging market equities, which resulted in a huge capital outflow from the greater China region in favor of less risky US dollar assets, mainly US treasury bonds. Greater China markets, especially the Hong Kong market, got the worst of both worlds. On the one hand, they reflect the economic and financial deterioration in the US and Europe.  On the other hand, they suffered from issues in China, particularly the stubbornly high inflation and the credit or liquidity crunch of many Chinese enterprises.

Shelton Fund response to market challenges

The Fund made several adjustments to its strategy after the completion of its portfolio rebalancing in early July.  The first round of adjustment focused on trimming the cyclical and materials stocks in favor of consumption plays due to economic statistics increasingly indicating a slowdown in global manufacturing activities.  In Taiwan, exposure to the technology industries was shifted to more domestic demand driven sectors. As the debt problem in Europe continued to worsen and risk aversion kept escalating in August while 2Q corporate earnings releases were not supportive of share prices, especially for the small cap stock segment, we reduced exposure to the mid to small cap stocks in favor of large cap blue chip companies. Entering September, investors became even more nervous about the US, Europe, and also the China issues, and news that the US authorities were investigating accounting irregularities at US listed Chinese companies led to a near market free fall, and as a result, macro concern and panic sentiment overwhelmed micro level fundamentals to the extant that solid fundamental stocks were dumped indiscriminately on the market as investors rushed for cash.  At that point we reduced exposure to the smaller cap stocks as much as possible, especially the non-state owned companies, in favor of the large state-owned enterprises, mainly in the telecom and energy sectors. During this period, the Fund tried to stay with liquid stocks and somewhat increased its cash level.  Overall cash level in three currencies (USD, HKD, NTD) was around 6-7% throughout the period.

Fund performance vs benchmark

The Fund showed a positive excess return of 0.94% vs the MSCI Greater China Golden Dragon Index (Net) during the 3Q 2011. Four factors contributed to the excess return, namely, stock selection, overweight in defensive sectors, cash level at above 5%, and the Fund’s overweight in the Taiwan market (which outperformed the overall greater China index by about 4 pp during this period).

Focus issues in China

The recent big sell-off in the stock market has brought down market valuation to make it look very attractive but many investors are still worried about a hard landing which in the past six months was the hottest debate in the greater China market. A series of developments in China’s economy recently triggered investor concern about an economic hard-landing scenario, namely, the continuous slowdown in China’s economy (investment, manufacturing activities, exports, etc.), the sticky inflation, property prices at bubble levels, the swelling local government debt problem and the liquidity crunch, especially in the non-state owned enterprises or the SME segment. Our view is that China’s economic growth may likely continue to moderate in the next 6 to 12 months but the chance of an economic hard-landing is slim.  First, China’s economy, which is more domestic demand driven than export-driven, will be less vulnerable to a global recession than the export-dependent economies.  Secondly, the central government has a very strong balance sheet and access to fiscal and public assets to fund future spending if needed to support growth.  Thirdly, the property market bubble is likely to deflate slowly given the strong end user demand support and the low gearing nature of most property investments. Fourthly, China’s overall debt burden is manageable and the credit crunch problem is not systemically leading to a widespread default, especially in the current negative real rate environment.  Finally, inflation is likely to ease towards the end of this year or early next year which gradually allows more policy flexibility in 2012.