Schroder ISF* Asian Total Return

Marketing material for professional investors and advisers only

*Schroder International Selection Fund referred to as Schroder ISF throughout this document

Schroder ISF* Asian Total Return September 2021 1

Schroder ISF* Asian Total Return Fund Update September 2021

Fund Performance Performance of Schroder ISF Asian Total Return (‘C’ Class Accumulation Units) Since Inception (16 November 2007) to end of Sept 2021, indexed returns in USD Calendar year returns (%) Fund Index Comparator

2020 31.0 22.4 0.7

2019 18.5 19.2 2.4

2018 -14.6 -13.9 2.4

2017 40.2 37.0 1.3

2016 7.2 6.8 0.8

2015 -2.5 -9.4 0.3 Index: MSCI AC Asia Pacific ex Japan, USD terms. Comparator: USD 3 Month LIBOR (or an alternative reference rate). Source: Schroders, bid to bid, with net income invested. Past performance is not a reliable indicator of future results, the prices of shares and the income from them may fall as well as rise, and investors may not get back the full amount originally invested.

% Sept 2021 YTD 1 Year 3 Years Annualised

Annualised Since

Inception

Annualised Standard Deviation

Sharpe Ratio (RFR =

USD 3-month LIBOR)

Schroder ISF Asian Total Return (C Class USD)

-4.1 1.5 20.0 13.1 10.8 16.4 0.6

MSCI AC Asia Pacific ex Japan index

-4.0 -2.1 16.6 9.2 4.5 20.6 0.1

USD three-month LIBOR 0.0 0.1 0.2 1.3 1.0 0.3 --

Lipper Equity Asia Pacific ex Japan universe

-3.5 -1.5 17.2 9.1 3.5 20.5 0.1

Quartile Ranking Q3 Q2 Q2 Q1 Q1 Q1 Q1 (Fund Ranking) (419/571) (168/539) (214/528) (97/491) (2/227) (6/226) (1/226)

Lipper universe annualised standard deviations and Sharpe ratios are calculated for the period since the fund’s inception, and annualised returns are calculated based on number of days since inception. For illustrative purposes only and should not be construed as a forecast, prediction or projection of the future or likely performance of the fund. The fund is not managed with reference to any specific benchmark(s) but its performance may be measured against one or more. Source: Bloomberg, Lipper IM, Schroders, as at end of August 2021. Quartile data source: Lipper universe.

Schroder ISF* Asian Total Return Fund September 2021 2

SEPTEMBER PERFORMANCE

• September was another disappointing month for Asian stockmarkets, with the fund’s reference benchmark the MSCI AC Asia Pacific ex Japan index falling 4%. This brought an end to a very weak quarter for most Asian stockmarkets, with the reference benchmark falling 8.4%.

• Looking at September in more detail, Chinese equities were again the worst performing part of our universe as regulatory concerns continued to affect the internet sector and spread to other sectors like Macau gaming stocks and luxury goods.

• Concerns were further heightened by the effective default and potential bankruptcy of China’s largest property developer Evergrande Group. With liabilities of US$300bn (and probably more off balance sheet) this has the potential to be a messy unwind. With many large Chinese property groups extended and facing a maturity mismatch (short dated bonds funding long term development projects) we saw a sharp sell-off in the offshore bonds and equities of Chinese real estate developers.

• The performance of the technology stocks was the other main point of note in Asia in September. Economic worries, talk of a slowdown in technology demand and rotation to more domestic, reflation plays like banks and energy stocks led to quite sharp falls for many technology stocks, particularly in Taiwan and Korea. The markets that did best were the ABC ones – or Anything But China – as we saw investors continuing to add to India and rotate back to the smaller ASEAN markets.

• Activity on the Asian Total Return Fund was relatively quiet for the month. We exited our remaining Macau gaming position as we believe the regulatory risks are too high, and we have used the proceeds to add selectively to a few technology names which we felt were oversold. We remain confident that the secular growth trends behind our positive view on Asian technology stocks remain intact – these are amongst Asia’s best companies. We also added to our Indonesian bank exposure, but are very much in the mindset not to chase either Indian or ASEAN names. As we discuss in more detail below, the negative change in the fundamental outlook for Chinese equities has not miraculously improved the fundamental outlook for stocks elsewhere in the region.

• Performance was mixed over the month. The fund was down 4.1% (C Acc, USD), in-line with the index. This was despite the fund’s low weighing in Chinese equities and the position in puts which added to performance. These positives were offset by the fund’s relatively high weighting in semiconductor stocks and some of our export names, which fell as investors switched to reflation plays.


RISK CONSIDERATIONS Capital may be subject to circumstances and periods where returns could be negative. Therefore, capital is not guaranteed and may decrease. Investments denominated in a currency other than that of the share class may not be hedged. The market movements between those currencies will impact the share class. Investments in small companies can be difficult to sell quickly which may affect the value of the fund and, in extreme market conditions, its ability to meet redemption requests upon demand. Emerging markets will generally be subject to greater political, legal, counterparty and operational risks. The fund may hold indirect short exposure in anticipation of a decline in the prices of these exposures or an increase in interest rates. The fund enters into financial derivative transactions. If the counterparty was to default, the unrealised profit on the transaction and the market exposure may be lost. Changes in China's political, legal, economic or tax policies could cause losses or higher costs for the fund.


STRATEGY – An attempt to answer some of the questions we’re regularly asked 1. Do we view an Evergrande default as a systemic financial risk in China?

We can start our Q&A on a relatively upbeat note. As it stands today, we do not see an Evergrande default as a trigger for a systemic financial meltdown in China i.e. a Chinese version of the Asian Financial Crisis in 1997/98 or the GFC in 2008/09. As Chart 1 below highlights, while Evergrande is big, with officially c.US$300bn of liabilities it is not that big in the scheme of the overall Chinese property market. It is also the case that the property sector today in China, after the bubble in activity post the GFC, is looking less overextended in terms of both construction intensity (the middle chart) and excess inventories (the right-hand chart). We were more worried about Chinese property and spiralling debt in the sector in the 2012-15 period, which is when we first wrote about Evergrande and its unsustainable balance sheet. Evergrande has to be one of the most widely predicted defaults in recent history in Asia so we have no sympathy for foreign bond holders. Chart 1: Evergrande may look huge but in China context on a stand-alone basis it doesn’t look a systemic risk

However, we should not gloss over the risks. Tighter monetary conditions in China and a slowdown in the real estate market are likely to lead to multiple defaults in the sector – as we are already seeing with Sinic and Fantasia defaulting. These stocks are small in equity terms, but material in debt terms, as is the case for the whole Chinese real estate sector. Once the debt unwinding process starts it can be hard to stop. The Chinese authorities will need to act quickly to ensure that paid for and partly completed properties are finished, domestic wealth management products (widely issued by developers and held by retail investors) are repaid, domestic banks get most of their money bank (over time and at low coupons), and foreign equity investors and bond holders are wiped out. We have been through this model before in China in the late 1990s when all the “ITICS” went bankrupt (local Government investment vehicles that were listed, raised local and USD debt and invested very badly), so there is a road map we can expect to be followed. In this case it is one where most domestic investors get all or some of their money back, and foreigners get correctly mostly wiped out. There was a reason why the coupons on USD Chinese property bonds were often over 10%, and one click on the “FA” function on Bloomberg for Evergrande would be enough for even a completely untrained eye to spot an issue!


It is also likely to be the case that what we “see” in the Chinese property sector is only part of the real picture, with significant off-balance sheet liabilities and hidden debt. Our friend, and ever knowledgeable strategist David Scott of Chaam Advisors, calls it “the Iceberg” – the real problems are hidden beneath the surface: Chart 2: David Scott’s Iceberg – we have been here before in Asia during the Financial Crisis and in China during the “ITIC” bust. What you see is not what you get!

Source: Cha-Am Advisors, Aletheia-Capital, September 2021 David Scott has also done some digging on Chinese Evergrande. It has 173 subsidiaries, of which 146 are 100% owned and there about 2,500 known related companies. We doubt anyone at Evergrande has a clue about the real situation with the group’s finances. The only winner in this one will be the bankruptcy lawyers… So why are we relatively relaxed on the systemic risks? Along with the factors already mentioned (inventories relatively normal and activity well off the past peaks), China has the advantage of controlling large state-owned real estate developers which we expect will be instructed to take on unfinished projects. China also controls all major banks and domestic financial intermediaries, so an immediate GFC-style bank led liquidity crisis should be avoided. A closed capital account is also hugely helpful in this situation and we expect all leakages, whether that be Macau, over-invoicing of imports etc will be ever more tightly controlled. The strict/closed border in China, while there for Covid reasons, is also likely to be maintained for some time (latest rumour is till 2023) to prevent leakages. Chart 3 highlights China’s dollar problem (a significant part of which is Chinese property debt), but with the capital account closed and Chinese USD property debt in the main unlikely to be repaid we feel this may be a case of the dog that didn’t bark. Chart 3: China’s Dollar Problem

Source: Bloomberg, Cha-Am Advisors, Aletheia-Capital, September 2021


2. What is likely to be the overall impact on the Chinese real estate sector and economy of an Evergrande default? Is China the new Japan?

The likely economic fall out from Evergrande and the Chinese property sector reset is much more interesting. As Chart 4 shows, while a systemic crisis appears unlikely, an economic jolt is almost certain. Investment to GDP in China is still running around 45% and residential and property construction has been around 15-20% of GDP since 2005. This is a very elevated level, as Chart 5 shows it is well above levels in Japan during its bubble in the 1980s or US prior to the GFC. Basically, China has rebuilt its housing stock in the last 15 years. Chart 4: We shouldn’t be to blasé – the property market is likely to slow regardless of Evergrande and a more disorderly unwind would be painful for the economy and local government finances

Chart 5: China’s residential construction activity since 2005 has been quite extraordinary and clearly unsustainable

Source: https://mobile.twitter.com/TomasDaubner/status/1381547272731832321/photo/1


The problem with the high residential construction activity in China is that it has been built on a rise in debt in the system, one that the authorities have clearly correctly decided is unsustainable. Introducing moral hazard and reducing leverage in the property sector should be healthy, assuming it can be done without creating a financial panic. However, this is likely to mean lower but better economic growth or as President Xi himself has referred to it in his Qiushi essay (your fund manager has been reading his Governance of China books!) the economic aim is to produce “genuine growth” rather than “fictional growth”, which is the result of debt-fuelled construction. Near term, however, the hit to economic growth is likely to be material. As can be seen in Chart 4, local government finances will be left with a significant funding problem and there is a close correlation between consumer expenditure and property activity (1-1 in case of autos). As the property sector slows there may be major ramifications across the economy. This comes at a time when the economy is already showing signs of weakness. As shown in Charts 6 and 7, even before the Evergrande default fixed asset investment and retail sales were weak. With ongoing Covid outbreaks and the jump in energy prices we see multiple headwinds for the Chinese economy. Chart 6: Chinese fixed asset investment slowing sharply

Source: Refinitiv Datastream, Schroders, September 2021 Chart 7: While Covid lockdowns are having a material temporary negative effect on retail sales, the overall picture was weak even before the property sector started to wobble……..

Source: China Bull Research

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On the second part of the question, we don’t think China is the new Japan c.1990, despite demographic similarities, given the much lower income levels in China and the potential for significant productivity growth. We do however think there are some parallels we can draw from Japan in the post bubble era. Like Japan, we think the unwind of the property market in China will be gradual as there is no trigger point for a crisis (due to captive capital and controlled banks). The property/construction slowdown could therefore drag on growth over a prolonged period. Similar to Japan post-bubble, we suspect China will get multiple stimulus packages (fiscal and monetary) to try and boost the slowing economy. Like Japan, we expect these will be initially greeted positively by the stockmarket until the realisation their impact is negligible leads to a sell off. As it stands today, we would be more inclined to reduce China weightings further into any policy driven stockmarket rallies. 3. Given the big correction in Chinese internet stocks, what are our latest thoughts and when should we be

buying?

As Chart 8 shows, even after the bounce in September the correction in China internet stocks and the disconnect from US peers has been very significant. Chart 8: What to do now given share price fall?

So, should we be buying? In the main we remain cautious on the sector and see no rush to add for the following reasons: (i) The new regulations governing the internet sector, as they currently stand, are uncertain and potentially all-

encompassing. We do not know what they mean in practice or how they will be implemented – this uncertainty is likely to act as an overhang on stocks. All we can really guess is that the major/large internet stocks are going to be more like quasi-SOEs (state owned enterprises) and that they will be required to undertake projects in the interest of “common prosperity”. As we discussed in the July monthly report, the uncertainty means we need to apply higher equity risk premiums and the “common prosperity” obligations are likely to mean a materially lower return on invested capital going forward.

(ii) Secondly, with ecosystems now opened up and significantly more competition about to enter the key growth

parts of the internet companies’ business (e-commerce, cloud, content etc), the industry looks set to enter a period of intense competition. With exclusivity removed and fintech severely limited, many of the moats that Alibaba, Meituan Tencent enjoyed have been reduced. In particular, we worry that e-commerce will become more competitive at a time when new formats and players (live streaming, group buy, Bytedance, Kuaishou) are emerging and Alibaba has made a commitment to defend market share. We expect margins in the e-commerce sector to fall, not rise, as most of the sell side continue to forecast. As Chart 9 shows, most companies are sitting on large cash balances and most have aggressive plans to take market share.


Chart 9: All players are cashed up and look set to compete aggressively in areas like e-commerce and cloud

Source: Arete Research, Factset, October 2021. (iii) Content restrictions and regulations look set to face strict limits for the foreseeable future. Platforms look

likely to have to implement ever stricter self-censorship rules – foreign content will be heavily restricted and local content inevitably less interesting. New game launches are already much reduced and obviously gaming for the next generation of gamers has been severely limited. Much of the investment thesis around the sector had also been based on consolidation and reduced competition, but with mergers of players now effectively not allowed (post the cancellation of the Huya and Douyo merger), this no longer applies. The combination of reduced user engagement (and thus advertising) due to restricted content and ongoing competition is likely to lead to further earnings downgrades in this area.

(iv) The final worry we have on earnings is that for Tencent and Alibaba in particular, profits were significantly

boosted by financial gains, both from selling equity stakes in IPOs and mark to market gains from their vast private investment portfolios (Chart 10). Investors looking at low headline P/Es for the internet stocks should tread with care. The route to profit generation from this area now looks much more difficult, with listing requirements in China and Hong Kong materially higher than US markets, and of course listings of Chinese entities on the Nasdaq is the one thing China and the US do agree on – no more please.

Chart 10: Percentage of Pre-tax profit from investment gains/income

Source: Arete Research calculations, October 2021. Note: Alibaba is FY to Mar. So, to sum up we are in no rush to add to Chinese internet stocks. We are not surprised to see the current bounce in stocks given how sharp the short-term falls were. However, we think 2022 will be a difficult year for margins and profitability as competition and regulations really start to bite – at time when the economy is slowing, and costs (workers wages and insurance, common prosperity projects etc) are rising. Intrinsically, we tend to favour the content companies (Tencent, Netease etc) over the e-commerce names (too much competition and a more mature market) but until the regulatory environment is clearer, we prefer to maintain rather than add to our existing positions.


4. Common prosperity policies appear to be a major policy reset in China. Do they signal an end to market-orientated reforms and a clear unequivocal move to a “socialist market economy”?

As we discussed in the July monthly report, the barrage of policy announcements in China do appear to constitute a significant change in overall economic direction. Private enterprise and market reforms were probably already in retreat in China, but the new policies indicate the state wants significantly more control, whether that be of data, financial control or the ability to direct investment priorities by listed companies. The Chinese state looks likely to advance while the private sector retreats. On a more positive note, the policies as stated could push the Chinese economy more quickly towards a consumer led economy. A few charts from our friend Gerard Minack perhaps highlight this issue, and also the financial risks that were building in China, and explain some of the potential positive implications of the policy changes (if they work of course). Firstly, if we consider Chart 11 due to aging demographics, the end of the movement of surplus rural labour to cities and the end of big gains from better infrastructure the Chinese economy is naturally slowing, following a very similar path to Korea and Japan at a similar stage of development. Chart 11: China’s delerating trend growth

Source: IMF, NBS, Cabinet Office, Minack Advisors, September 2021 The problem for China today is that what is still driving economic growth is very different from Korea and Japan. As Chart 12 shows, growth in China is still very dependent on capital spending and, as highlighted earlier, far too dependent in particular on a real estate market that has been aggressively building for 15 years. China’s other engine of growth has been exports, where aggressive investment in new industrial capacity has led to market share gains but often at the risk of deflation. The consequence of this has been a build-up in financial risks (Chart 13) and we believe part of the current policy reset is to try and move away from the leveraged, investment driven growth model to a more balanced economy.

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$7k PER CAPITA THRESHOLD HIT:

JAPAN 1969 KOREA 1988 CHINA 2007


Chart 12: China’s excessive reliance on investment for growth

Source: IMF, NBS, Cabinet Office, Minack Advisors, September 2021 Chart 13: Excess investment means Debt and Deflation – a problem for leveraged corporates

Source: BIS, MBER, Minack Advisors, September 2021 The key for China to have healthier and more balanced growth is to boost consumption. As Chart 14 shows, China’s savings rate remains stubbornly high, much higher than other countries at this stage of development. Excess savings fund the very high investment rate heightening risks of deflation and financial problems. Why are savings so high in China? A limited welfare state, high education and healthcare costs, high housing costs and a high and rising Gini coefficient (i.e. rising inequality which tends to correlate with a higher savings rate as shown in Chart 15) all appear to be factors.

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Chart 14: China’s consumers save too much

Source: IMF, NBS, Cabinet Office, Minack Advisors, September 2021 Chart 15: Rising inequality and rising household saving

Source: Oxford Econimics, World Income Database, Minack Advisors, September 2021 Many of the common prosperity policies do appear to be an attempt to address the issues of rising inequality and wasteful investment, and if successful could rebalance the economy and reduce financial risks. So, on a positive note, while much of the reset looks potentially painful for the earnings of the real estate, healthcare, insurance, banking and internet sectors, if the policies are successful it could improve the outlook for consumer and industrial names and reduce overall financial risks. However, in the interim given the extensive and aggressive nature of the policies, we find it hard to get excited about the overall Chinese equity market.

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* WORLD INEQUALITY DATABASE ESTIMATE. † 3 YEAR MOVING AVERAGE.


5. Surely the basic ingredients are still there for productivity to drive growth in China – given this aren’t we letting the current noise make us too negative on the stockmarket?

This section is perhaps best answered mostly in charts. The Chinese economy, as we have pointed out in the past, has much better ingredients for growth than most other emerging economies. The Chinese education system is extremely good for a country at this level of GDP/per capita and the growth in Tertiary education in China has been spectacular (Chart 16), and the best Chinese universities now regularly appear in tables of the top universities in the world. China may have a shrinking workforce, but it is one that is better skilled and thus potentially more productive. Chart 16: Why we are bullish on the right parts of Chinese stockmarket – Bright Young Things will drive growth

China is also an extremely efficient place to do business due to very good infrastructure and rapid digital adoption (Chart 17). While legal rules and the protection of local and particularly state interests can make ease of doing business in some sectors difficult, for many areas good infrastructure and a well-educated population make China very efficient. China is also spending aggressively on trying to move up the value-added curve and now outspends the US on research and development investment (Chart 18). Chart 17: Why China works and much of Asia doesn’t – efficiency and connectivity provide the ingredients


Chart 18: China’s catch up with the US on Innovation-Driven Growth: R&D Spending

Source: BofA Research Investment Committee, OECD, August 2021

So, this all sounds pretty positive – so why the caution on Chinese stockmarkets? Our issue is the increasing prominence of state-owned enterprises (SOEs) across most key industries in China, and those not dominated by SOEs such as the internet sector are increasingly required to accept a much greater degree of state involvement in their operations. Perhaps this should not be a surprise. President Xi has always been very clear on the importance of SOEs. As he made clear in a speech in April 2019, SOEs are “important, material and the political foundation for socialism with Chinese characteristics and that they should be made stronger, better, bigger”. (quote from Project Syndicate, December 31st, 2020, China’s Pro-Monopoly Antitrust crusade) As long-term fund holders know, we typically don’t invest in state owned enterprises anywhere in Asia. We view SOEs as primarily political organisations that are beholden to the state and likely to do what is deemed in the best interest of politicians and civil servants rather than investors. This misalignment of interest is likely to lead to poor long-term returns. Going back to Chart 18 it is all very well to invest in R&D, but if it is state directed, as increasingly looks like to be the case in China, will it be in areas that are likely to lead to the best returns for shareholders? This is what worries us about the internet sector as the state starts to influence how they invest - will this materially affect the long-term returns in the sector? As Chart 19 and Chart 20 show, Chinese SOEs operate typically with higher leverage than the private sector, despite this their return on equity is very much lower struggling to cover their cost of capital. Chart 19: China – leverage – SOEs vs Private

Source: IMF, Macquarie Research, June 2021


Chart 20: China – ROE (%) – SOEs vs Private

Source: CEIC, Macquarie Research, June 2021 So, to sum up: the Chinese economy still has many ingredients for strong growth; however, the state advancing as the private sector retreats means the outlook for returns for shareholders in many sectors has become more difficult, and the overall outlook for the Chinese stockmarket in our view has become less exciting. 6. Is the Chinese stockmarket now uninvestible for overseas equity investors? Or, as the bulls claim, with

economic growth set to exceed developed economies, is a significant strategic weighting in Chinese assets merited?

The first comment we always make here is investors MUST remember that stockmarket returns and economic growth do not correlate, particularly in the case of emerging markets. The first chart in the Schroder Asian Total Return Fund standard presentation pack is shown in Chart 21. In the 20th century Australia, closely followed by Sweden, was the best performing stockmarket – neither had anywhere near the best economic growth rate (using real per capita GDP growth). Chart 21: Asian Equities beware of those speaking with forked tongues

Why was this? Clearly returns on a stockmarket reflect the returns of the stocks listed in that market – the quality of those companies (management, industry and countries in which they operate etc) will define returns. Even where we have domestically orientated stockmarkets, returns will be affected by proper legal systems and protection of property rights, this at least in part explains why stockmarkets based in countries with sound government and independent legal systems like Australia and Sweden have done well.


What about more recent performance in Asia - does the thesis still hold true? Chart 22 has the respective MSCI returns (all in US dollars) from December 1992 when the MSCI China index was first launched. As can be seen, the MSCI China has had the poorest returns over the period – the index is still actually below its starting level and even with dividends reinvested has only returned 1.9% p.a. over 30 years. Our Japanese team in London were particularly cheered to note over this period the MSCI Japan has had more than double the return of the MSCI China at 164% vs 75%. Chart 22: MSCI index returns for Asia in US$ since 31st December 1992

Source: Bloomberg, as at 7 October 2021 The best performing market by some margin over the period is the MSCI Australia, which has returned 1892% or 11% p.a. which is actually slightly more the MSCI USA. The ASEAN markets with a history of relatively poor capital allocation and government interference have offered mediocre returns, whereas those countries with better property rights and legal protection and few state-owned enterprises (Hong Kong, Taiwan and Korea) have done materially better. Only India, where private sector banks and domestic entrepreneurs have been allowed to operate with less government interference, has really lived up to the emerging market promise. Clearly on a long-term basis it would be hard for your fund managers to claim a large strategic weighting is justified to Chinese equities based on: 1. past experience and 2. the fact that regulations appear to be moving away from a market economy with property rights, to a socialist economy with a larger state. So does this mean China is uninvestible? No, it does not, but clearly buying a Chinese ETF to us looks an extremely unappealing long-term investment. For some time, we have thought large parts of the Chinese market uninteresting for our funds – this being the state-owned enterprises (banks, telecoms, utilities), heavy industry and mining (ESG and overcapacity), and real estate (overcapacity, opaque balance sheets, demographics). This left us focussed on internet stocks, insurance, selected healthcare, higher end manufacturers and technology stocks and consumer related names. What the current regulatory barrage has done is cause us to re-evaluate the exposure we want to have to internet, insurance and healthcare stocks as clearly some of them will become more regulated as their priority moves to helping achieve “common prosperity”. So China hasn’t in our mind become uninvestible. Instead, the range of industries and stocks we are interested in investing in has become narrower, and the valuation we are willing to pay for certain stocks is lower, reflecting the new risks. Many active China fund managers, including our colleagues Jack Lee and Louisa Lo, have demonstrated


you can make good returns by investing in Chinese equities. The key in China is to ignore the overall index as it is fundamentally unattractive. 7. Would global investors be better off just focussing on ASEAN and South Asia exclusively given the policy

direction in China and the poor demographics and lower economic growth potential in South Korea, Taiwan and Australia?

Hopefully the answer to question 6 (and the numbers in Chart 22) partly answer this question. Some of the best companies in Asia are listed in Australia, Taiwan and Korea whether this is healthcare companies like CSL, Cochlear and Resmed, tech leaders like TSMC and Samung Electronics, battery companies like LG Chemical and Samsung SDI, or niche global leaders like Merida, Giant and James Hardie. So, to write off a stockmarket for the reasons stated above would be churlish. You only write off a stockmarket in a country when the state takes complete control of capital allocation and property rights. Going back to ASEAN, we remain relatively cautious on the stockmarket outlook. We are not convinced the ingredients exist to get countries like Indonesia, Malaysia, Philippines and Thailand out of their middle-income traps. As Chart 23 shows, corruption and protection of property rights is weak in Indonesia, Thailand and Philippines – and their ease of doing business ranks poorly. Educational attainment remains relatively low (Chart 24), resulting in a workforce that is often not well suited to the changing environment. The factories of the future will be more automated. This means less labour but more capital and skilled labour (software engineers, robotic specialists); you therefore need more than cheap labour to have a comparative advantage in manufacturing. Chart 23: Why ASEAN is stuck in a middle income trap


Chart 24: What are the consequences of serious education failings

Of course, stockmarket returns do not equate to GDP growth; however, as Chart 25 shows the current make up of ASEAN stockmarkets is not particularly attractive given the disruption faced by incumbent banks and traditional energy stocks. This may change with new listings coming but overall it is hard to get excited on ASEAN stockmarkets at the current time, particularly given the high valuations better companies trade on due to their scarcity premiums. Chart 25: Why are ASEAN stockmarkets moribund – c.50% index is incumbent banks and traditional energy names

We emphasise to investors: just because the Chinese stockmarket may have become less attractive for foreign investors DOES NOT mean suddenly other stockmarkets in Asia have miraculously become more attractive. India and Vietnam look more interesting from a macro perspective, both are attracting significant FDI flow (Chart 26) and Vietnam (Covid apart) has become the Asian production base of choice for companies looking to diversify away from China. While we have issues with some parts of the current Indian government’s policies, it would be fair to say progress is being made in some areas. With improving infrastructure and the roll out of digitalisation (Chart 27) the outlook for the Indian economy is more promising than other developing Asian countries. The


problem of course in India at the moment is valuations (Chart 28), so we are not adding at the current time, instead with a huge backlog of Indian IPOs and placements to come we will see if this throws up better opportunities to add to our weightings. Chart 26 : India and Vietnam are attracting the bulk of regional Foreign Direct Investment

Chart 27: India is building a strong digital infrastructure


Chart 28: The Indian market has rerated from 15x to over 30x over last 10 years – is all the good news in prices?

Source: Bloomber, October 2021 8. Are you relooking at reflation and value names in the region? Where do you see the best opportunities?

The drop in markets in Asia has brought valuations back to more normal levels. As shown in Chart 29, the top-down valuation indicator we use in the fund’s process -is now back in the neutral range, after having been expensive in March. Meanwhile, the bottom-up indicator (percentage of stocks that Schroders covers in Asia with upside to fair value) is at 55%, exactly in-line with the long-term average. Chart 29: Our valuation Indicators are now back to neutral

The problem with this analysis is most of the correction has come in China where, as we have hopefully explained above, we feel stocks have fallen for good reasons. Most other parts of the market have seen only mild corrections or none at all in the case of India and ASEAN. As Chart 30 shows, parts of the stockmarket in Asia do look prima facie cheap but these remain ones like banks, insurance, utilities, property that often face structural challenges.


Chart 30: Valuation chart – headline PE now less extended but “cheap” stocks are in “difficult” sectors

Given the rapid rise of fintech and e-commerce in the region we are not rushing to add to reflation plays like banks, property and insurance. While we would accept that inflation does not look simply to be transitory, we do not think the rapid industry level disruption we are seeing in many sectors is going away. We have added to some financials over the last six months, but we only want to own those we feel will be able to adapt and thrive in the changing environment. Property is a sector we struggle with across the region and the fund only has exposure to three property stocks in Hong Kong and Singapore. Materials and traditional energy are areas that, outside of Australia, we are extremely unlikely to invest in for ESG reasons. So where are we investing? We continue to like Asian-based companies that are global leaders in their respective niche. These are companies like Techtronics (Chart 31) and Resmed (Chart 32) that are operating in segments where new technology means their addressable market is growing. We also like companies like Merida (e-bikes), Nien Made (window coverings) which are using their comparative advantages to take market share. The biggest overweight in the fund remains our technology positions which are primarily focussed on semiconductors (TSMC, Samsung), design services (Mediatek, Realtek, Advantech) and software (India IT services, Thundersoft). This is an area that has been weak over the last two months as markets moved to the “reflation” trade. We have used this as an opportunity to add to some of our technology and export related names – the structural reasons why we favour technology stocks in Asia have not changed and valuations are we believe reasonable (Chart 33).


Chart 31 – Techtronics

Chart 32 – Resmed


Chart 33 – Technology stocks

Despite our worries on China, and cautious stance on the region as a whole, we can still find enough opportunities to keep the fund close to fully invested. The biggest change in the fund over the last 12 months is the “blue” areas of investment on chart 34 (best technology, exporters, global leaders) have become materially bigger, while the China consumer and services plays have shrunk. Our weightings in the more “value” orientated parts of the market have not changed. We have added to financials, but we include these in the “green” part of Chart 34 as we would define these as financials with good growth options, rather than incumbent companies where we are primarily clipping a dividend yield and expecting less capital appreciation. Chart 34: Where we investing chart.

Robin Parbrook and Lee King Fuei

11th October 2021


FUND POSITIONING

Source: Schroders, as at end of September 2021. For illustrative purposes only and does not constitute any recommendation to invest in the above-mentioned countries.

11.6%

13.1%

1.5%

7.6%

11.1%

11.9%

0.6%

9.6%

20.2%

3.7%

0.9%

93.0%

-4.7%

Australia

China

France

Germany

Hong Kong

India

Korea

Philippines

Singapore

Taiwan

United Kingdom

United States

Vietnam

Tactical Hedges - Delta-Adj.

Strategic Hedges - Delta-Adj.

Net Exposure - Delta-Adj.

11.3%

12.3%

0.9%

14.4%

4.5%

5.9%

36.9%

7.0%

4.4%

93.0%

-4.7%

Communication Services

Consumer Discretionary

Consumer Staples

Energy

Financials

Health Care

Industrials

Information Technology

Materials

Real Estate

Utilities

Tactical hedges - delta-adj.

Strategic hedges - delta-adj.

Net Exposure - delta-adj.

Important information

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TOP 10 HOLDINGS

Stock Fund (%)

TSMC 8.9

Samsung Electronics 7.2

Tencent 4.4

Techtronic Industries 4.1

Mediatek 2.9

BHP Group 2.5

HDFC Bank 2.4

Tata Consultancy 2.4

DBS Group 2.4

SEA Ltd 2.4

Total 39.7 Source: Schroders, as at end of Sept 2021. For illustrative purposes only and does not constitute any recommendation to invest in the above-mentioned countries.

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Schroder ISF* Asian Total Return