Will China’s large-cap ETF, iShares’ FXI, stop underperforming?

Market Realist

China’s slowing investment bubble will hurt Apple’s sales growth (Part 11 of 11)

(Continued from Part 10)

China’s bank-ridden FXI: The best of the worst since 2012?

The below graph reflects the performance of Asian equity ETFs since the election of Japan’s new prime minister in November 2012. The Japanese ETFs—DXJ and EWJ– performed very well as the currency weakened under new policy initiatives. Meanwhile, both Korean and Chinese ETFs—EWY and FXI—have been flat, with China still in slightly negative territory, remaining the worst performer to date. The Blackrock iShares China Large Cap ETF (FXI) holds China’s construction bank as its top holding, at 9.03% of holdings, Industrial and Commercial Bank of China as its fourth holding, at 7.01%, Bank of China as its fifth holding, at 6.17%, and the Agriculture Bank of China as its ninth holding, at 4.03%.

This article considers the prospects for these main Asian ETFs to break out of the doldrums in 2014. With FXI holding 26% in large-cap Chinese banks, we would really need to see some better capacity utilization and producer price index improvement before these shares lead the market higher. The loan portfolios of Chinese banks are in dire need of improved credit quality. For Baidu, Apple, and Google China, the improvement in the domestic consumption area has been encouraging, though construction and manufacturing still aren’t firing on all eight cylinders. Perhaps we’ve seen enough investment and banking activity in China in the near term and technology companies like Baidu, Apple, and Google China can outperform the broader market in this environment.

China’s investment drives the economy

Capital formation in China—investment—is the main driver of China’s economic engine. Investment is financed by banks, and the FXI ETF is heavily invested in banks. As the International Monetary Fund pointed out in its “World Economic Outlook,” in January 2014, “In China, the recent rebound highlights that investment remains the key driver in growth dynamics. More progress is required on rebalancing domestic demand from investment to consumption to effectively contain the risks to growth and financial stability from overinvestment.”

Investment is key in China

Japan’s consumption as a percent of GDP is around 61%. The U.S. is around 68%. China’s final private consumption comes in around 33%—half of the average U.S. and Japan rates of consumption as a percentage of GDP. Notably, as a percent of GDP, China’s trade surplus of 10% of GDP in 2008 has declined to 2.0% of GDP currently. At least the capital and current account balance seems well in hand. The investment growth into the 2008 crisis raises eyebrows at the IMF. On the other hand, China is still a rapidly growing economy.

The recent, though modest, pickup in China’s domestic consumption growth and consumer sentiment are welcome developments. Should this trend accelerate as the year progresses, this could take some of the pressure off of China’s export reliance and ease banking pressures at home. This would be a positive scenario for the iShares FXI, as bank shares could become perceived as less risky in the future. However, investors will need to look for ongoing improvement in China’s producer price indices and industrial capacity utilization rates.

Though consumer goods-related PPI indices haven’t dipped into negative territory yet, further declines in non-consumer PPI indices could drag even consumer prices into negative territory as the Chinese domestic economy weakens. Investors will need to be mindful of these key economic indicators as the year progresses. Further declines in PPI indices could lead to increased price and profit margin pressures for even consumer-oriented companies such as Baidu, Apple, and Google China. Perhaps the soft landing will continue and China’s domestic consumption growth surprise to the upside.

To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Asian equity outlook

The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.

To learn more about investing in global equities like FXI or DXJ, check out Market Realists’s Global Equity ETFs page.

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