Why China’s FXI could outperform Korea’s EXY in 2014

Market Realist

Apple’s earnings: Why the biggest risk to investors is now China (Part 10 of 10)

(Continued from Part 9)

China’s bank-ridden FXI—the drag on performance

The following 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 and the worst performer to date. However, the past month has shown improvement in both Chinese and Korean ETFs FXI and EWY, while Japan’s DXJ and EWJ have declined. BlackRock iShares China Large Cap ETF (FXI) holds China Construction Bank as its top holding (9.03%), fourth to Industrial and Commercial Bank of China holding at 7.01%, fifth to Bank of China at 6.17%, and ninth largest holding to the Agriculture Bank of China at 4.03%.

This article considers the prospects for the main Asian ETFs to break out of the inactivity they’ve seen in 2014. With China (FXI) holding 26% in large cap Chinese banks, we’d really need to see some better capacity utilization and producer price index improvement before these shares lead the market higher. Perhaps we’ve seen enough investment and banking activity in China near-term, and global growth will clean up excess capacity as the year progresses, taking pressures off of raw material sectors in China as well as its bothered bank lenders.

China’s investment drives the economy

As we pointed out in a related article, 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, January, 2014: “ In China, the recent rebound highlights that investment remains the key driver in growth dynamics. More progress is required on re-balancing domestic demand from investment to consumption to effectively contain the risks to growth and financial stability from over investment.”

Excess capacity and real estate decline in China are Apple investors’ largest near-term risks                                                            

What the IMF is referring to is illustrated in the following graph. China is an investment leader. Japan’s consumption as a percent of gross domestic product (or GDP) is around 61%, and in the case of the U.S., the equivalent is around 68%. China’s final private consumption comes in around 33%half of the average U.S. and Japanese rate. Notably, as a percent of GDP, China’s trade surplus of 10% of GDP in 2008 has declined to 2% of GDP currently.

At least the capital and current account balance seems stable. The investment growth into the 2008 crisis raises eyebrows at the IMF. In contrast, China is a rapidly growing economy. Given its population and fairly low-cost basis, significant investment is only natural, as it’s a rapidly growing, young, capitalist economy. Economically, it might appear that the central planning of the Chinese government over-invests at times, as the Chinese economy, like a young child, grows very quickly. Sometimes parents buy shoes a size or two too big for their young, rapidly growing children. This might appear to be the case in China.  There’s little doubt that China can eventually grow into what it has invested in so far. However, if the investment is like a shoe that’s four or five sizes too big, the economy could trip in the near future, and Chinese markets could be disorganized and slow until growth stabilizes years later. Investors will need to keep an eye of China’s capacity utilization levels as the year progresses.

While overall wage growth has been supporting China-based sales for Apple, serious credit problems among large industrial manufacturers outside of the consumer sector could add to already weak asset valuations for China’s banks. A bank-driven credit crunch remains a potential threat for the Chinese soft landing scenario. Should a U.S.-style housing and real estate price decline begin to develop in China, investors would have to temper Apple’s sales growth expectations. Without a strong China story continuing, Apple’s growth story and stock could take a serious short-term hit. A hard landing for China in 2014 would likely result in a very bad year for Apple’s share price. 

For 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.

Economic Future in China

While China has various growth-related issues to decrease as the year progresses, at least China has managed a soft landing so far. If the U.S. and the European Union (or EU) can get back to trend growth of 2.5% or so in the next year or two, that should be enough to support China’s excess capacity and producer price weakness in the near term. This scenario would support Chinese equity valuations and Apple’s China-based revenues. However, if a real estate bubble begins to implode in China any time soon, investors may have to wait quite a while before they see Apple trade above $700 per share again.

Browse this series on Market Realist:

Rates

View Comments (0)