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Hong Kong ETF In Bad Spot As Tensions With China Rise

·2 min read

The iShares MSCI Hong Kong ETF (NYSE: EWH) dipped 4.33% last week and is at its lowest levels since early April as Beijing pushes ahead with new policies that would limit the Special Administrative Region's autonomy, effectively ending the “two systems, one country” policy to which investors have been accustomed for over two decades.

What Happened

In a scene reminiscent of the protest that marred the SAR last year, on Sunday, Hong Kong police fired tear gas at pro-democracy demonstrators — and there's talk that the White House will impose sanctions against China. Not surprisingly, the move to limit Hong Kong's autonomy isn't well-received by investors.

“Such a move is likely to not only reignite the pro-democracy protests in Hong Kong, but also threatens the special economic status the city enjoys with the United States, to obvious economic harm,” the ETF Research Center said in a recent note.

Why It's Important

While there are myriad options for investors looking to access China, particularly via exchange traded funds, Hong Kong remains a vital financial gateway for international investors looking to access the world's second-largest economy, and autonomy is a big part of that equation.

Even the iShares China Large-Cap ETF (NYSE: FXI), a basket of big-name Chinese companies listed in Hong Kong, declined last week on the back of the heightened geopolitical tensions.

“The cold hard reality for investors however is that erosion of Western-style rule of law in favor of Chinese-style party rule could also result in Chinese-style valuations. In other words, single-digit multiples,” said ETFRC.

What's Next

Data suggest escalating tensions are creating a disconnect between Hong Kong and China in terms of multiples with discounts favoring FXI.

“EWH and the iShare China Large Cap ETF have similarly Financial-heavy sector allocations (at about 45% each). Despite this, firms in EWH enjoy a P/E multiple of about 15x forecast earnings, whereas firms in FXI--despite catering to a much faster growing economy--trade at only about 8x,” notes ETFRC.

“We believe that this discount for mainland Chinese stocks reflects the market's concern over the weaker protections for property rights, including honest and transparent accounting standards (to say nothing of individual liberty). As Hong Kong's rule of law is eroded, we fear so too will its stock market valuations.”

Year-to-date, EWH is lagging FXI by 520 basis points.

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