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 a slightly negative territory, and remains the worst performer to date. Blackrock iShares China Large Cap ETF (FXI) holds China construction bank as its top holding (9.03%), Industrial and Commercial Bank of China as #4 at 7.01% of holdings, #5 Bank of China at 6.17%, and at #9 the Agriculture Bank of China 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. For Baidu, the improvement in the domestic consumption area has been encouraging, though construction and manufacturing are still not firing on all eight cylinders. Perhaps we have seen enough investment and banking activity in China in the near term. Technology companies like Baidu can outperform the broader market in this environment.
China’s investments drive the economy
As 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 their 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 rebalancing domestic demand from investment to consumption to effectively contain the risks to growth and financial stability from over investment.”
Investment is the key
What the IMF is referring to is illustrated in the below graph. China is an investment colossus. Japan’s consumption as a percent of GDP is around 61% and in the case of the U.S., around 68%. In the case of China, final private consumption comes in around 33%—half of the average U.S. and Japan rates. 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 seem well in hand.
The investment growth into the 2008 crisis raised eyebrows at the IMF. On the other hand, China is a rapidly growing economy. Given its population and fairly low cost basis, significant investment is only natural, at it is a rapidly growing, young, capitalist economy. However, the recent pick up in China’s domestic consumption growth and consumer sentiment are welcome and long overdue developments. Should this trend accellerate as the year progresses, it can take some of the pressure off China’s export reliance, and ease banking pressures at home. This would be a positive scenario for iShares FXI, as bank shares may become perceived as less risky in the future.
For an overview of the U.S. macroeconomic recovery, which may support China’s export economy, read 2014 US macro outlook: The crack in the debt ceiling.
Asia’s equity outlook
The weakening yen and relatively flat wage growth in Japan has supported Japanese markets, as reflected in Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETF’s. Aggressive monetary policy in the U.S. has supported the S&P 500 as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), State Street Global Advisors Dow Jones SPDR (DIA), and 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 can 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 eventually become increasingly compelling. With FXI’s key holding, banking flagship Bank of China, trading at 0.84 price to book and a 4.95 price-to-earnings ratio, one has to wonder how much lower Chinese banks and financials could go.