China Stumbles But Does Not Fall: ETFs To Play The ‘Chinese Century’
The Chinese government has the will and resources to create national wealth while helping smooth economic bumps and market volatility. Chinese ‘B’ shares trade at a PE of 21.6 (‘A’ shares trade at 16.7x), comparable with the S&P 500. FXI (iShares) is the largest China ETF, while Vanguard’s VWO is 27% invested in China. China’s stock market has been on a roller-coaster ride in 2015, with the largest China ETF, the iShares China Large-Cap ETF ( FXI), down 8% YTD. Recently, China’s market has been in the news, first for its huge run-up, then for its dramatic decline. I wanted to share some perceptions on the strength of China, and its internal resolve, that I think provides some perspective on the long-term opportunities in the Middle Kingdom. (click to enlarge) Source: Yahoo! I recently had the privilege of attending a conference in Miami sponsored by the Financial Times- ‘Trade Links With The New Latin America.’ While I learned a tremendous amount regarding the resource, political and financial/structural issues regarding trade with Latin America, my biggest takeaways were about China. A discussion regarding China is especially timely, as that country’s recent stock market meltdown, government response and growth forecasts have been in the news in recent months. Below I will discuss several of the more interesting observations; many of the observations will be directly attributable to Charles Tang, Chairman, China-Brazil Chamber of Commerce & Industry. Mr. Tang is not formally a part of the Chinese government, but spoke as if he was representing the views of his government, and equally as important, was thought by other panelist and conference participants to be representing the views of the Chinese government. Non quotes are my perception of comments by Mr. Tang and other participants at the conference (bankers, scholars, businesspeople and government representatives). I will start with the summary observations, and support with examples throughout the article. 1) China views the US as a competitor eager to keep the growing country down, 2) China has literally trillions of dollars saved to support its economy, help its friends and to secure its goals, 3) China is generous with its friends and does not (think it) attach moralistic strings to its aid/deals. 4) China will do what it takes to gain power, influence and respect. A very frank and telling quote, “The current administration will not be successful in dealing with China.” My initial thought was, are we (the US) playing the same game (as the Chinese)? It is well-known that we tend to view events and actions through our own prism. The conference brought into stark focus how actions can be viewed very differently depending on your ‘side.’ For example, actions by the US (and the West in general), that may be thought as motivated to help our partners or our economy are viewed by the Chinese as structured to isolate (China). The Trans Pacific Partnership (“TPP”), while controversial in the US for a variety of domestic reasons is viewed in China as a tool to exclude and isolate that country. While not a primary motivator, I think the Chinese, at least perceptually, have a point. A quote was, because the TPP excludes China “it will be difficult to be very successful.” The International Monetary Fund (“IMF”) is well known as the agency that tries to help troubled economies. From China’s perspective, it has been excluded from participation; ironic to China as it is the great creditor nation (and those that have the most say at the IMF are big debtors- bad at running their own economies!). Having successfully kept China out of the leadership of the IMF, the country decided to start its own development bank, the Asian Infrastructure Investment Bank (“AIIB”). Despite heavy lobbying by the US against joining the bank, the UK was the first western country to join; the headline in the New York Times summed up the situation: “Stampeded to Join China’s Bank Stuns Even Its Founder.” China’s success in getting the AIIB off the ground promises to increase the country’s stature and influence. Unfortunately (for the US), China’s gain is at the expense of the US. Poorly played by the US; the lack of influence (with heavy lobbying) is a real sign of diminished US influence. China wants its currency, the Renminbi, to be a trade and reserve currency, like the US Dollar and (to a lesser extent) the Euro. China’s attempts at currency control and manipulation have hurt itself in this regard. However, as conference attendees demonstrated, banks such as Commerzbank ( OTCPK:CRZBY ) are eager to facilitate Renminbi transactions (as opposed to having a transaction conducted in US Dollars or Euros); it appears almost inevitable that China will eventually succeed in having its currency join the US dollar as a trading and (later) a reserve currency. China will need to remove most capital controls before the currency can truly be a reserve currency. China is not “on the rocks.” While tacitly acknowledging some clumsiness in dealing with the stock market situation, the real point emphasized was that China has $4 trillion (with a ‘T’) to play with. Interesting quotes included: (the first part partially in jest), “China is not going broke . . . it has tremendous financial depth.” And, there have been “a few hick-ups” in transitioning China to a consumer economy. Also, “China was a slight cold . . . the US has had pneumonia for the last 16 years.” Note the confidence, arrogance and (by being arrogant) lack of confidence. In talking about the financial situation, it was noted that almost none of Chinese property is subject to a property tax. The imposition of a property tax was noted as a lever that could be used to support indebted regions. From a practical point of view, China feels, instead of exploiting Africa as the colonial powers (or the post-colonial rulers) did, they have “transformed Africa into a continent of hope.” After hearing this quote, I did realize there was a certain ‘Alice in Wonderland’ feel to the perspectives of the Chinese and the West. However, China feels its investments in Latin America are a counter-point to the historically more exploitive investments of the US. Coincidently, on September 3, the Financial Times reported that China had made a $5 billion loan to beleaguered Venezuela. While risky from a credit point of view, China is clearly buying influence with money (even at the risk of default) and securing supplies of commodities (in this case oil). China also continues to invest in Brazil, though more cautiously as the Petrobras (NYSE: PBR ) scandal has made the money-for-influence transaction more challenging (who know who will be in power in six months). However, never one to miss a good crisis, China is “taking advantage of opportunities to buy assets” in Brazil. Like Donald Trump, you have to admire the straightforward audacity of the Chinese even if you do not respect the underlying morals/motivations. Frankly, lending when all others have left is a great way to gain favors and bargains. Another interesting quote regarding investment, “Chinese money has no conditions.” Of course Chinese money has conditions, just not the moral conditions or requirements used to satisfy local political constituents (e.g. unions) in the US. While I don’t know if anything I heard was entirely new. What was new to me was the blunt, forthright and unapologetic way the Chinese perspective was presented; hearing a direct Chinese justification was certainly different than a Western interpretation. My takeaways are: China is buying assets and influence on the cheap. China is amoral and guided by enhancing security and stature. China views the US as attempting to isolate the country; China’s response is to create parallel institutions that will ultimately weaken US influence. The US would be better to compromise (in some areas) than compete. China’s $4 trillion war chest gives it flexibility and a long-term perspective the US (and the West) cannot match. A parallel thought is the impact to the US if China stops buying US Treasury bonds (he who has the gold . . .). China’s arrogance and insecurity will cause it to waste a good portion of its war chest (e.g. Japan in the 1990’s). The influence China’s money will buy, will be somewhat like what the old Soviet Union used to buy. Effective, but generally in areas where ideology trumps economics. China’s no-strings attached money come with ‘other’ strings (see: Godfather Part I). The US is wasting goodwill and money in threatening the Chinese; the Chinese are proud, determined to be respected and will create a lose-lose situation if necessary (e.g. Creation of the AIIB). The lack of a well-articulated and consistently applied economic policy is hurting the US vis a vis the Chinese. I would regard any commitments the Chinese make with respect to climate change as credible as the commitments the Iranians make on nuclear weapons (probably well-intentioned when made, but not likely to be adhered to in the long term). I mention this topic as it is one where the US would likely make concessions in international agreements in order to get cooperation from the Chinese. While much of the above was not directly about the stock market, much of it has a direct impact. In short, China is playing the long-game to enhance its financial and strategic power. The government will do what is necessary for stability. From a market perspective, that means investors benefit from the government’s desire to increase overall national wealth and use its resources to smooth bumps and minimize market volatility. The macro growth of 7% (or even 5% or 6%) is a strong tailwind. Last week’s announcement changing the one-child policy is a new (with a nine-month lag ) tailwind. The Shanghai Stock Exchange reports an average PE ratios of 16.7x and 21.6x for ‘A’ shares (those available for purchase by mainland Chinese) and ‘B’ shares, respectively. By comparison, the S&P 500 currently trades at a 21.9x PE ratio. While confidence in earnings reported by Chinese firms is not as high as those reported by US firms, the valuations provide a sense of relative value. Despite recent volatility, given Chinese tailwinds, valuation does not seem excessive. From a long-term perspective, China should be considered a part of a well-diversified portfolio. FXI is the largest ETF (0.74% expense ratio), though eight other China ETF’s exist with assets of more than $100 million (see the ETF database for more information). Personally, I participate in China via the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) (0.15% expense ratio). VWO’s portfolio is 27% China.