2023-10-10 12:50:08 ET
Summary
- iShares China Large-Cap ETF holds top Chinese companies like Tencent, Alibaba, and Baidu.
- The FXI ETF slightly outperformed the SPDR® S&P 500 ETF Trust in Q3, suggesting a possible bottom.
- A weak Chinese economy and geopolitical factors continue to weigh on FXI, but it offers significant value and potential rewards.
The iShares China Large-Cap ETF (FXI) product owns shares of the leading Chinese companies. The most recent top holdings are shown in the image below.
Tencent Holdings Ltd. (TCEHY), FXI's top holding, is a multinational technology and entertainment conglomerate. FXI also has significant exposure to Alibaba ( BABA ) and Baidu (BIDU), two high-profile Chinese companies.
I last wrote about FXI on Seeking Alpha on August 11, when the shares were at the $28.83 level. I wrote:
In August 2023, Chinese stocks are inexpensive compared to U.S. equities. While there is always a chance of a positive breakthrough in U.S.-Chinese relations that will lift Chinese stocks, markets reflect the current economic and geopolitical landscapes. Weak Chinese economic data and growing tensions support the discount for FXI compared to U.S. large-cap stocks.
In October 2023, nothing much has changed for FXI and Chinese stocks, as they have displayed no signs of breaking out from the bearish price action.
FXI slightly outperforms SPY in Q3 - A sign of a bottom?
The SPDR® S&P 500 ETF Trust (SPY), the exchange-traded fund ("ETF") that reflects the most diversified U.S. stock market index, the S&P 500 (SP500), fell 3.56% in Q3 but was 11.8% higher over the first nine months of 2023.
The monthly chart highlights the iShares China Large-Cap Shares ETF moved 6.25% lower from $28.30 at the end of 2022 to $26.53 over the first three quarters of 2023. However, FXI closed Q3 with a 2.43% loss, slightly outperforming the SPY ETF.
FXI fell to a $20.87 low in October 2022, the lowest level since 2008 when the global financial crisis gripped markets. The SPY has done far better than FXI over the past years.
FXI has stabilized in 2023, trading in a $25.48 to $33.38 high, with the peak in January and the bottom in early October. Chinese stocks remain in a bearish trend, searching for a bottom.
The Chinese economy remains weak
China's economy has been weak, but the data from Beijing is always suspect, given the centrally planned government's control. China has been cutting key interest rates after July's industrial output and retail sales slowdowns. Property investment continues to decline. Meanwhile, the August data showed some improvement in retail sales, but the real estate sector continues to weigh on the overall economy and infrastructure investment.
The action in FXI over the early days of October remained negative.
Geopolitical factors scare investors away
FXI's price action since early 2021 reflects the growing geopolitical fears.
The chart illustrates the pattern of lower highs and lower lows after the relief rally from the March 2020 pandemic-inspired low. In February 2022, the handshake between President Xi and Russia's President Putin on a " no-limits " alliance increased geopolitical fears and caused many investors to shun Chinese stocks.
Less than one month later, Russia invaded Ukraine, increasing concerns that China would force reunification upon Taiwan. Since February, the bifurcation of the world's nuclear powers has only increased investors' fears surrounding Chinese investments.
Meanwhile, this past weekend's turmoil in the Middle East will only increase geopolitical concerns. After the tragic events in Israel, visiting U.S. Senate Majority Leader Chuck Schumer asked President Xi to condemn the attacks, and the Chinese leader strengthened his statement above the atrocities. However, Chinese relations with Russia and Iran could remain a significant sticking point if the Middle East conflict escalates and spreads.
Chinese stocks offer significant value, but the risks are a function of the potential rewards
Despite the significant value proposition, investors will likely stay clear of Chinese exposure over the coming weeks and months. The most recent price-to-earnings ratio of FXI is 10.62, while the SPY's is 17.86. SPY's annual dividend translates to 1.5%, while the yield on FXI is 2.8%.
The objective P/E and dividend data may make Chinese stocks compelling in the current environment but reporting requirements and corporate structure favor U.S. stocks. Meanwhile, the geopolitical climate remains highly volatile, which could cause distortions in Chinese stocks over the coming months. Since risk is always a function of the potential rewards, the low valuation and higher dividend of Chinese stocks compensate for the high-risk environment.
The two factors that could cause a substantial rally in FXI
Two unlikely factors in October 2023 could cause a sudden rally in Chinese equities listed on U.S. and foreign exchanges.
First, a warming of relations between Washington and Beijing would attract significant buying in Chinese large-cap stocks. The U.S. and China are the leading economies, each exposed to the other for economic growth. The U.S. is a vast consumer market for Chinese companies and vice versa. Therefore, any moves that improve relations could cause capital to flow into China's leading companies.
Second, if China emerges from its economic malaise, investors could buy shares in Chinese companies. The property sector has weighed on China's economy, and a stabilization could lead to a recovery.
Even though the relations between the U.S. and China remain strained, I favor a small exposure to Chinese stocks via the FXI ETF product. I will leave plenty of room to add on further declines, limiting total portfolio exposure to under 5%. Chinese equities are inexpensive for good reason, but a contrarian approach to the world's second-leading economy could pay off in the coming years despite the ugly bearish trend.
For further details see:
Update On FXI: The Trend Remains Ugly