China: No Bursting Bubble, Buy The Banks

August 03, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Tyler Mordy, president and co-chief investment strategist of Toronto-based Hahn Investment Stewards.

“Beautiful sunlight always comes after the rain.” So declared the Asset Management Association of China in a somewhat Confucian statement following recent carnage in the mainland’s stock market.

Many investors may scoff at the above, but no one should question whether China’s future is a key concern for investors. It is. As the country’s world economic footprint has increased, its impact on client portfolios has also been amplified. Getting China “right” is increasingly crucial.

Yet, wide-ranging perspectives are generating confusion and volatility, adding a new dimension of risk to the “China factor” on a still-fragile world.

The China Debate

Two main opposing views frame the debate. The first is that the era of China’s blockbuster growth is over. In the past decade, the country built its economy through massive infrastructure and export promotion, becoming the world’s largest trading nation and second-largest economy.

From 2002 to 2011, China grew at an average GDP rate of 11 percent. That is enormous. Unsurprisingly, many commodity-oriented countries and sectors profited handsomely during that period.

But GDP is now dramatically slowing to less than 7 percent—and perhaps substantially lower in the coming years. Further moderation is near certain. Debt also continues to rise, and a necessary deleveraging phase can only contribute to even more tepid growth. Now the boom is over and related investments will suffer.

The above is the dominant market view. However, that perspective very likely represents both a failure to think outside the Western box and to read Beijing’s policy signals.

Our actionable takeaway in preview? Buy China’s banks through ETFs like the Global X China Financials ETF (CHIX | B-96) or even the iShares China Large-Cap ETF (FXI | B-41), which has more than 50 percent in Chinese financials exposure.

To be sure, this is a highly unpopular view. We have written extensively on China and continue to support a bullish view, but with the added recommendation to overweight the banks.

The Big Picture

Before laying out the case, some scene-setting is required.

First, the scale of China’s global ambitions should not be understated. Their goals are gigantic. Importantly, China has a strategic objective of massively increasing its significance as a world financial power (in addition to having major economic and trade influence).

A better financial system is crucial if China wants to transition away from the rapid industrialization phase where the target was building up as much infrastructure as possible. Now the aim is a higher-quality growth phase with a focus on maximizing the return on investing.

Two outward thrusts are noteworthy here. One is the “Belt and Road” initiative; an infrastructure program with the goal of creating China-financed transport links across Central Asia to Europe via a “Silk Road economic belt,” and across Southeast Asia to the Middle East and Africa via a “Maritime Silk Road.”

If executed correctly, the new infrastructure would greatly enlarge the economic ecosystem within which China operates, creating investment and trade opportunities far beyond the initial infrastructure projects. Efficient transport and communications infrastructure effectively lowers the cost of moving goods, people and ideas around. Economic activity is boosted and smaller countries become clients of the central power that built it.

The second longer-running initiative is the promotion of the Chinese renminbi as a major global currency.

Clearly, if China is to become a serious financial power, it must have stable capital markets. A strong renminbi is key here, not least to finance trade and outward investments in its own currency. This is already happening. The renminbi has stealthily been one of the world’s strongest currencies in the last decade and now accounts for about 35 percent of China’s total trade (a tripling from three years ago).

The next stage is to achieve “reserve currency” status. The first milestone will be inclusion in the International Monetary Fund’s Special Drawing Rights basket—perhaps as early as November 2015.

Focus On China’s Banks

Why is all this important for China’s banks? Simply because many of these initiatives will supply longer-running support for China’s financial sector. More productive infrastructure and increasingly stable capital markets will only increase profits and stability.

The good news doesn’t stop there. At the current juncture, several positives exist for China’s banking sector.

First, the broad sell-off in the Shanghai index disguises a huge bifurcation. Financials have lagged far behind other index constituents, but were much more resilient during the acute phase of the decline.

Relative to the rest of the Chinese market, bank shares are extraordinarily cheap. The top 20 financial holdings of Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-61) have a weighted average price/earnings multiple of just 12 versus the broader Shanghai Stock Exchange A Share Index at roughly 20.

Secondly, fears of a China property bubble have now receded. As we have argued, widely advertised crashes (as it was in the last few years) have a habit of not showing up. And, unlike America’s property boom, China’s was financed in large part through state-run banks, as opposed to a private banking system.

In a command-style economy, will China really allow their banks to go bust? Unlikely. Investors will have to wait for China’s “Minsky moment.” But success in stabilizing property markets should bolster confidence in bank asset quality and future profitability.

Thirdly, recent stock market declines have not been driven by any policy tightening. Rather, significant monetary easing by Chinese monetary authorities has steepened the yield curve. That’s a boon to banks, which become increasingly profitable when the spread between short and long rates widens.

To be sure, China’s micromanagement of the stock market has been somewhat shocking. The grab bag of policy measures designed to support the stock market run counter to Beijing’s aim of creating a liberalized financial system where market forces are given a larger role. That’s a big step backward. Further developments will need to be monitored.

However, heavy-handed intervention is hardly unique to China. The world’s monetary authorities have been underwriting risk and a virtuous cycle of higher asset prices for some time now. America has a “Yellen put,” the eurozone has a “Draghi put” and, not to be left out, China now has a “Xi Jinping put.” The era of market manipulation continues.

And if investors are looking for a transparent and well-functioning market, one exists. It’s called Hong Kong. Many of these listed shares have been indiscriminately sold off during the mainland’s slump. FXI provides exposure to the largest and most liquid Chinese companies listed in Hong Kong (with more than 50 percent allocation to financials). Or for a more concentrated approach, CHIX’s underlying constituents primarily comprise Hong Kong-listed shares, American depository receipts and global deposit receipts.


Confucius once said that "everything has beauty, but not everyone sees it." China may be today’s case in point. Investors have incredible difficulty making the leap that the paradigm is changing. Views of the future tend to rely heavily on the recent past.

Looking ahead, there is much work to do if China is to fulfill its strategic global ambitions (and stabilize the banking sector). Financial reform and opening China’s capital account will be a volatile process. Cyclical head winds are indeed present, and prophecies of doom will continue to plague China.

Yet this is the time to be investing in an unloved sector. In the coming decade, the world will have to reckon with China not as a rapidly growing export nation, but as a burgeoning financial power. The practical challenge will be to identify a broader range of both Chinese and non-Chinese assets that will be rerated due to China’s global objectives.

Tactical asset allocators should start with an overweight to the banks.

Tyler Mordy, president and co-chief investment officer of Hahn Investment Stewards, is a recognized innovator in the design and application of global macro ETF managed portfolios. He is widely interviewed by the financial media for his global investment strategy views, as well as ETF trends. CNBC has called him one of the “best independent ETF experts.” At the time of this writing, the author, along with his firm's clients, own FXI and ASHR.

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