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 is by K. Sean Clark, chief investment officer of Philadelphia-based Clark Capital Management.
I recently spoke on a panel hosted by S&P Dow Jones on the topic of the fixed income and equity markets in China. I’ll share some of my thoughts on China specifically, but first I’d like to address the larger opportunity we see playing out across the Asia-Pacific markets.
In the ETF space, the iShares MSCI All Country Asia ex Japan ETF (AAXJ | B-85) has exhibited relative strength globally. Furthermore, many of the countries in the region are exhibiting relative strength and strong valuations. In other words, they are advancing at a faster clip than their peers and they are relatively cheap—the best of both worlds.
The iShares MSCI South Korea Capped ETF (EWY | B-93) has been the biggest mover in the last six weeks among all the countries we monitor. It’s important to note that Samsung, which is not available for purchase via an ADR, accounts for 20 percent of the South Korea ETF. Samsung has helped support South Korea’s growth, but the high concentration of the company in EWY results in reliance on Samsung to perform. Also, the recent easing of the currency wars between China and Japan has helped South Korea’s currency—the won—stabilize.
The iShares MSCI Taiwan ETF (EWT | B-94) is another strong player in the relative-strength-at-a-discount market in Southeast Asia. Taiwan’s shared language, culture and history with China make it an excellent broader long-term play on Chinese growth. As with Samsung in EWY, there’s a high concentration of a single company in EWT, Taiwan Semiconductor, which makes up 23 percent of EWT.
As such, we tend to favor AAXJ for its broad-based, diversified exposure to Asia ex-Japan.
With an overall positive attitude toward the Asia-Pacific region, let’s delve into some of the specifics on China.
We think the Chinese stock markets have the potential to do well into the future for three main reasons:
- The favorable equity valuation (price-to-earnings multiples, or P/E, of the China offshore equity market
- The historic growth rate of the Chinese economy and expanding manufacturing and service PMIs, or purchasing
- The 50- and 200-day moving averages and relative strength of China, which look attractive when compared with their benchmarks
3 Important Factors
To an asset manager making allocation decisions in global markets, China stacks up well. There are three characteristics we believe are particularly appealing: First, there are clear catalysts for change; second, valuations are attractive on a relative and absolute basis; and finally, China has displayed good relative strength along with strong price trends.
As far as the catalyst goes, the Chinese government has shown a commitment to market liberalization, and more importantly, to globalization of the Chinese economy. With reforms to support private companies, liberalize markets and open the financial sector, the Chinese government intends to boost the market economy and strengthen the drivers of economic growth.
Starting May 1, the government will insure individual deposits of up to 500,000 yuan (about $81,000) at Chinese banks. By providing an explicit guarantee on bank deposits, the insurance plan paves the way for Beijing to liberalize deposit interest rates, allowing banks to compete more fiercely to attract new depositors.
At the same time, it will enable China's government to step back from its implicit promise not to let individual banks fail, injecting free market risk into the system. This deposit insurance is a key step toward curbing the moral hazard and widespread capital misallocation that characterize China's economy.
A Fast-Growing Economy
With gross domestic product of approximately $8 trillion, China is one of the world's fastest-growing economies, with growth rates averaging 9 percent over the past 30 years.
We maintain a view, which is largely the consensus view, that China will experience a gradually slowing economic expansion over the coming years as the government focuses on transitioning its economy from export driven to consumer driven. Even though China’s growth is slowing, its base has gotten so large that it will likely contribute more to global growth this year than when it grew at a double-digit pace 10 years ago.
The Chinese government already lowered growth forecasts from 7.4 to 7.0 percent, but said the 7.0 percent number would be difficult to reach. That’s the slowest growth in 24 years. Analysts are predicting something in the mid-6 percent range. Growth in the area of 6 percent would likely result in more stimulus and lower interest rates.
The second reason we like China is valuations. Emerging markets are trading at steep valuation discounts to the developed world. On a price-to-book value basis, they are trading at only 65 percent of the multiple of developed-world stocks. This 35 percent discount is the deepest in 12 years. As recently as November 2011, they sold at a premium.
Further, the market seems to think that the Federal Reserve has issued a reprieve on rate hikes. Its March meeting left the timing of a first U.S. rate rise dependent on data (which has looked weaker of late), and caused many to push back their forecasts for rising rates. Emerging market stocks have outperformed since the Fed news.
Asia’s economy is looking better, both in comparison to itself over the past couple of years and compared with the rest of the world. Within the region, Southeast Asia appears most attractive, with economies in that part of Asia generally growing faster.
In our opinion, China has the most favorable valuations in Southeast Asia and all of the emerging market.
Its earnings yield stands at 9.0 percent, its 10-year yield is 5.90 percent, with 7.3 percent GDP growth. That translates to a growth-adjusted relative valuation score of 10.4 (earnings yield – 10 year yield) + year-over-year change in real GDP). Only Norway scores higher on a growth-adjusted relative valuation measure. The U.S.’ is 5.3, or roughly half of China’s.
The Significance Of A-Shares
Due to capital and foreign-ownership restrictions, China remains underrepresented among global investors’ portfolios.
When you fully include A-shares capitalization in the emerging market indexes, China’s portion immediately jumps from 20 to 30 percent. MSCI will decide in the next 12 to 18 months whether to include A-shares in its EM indexes. If it does, this will be accomplished over a number of years, probably in 5 percentage point to 10 percentage point increments.
If so, this represents a huge, steady and growing passive demand for Chinese shares.
There are 50 or so companies listed in H-shares in Hong Kong and A-shares in mainland China. The A-shares of these companies sell at a 30 percent premium to H-shares. The premium has gone as high as 40 percent, and the lower end is 10 to 15 percent.
We think the key to thinking about this is that H-shares are undervalued, and if you believe in the China story, the H-shares look like good value, even though relaxing the foreign-ownership restrictions mostly benefits the A-shares.
Attractive Relative Strength
The third characteristic in China’s favor is good relative strength.
Investors evidently are continuing to adopt the expectation that the People’s Bank of China will deliver more policy directives in coming months and that the U.S. Fed will be cautious about its policy deliberations.
That has helped lead the markets higher. Asian stocks had their biggest quarterly advance since 2012 amid speculation that central bank stimulus globally will continue to support asset prices. The Shanghai and CSI indexes gained 15.9 percent and 14.7 percent, respectively, in the first quarter.
An A-Shares Bubble?
The rise in price of A-shares does seem a little bubble-ish recently. That seems to be the case even more so when considering that new, probably inexperienced and less educated retail investors in China are entering the market and opening trading accounts at a record pace.
Given the valuation analysis earlier between the H- and A-shares, this is one big reason we like investing in China via ETFs. Specifically, China ETFs give us the ability to access the emerging market with the most global impact and strongest growth potential.
In fact, we have a large overweight in China. In our international portfolios, we own 15 percent China versus 5.5 percent for the benchmark. In global portfolios, we own 6.75 percent China versus a benchmark weight of 2.5 percent. Our exposure is primarily in the SPDR S&P China ETC (GXC | C-35).
We like this ETF because it gives us good China exposure, access to the H-shares that we view as undervalued and, with an annual expense ratio of 59 basis points—or $59 for each $10,000 invested—it’s cheap compared with other choices. From a valuation perspective, it is attractive. The underlying index it tracks has a P/E of 11.77 with an estimated three- to five-year earnings-per-share growth rate of 17.35 percent.
When it comes to investing in China, the Asia-Pacific region or any emerging market opportunities, it’s important to recall that the S&P 500 Index and U.S. large-cap stocks have dominated the landscape for most of the last few years.
We think that the opportunities in Asia may represent a larger trend whereby the benefits of diversification finally pay off again for investors who adopt a diversified, long-term approach.
At the time of publishing, the author’s firm owned shares of AAXJ and GXC in client portfolios. Clark Capital Management Group is an independent investment advisory firm providing institutional-quality investment solutions to individual investors, corporations, foundations and retirement plans. Clark Capital was founded in 1986 and has been entrusted with approximately $3 billion in assets. For more information about Clark, contact Advisor Support at 800-766-2264 or [email protected]. Please click here for a complete list of relevant disclosures and definitions.