China ETFs Surging Ahead Of Trade Deal

The market seems to think the U.S.-China trade war is coming to an end. Since bottoming out at the end of last year, Chinese stocks have roared back on hopes the year-long trade war could be resolved soon.

On Monday alone, the $1.6 billion Xtrackers Harvest CSI 300 China A-Shares ETF (ASHR), which tracks mainland Chinese stocks, surged 6.3%, bringing its year-to-date gains to a hefty 25.8%. The move followed news that President Trump had delayed a scheduled hike in tariffs on Chinese exports to the U.S.

ASHR YTD Performance

The U.S. has made “substantial progress” in trade talks with China, Trump tweeted. Therefore, “I will be delaying the U.S. increase in tariffs now scheduled for March 1. Assuming both sides make additional progress, we will be planning a summit for President Xi and myself, at Mar-a-Lago, to conclude an agreement,” Trump added.

On the surface, the president’s optimistic tone makes it seem like a trade deal with China is likely to be clinched by next month. But is that truly the case? And if so, what form will the trade deal take, and what will the lasting impact be on Chinese stocks?

Trade Deal Likely

Most analysts tend to agree that some sort of trade deal with China is likely this year, though there’s disagreement on the details.

“A trade deal is very likely given that both the U.S. and Chinese economies are weak, and both leaders are under pressure to get a deal done,” opined Jay Pelosky, CIO at TPW Investment Management. He expects a deal to be struck relatively soon, because the impetus for a deal is significant, and “a lot of the heavy lifting has been done.”

Gregory Daco, head of U.S. Macroeconomics at Oxford Economics, agrees that a deal is more likely than not. He pegs the odds of a deal in the next month at 60%, and the odds of a deal in the next three months at 75%.

“The deal will involve promises by China to import more goods from the U.S., address intellectual property rights and maintain a stable currency,” Daco explained.

Will It Have Teeth?

While a deal seems likely, whether or not that agreement eliminates current tariffs on $250 billion worth of Chinese exports remains to be seen.

Daco expects existing tariffs to remain in place. On the other hand, Brendan Ahern, chief investment officer at Krane Funds Advisors, believes there is a high probability they could be eliminated if important issues related to intellectual property and joint ventures can be solved.

Of course, whether those tough issues are adequately resolved is what will be most closely scrutinized to determine who “won” in the trade war.

Pelosky believes both countries can end up winners, since the U.S. is asking China to do what is in its best interest anyway, such as rebalancing its economy more toward consumption.

But not everyone is convinced that the deal will have teeth. Hao Zhou, senior emerging markets economist at Commerzbank, said that China “will probably agree to buy more stuff from the U.S. and lower the barrier for farm goods imports,” but really meaningful structural change to its economy is unlikely. Additionally, Zhou notes that any pact will be fragile given the unstable U.S.-China relationship.

China Stocks To Benefit

Regardless of what the final form of any potential U.S.-China trade deal takes, one thing that is fairly certain is that the resolution of this bitter saga will be a net positive for the Chinese economy. Does the same hold true for Chinese stocks—especially since they’ve jumped so much already?

KraneShares’ Ahern and TPW Investment’s Pelosky think the rally may just be getting started.

“I believe China is on the cusp of a structural bull market as the economy bottoms, companies generate double-digit EPS [earnings per share] growth off a low valuation base and foreign interest grows as both equity and debt become bigger parts of global benchmarks,” Pelosky said.

Meanwhile, Ahern says that even though Chinese shares have jumped sharply so far this year, valuations for both Hong Kong and mainland stocks are still low, with price-to-earnings ratios of 11 and 14, respectively.

If the economy and earnings accelerate as he imagines, those P/E ratios could decline, keeping Chinese stocks cheap even as they rally.

Potential Catalysts

That said, after such a sizzling start to the year, a pullback or at least some consolidation in China stocks wouldn’t be surprising.

Pelosky says a classic buy-the-rumor, sell-the-news type of action could occur once a trade deal is struck, but he’d use that as an opportunity to accumulate positions in China ETFs, which are still down 10-20% from their highs of last year.

Ahern adds that there are two catalysts that could keep any pullback in China shares short-lived: the annual Two Sessions policy meetings in March, where potential further tax cuts and stimulus could be announced; and an increase in China’s weighting in MSCI indices.

“MSCI is adding 235 Chinese A-shares, but is adding their market cap incrementally,” Ahern explained. “I believe the inclusion factor will be raised from 2018’s 5% to 15% in 2019. I also believe they will add ChiNext stocks in 2019 and midcaps in 2020.”

Email Sumit Roy at [email protected] or follow him on Twitter sumitroy2