EWH: Hong Kong’s Success In Fighting COVID-19 Could Result In A Strong Return For Investors (NYSEARCA:EWH)

COVID-19 was the primary driver of stocks across the globe for most of 2020. While the virus will have a material impact on the global economy, some countries will fare better than others. Hong Kong appears to be one of the countries where COVID-19’s impact will be more limited. If Hong Kong is successful in containing the virus, the iShares MSCI Hong Kong ETF (EWH) could generate a very attractive return since Hong Kong’s price-to-earnings (P/E) multiple is at its lowest level since the Great Recession.

COVID-19 Exposure

A country’s exposure to COVID-19 is probably the most critical short-term factor in allocating investments to specific countries, and the virus’s direct impact on Hong Kong has been more limited than in most countries. Only four people in Hong Kong have died from COVID-19. The below chart shows Hong Kong has a lower rate of known COVID-19 infections than almost all the industrialized nations. Hong Kong has also tested a greater portion of its population than all of the countries listed except Italy, Germany and possibly China, which has not provided data on citizens tested. The combination of a low rate of known infections and high testing rate means Hong Kong should fare better than most countries.

Known COVID-19 Cases as Percentage of Total Population

Source: www.worldometers.info/coronavirus

Ending Civil Unrest

One side effect of COVID-19 in Hong Kong is the end of anti-government protests that led to civil unrest, an armed response from Hong Kong’s government and a recession. The protesters were rallying against a proposal that would have made it easier for Hong Kong residents to be extradited to mainland China. While the protesters’ goal may have been laudable, it hampered economic activity in Hong Kong. According to the BBC, the protests caused Hong Kong’s economy to fall into a recession in 2019.

Fiscal Aid Related to COVID-19

Fiscal aid to blunt the economic damage inflicted by COVID-19 is probably the second most important short-term factor to consider in allocating international investments within a portfolio. Despite having a significantly lower infection rate than most advanced economies, Hong Kong’s government has been aggressive in responding to the virus. Hong Kong has executed three rounds of aid totaling HK$287.5 billion (U.S. $37.1 billion). Hong Kong’s aid averages U.S. $4,979 per citizen compared with $6,703 per citizen for the CARES Act, but the virus has disrupted more economic activity in the U.S. The structures of the aid packages are similar with most of the aid directed toward businesses in an effort to minimize layoffs.

Stable Currency

The Hong Kong Dollar has been one of the most stable foreign currencies for U.S. investors. Unless a fund is hedging its foreign currency exposure, it is always important to consider the stability of a foreign country’s currency; however, this issue has become increasingly important due to the uncertainty created by the coronavirus.

The Hong Kong dollar is one of the few currencies that have appreciated in 2020. Data from OANDA shows the Hong Kong dollar has appreciated 1% in 2020 compared with depreciation of 3% for the Euro, 5% for the British Pound, 8% for the Canadian Dollar, 11% for the Australian Dollar, and 25% for the Mexican Peso. Furthermore, the Hong Kong Dollar has traded within a tight range for several years around its exchange rate of HK$7.75 to one U.S. Dollar.

Macroeconomic Landscape

The International Monetary Fund’s (IMF) World Economic Outlook for 2020 predicts Hong Kong’s economy will report a milder contraction than most advanced economies. The favorable comparison stems from two reasons. First, Hong Kong faces softer comparisons in 2020 due to the impact protests had on economic activity in 2019. Second, Hong Kong has been aggressive in identifying and isolating people who are infected with COVID-19, which has allowed the government to refrain from imposing strict stay at home orders as many states in the U.S. have. For example, restaurants remain open albeit at 50% capacity. Science Magazine published an article explaining what they call Hong Kong and Singapore’s “Suppress and Lift” strategy.

Real GDP Growth in Local Currency

Source: International Monetary Fund World Economic Outlook April 2020

Corporate Earnings

The IMF’s projections for real GDP growth are a top-down assessment of economic conditions in countries. Thomson Reuters’ compilation of analysts’ estimates for corporate earnings provide a bottom-up assessment that supports the IMF’s view that Hong Kong’s economy will perform better than most advanced economies. The reasons for the relative outperformance of 2020 corporate earnings in Hong Kong is the same as its relative outperformance of real GDP growth. The disruption created by protests in 2019 will make comparisons in 2020 easier, and the government has been more effective at battling COVID-19, which has allowed them to refrain from imposing strict stay at home orders that dramatically reduce economic activity.

Analysts’ Estimates of Corporate Earnings Growth

Source Thomson Reuters

Valuation, Conclusion and Antithesis

EWH seems like an appropriate fund for investors who believe the COVID-19 virus will have a more limited impact on Hong Kong than other countries. The Hong Kong Dollar has been more stable than most foreign currencies, which should mean less risk of unfavorable currency movements for EWH investors.

Hong Kong companies are trading at their lowest P/E multiple in over a decade. The decline in valuation reflects a combination of the impact of last year’s protests and the uncertainty created by COVID-19. However, Hong Kong still looks cheap to investors who believe the estimates compiled by the IMF and Thomson Reuters. The Wall Street Journal estimates the S&P 500’s P/E multiple is 22 based on firms’ earnings in the past year. Hong Kong typically trades at a lower P/E multiple than the S&P 500, but the current difference of 11 is significantly greater than the historical gap.

Price to Earnings Multiple for Publicly Traded Firms in Hong Kong

Source Thomson Reuters

The chief antithesis to investing in EWH is the tremendous uncertainty created by COVID-19. The IMF’s projections and Thomson Reuters’ compilation of analysts’ estimates for corporate earnings suggest a quick bounce back once economies reopen. This bounce back would contradict John Maynard Keynes’ view that economies slowly return to equilibrium after an adverse shock even with fiscal and monetary stimulus. The bounce back scenario also seems unlikely if the downturn is more severe. During a recent earnings call, JPMorgan Chase CFO Jennifer Piepszak stated that Chase’s economists now expect GDP to decline 40% and unemployment to reach 20% in 2Q20.

Investors interested in allocating funds to Hong Kong could mitigate some downside risk by executing a covered call. For example, an investor could have bought EWH for $21.67 at the close of trading on Friday, April 17 and received a premium of $1.67 for selling a call with a strike of $21 and an expiration of Dec. 18, 2020. This position would generate a profit of 4.6% as long as EWH remains above $21. The investor would still break even if EWH declined to $20.07, which would be a decline of more than 7% from Friday’s price.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EWH over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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