iShares CNYA ETF To Outperform Western Markets

100 Chinese Yuan. close up

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Investment thesis

The iShares MSCI China A ETF (BATS:CNYA) offers investors broad exposure to the Chinese market. Current geopolitical trends make for a favorable environment for the Chinese economy relative to the outlook for the Western economies, which are now embroiled in an economic confrontation with Russia. Even as surging commodities prices are pushing inflation in much of the Western World higher, into dangerous territory, China, as well as other major Asian economies, are benefiting from discounted Russian energy supplies, as well as other commodities that Russia sells, in addition to discounted Iranian and Venezuelan oil flows. Lower inflation will keep interest rates low, which will help to prevent costs of production from spiraling out of control, while profit margins will benefit, relative to companies that are mostly operating in the Western World. CNYA is therefore a compelling investment opportunity right now.

CNYA is an ETF that broadly mirrors the Chinese economy.

CNYA sectoral breakdown

CNYA sectoral breakdown (iShares)

As we can see, there is not a single sector that is overly dominant. Of note, real estate makes up a relatively small portion, which is important, given some recent worries about a bubble in the sector. Of course, the financial sector will be the most exposed if a significant crisis develops in the Chinese property market, and as we can see, the financial sector is the largest contingent within the fund. The Chinese financial sector could however benefit from other aspects of China’s economic dynamics going forward, as I shall explain.

Other facts of note in regards to this fund include the fact that it currently trades at a P/E ratio of 17, which is much cheaper than the S&P, which is currently trading at a P/E ratio of 25. There are potential factors that may justify a geopolitical risk discount, especially for foreign investors. It is something we have to increasingly consider, given the fallout we have seen for all who held Russia-related investments prior to the attack on Ukraine. If China were to ever move on Taiwan, which many people seem to think that it may only be a matter of time before it happens, CNYA investors would most likely get crushed, as is the case with most other China-related investments. Delisting is also always a possibility, as is the case with Russian stocks. Although, it should be noted that in such a scenario, most global stock indexes and the overwhelming majority of global stocks would suffer a major shock.

China’s economy is set to reap long-term benefits from its growing trade with Russia, including in discounted oil and other commodities

I have been pointing out for many years now the fact that Russia was in the process of pivoting away from the EU in terms of its energy and other exports, as well as other economic connections. The global center of economic gravity has largely shifted to Asia, which just a decade ago was only the third-largest economy measured by continents, while now it is in the first place, by a very wide margin. By my own rough estimate, it is set to surpass the entire Western World, in other words, the EU and North America combined by around 2030.

The current acceleration of Russia’s pivot to the Eastern markets, due to the Ukraine war and the resulting sanctions may serve to accelerate Asia’s rise to economic dominance over Europe and North America. Not only is the region set to receive far more Russian resources, which are increasingly crucial given the current sustained global commodities bull market, but it is currently receiving those resources at a discount. Russian oil for instance is trading at a roughly 30% discount currently and Asia is gobbling up more and more of it, with China being a growing new destination for that oil. Russia’s LNG shipments are also increasingly redirected to China. Other commodities such as Russian coal, fertilizers, agricultural products, and other goods and services are also set to continue flowing from Russia into China at a higher pace. Overall Russian exports to China surged by 31% in the first quarter of this year, compared with last year.

Because China is getting a significant share of its oil, gas, and other resources from sanctioned countries like Russia, Iran & Venezuela, its overall energy bill is increasingly getting cheaper compared with the price that is being paid in Europe as well as North America, and also in relation to some of China’s competitors in Asia, such as Japan & South Korea. India is also getting in on this, with growing imports of discounted Russian oil.

Inflation chart, US versus China

Inflation US versus China (Trading Economics)

Even as much of the world is faced with an increasingly aggressive inflationary environment, as we can see, China’s inflation has been rather tame in the past few years. Energy and other commodity costs, transport bottlenecks, as well as labor issues combined to create some scarcity, and upward inflationary pressures. An accommodative monetary policy, as well as high fiscal deficits, are also arguably contributing to sustained upward inflationary pressures in major economies like the US, EU, UK, and other mostly developed nations. Some developing nations like Turkey are already experiencing inflation rates that are self-sustaining and out of control.

China stands out in this regard, with low inflation rates. Some may argue that it is a deflationary trap, caused in part by the fact that economic growth has slowed dramatically compared with the average we saw in China over the last few decades. The argument may have some merit, except for the fact that even as China’s economy slowed dramatically to half the pace it was growing at in the past few decades, it is still growing considerably over the global rate of economic growth. It may seem like a stagnant economic environment when compared with the previous pace of economic growth, but with growth this year forecast to be around 5%, it is hardly a stagnated economy, especially within the context of a largely stagnated demographic dynamic. In other words, GDP/capita is still expanding at a very robust rate.

Between its electricity still coming from the domestic coal industry, which tends to be cheaper, its petroleum import bill being somewhat moderated by cheaper oil flowing from countries that are selling at a discount due to Western extraterritorial sanctions, China’s economy is facing less of an energy price pressure compared with many other countries. Rising natural gas imports from Russia, as well as a surge in food imports from the increasingly sanctioned major commodities exporter, are also playing a major role in keeping the price of energy and many goods under control, unlike what we see happening in much of the Western World.

It should also be noted that China is not known as the world’s factory for no reason. It does produce a lot of manufactured goods for its own needs as well as for export for consumers in much of the rest of the world. While here in the Western World we grapple with logistical issues such as port backlogs, which are also in large part responsible for an increase in inflation, China has no such problem, because the factories are right there, providing their retail chains with finished goods for consumer needs, as well as intermediary products for its industry. There are of course manufactured goods that China still has to import, but it is arguably less reliant on manufactured goods imports than we are. Its self-reliance in this regard, combined with the much more crucial lower-priced energy imports can provide China with a way to avoid the stagflationary trap that much of the Western World seems to be sliding into.

Investment implications

If China does not have to fight a slowing economy and inflationary pressures at the same time, as our governments and central banks are now tasked with doing, its business sector can arguably perform much better than ours in the coming quarters and years. In the US, Canada, the EU, and even in Australia, we are arguably faced with the tough decision of allowing inflation to continue spiraling out of control, risking having it take on a life of its own and become self-sustaining, or implementing measures meant to rein in inflation, which will have negative effects on the economy and also on the business sector’s real revenues as well as on profits.

While high inflation rates can make revenue growth and at times even profit growth look positive in absolute terms, in nominal real terms, revenues, as well as profits, are set to shrink, because companies can almost never pass on the entire cost of production increase. Most of the time, it becomes a tough balancing act, where prices are allowed to increase but not by as much as the costs of production. This tends to be the case, especially when the underlying factor tends to be a robust commodities price boom.

If we add in the stagflationary factor, in other words, not only is inflation rising but also consumers are cutting back on real consumption volumes as they increasingly feel squeezed by wages not keeping up with inflation, the Western World’s corporate financial results outlook can easily start turning dismal once we adjust for inflation.

As interest rates rise, pushing up the cost of servicing debts, the corporate sector is set to suffer another financial blow, on top of the tough business environment I described. As I pointed out in a recent article, the EU especially is vulnerable to experiencing a drastic fall in the relative value of the euro currency, which is set to greatly accelerate the commodities-driven inflationary trend in the EU economy. A weak euro can also drastically increase the cost of basic manufactured goods imports, which will further squeeze European manufacturers that depend on imported intermediary goods, retailers that sell a high volume of imported manufactured goods, and ultimately consumers. Overall, we are looking at a confluence of factors that has the potential to greatly and permanently diminish the real buying power of EU consumers. Most companies that are heavily reliant on the EU consumers as a customer base can see a dramatic decline in demand if things will shape up the way I foresee it.

Chinese companies on the other hand face a benign inflationary environment at home, even if it comes within the context of a slowing Chinese economy. Interest rates are not likely to rise in China as much as they will rise in the Western World, therefore the costs of servicing their debts are not as great of an issue. This is where Chinese financial institutions might benefit, given that they have a chance to charge interest rates on loans that are at least keeping up with inflation, which is not the case in much of the Western World, where banks are stuck collecting low interest on outstanding loans that were taken out in the past decade.

Costs of production are also not rising as fast in China as in the US or in Europe. And even as the Chinese economy grows at only half the pace it did in the past decade, it is still growing at perhaps double the rate of growth we are experiencing in the Western World. With Europe’s economy in particular set to further decelerate, even possibly falling into a deep recession, in part due to the fallout from the Ukraine conflict, China’s growth rate may far outpace that of the Western World this year and beyond. This means, that real consumer spending growth in China can still sustainably occur, even as consumer real spending in Europe and North America is likely to falter this year and beyond. It is overall a far superior business environment for Chinese companies compared with their Western peers.

CNYA should outperform most Western stock indexes within this context. It may take a while for investors to catch on to the trend, so the ETF may not respond to the financial performance instantly. As the superior position of China’s economy relative to that of its main global competitors becomes more obvious, the market should eventually react accordingly. As long as the current situation persists, I see positive trends for CNYA, which is why I decided to take up a small initial position in this ETF.

Risks

The main and most dramatic risks involved with this investment choice are geopolitical in nature. There is much talk of China potentially taking an adventurous approach to its One-China policy, in other words, it may decide to invade Taiwan at some point. As we have seen in the case of Russia’s invasion of Ukraine, the Western reaction has been dramatic, with very heavy-handed sanctions that did hit all foreign investors with exposure to Russian ETFs or individual stocks rather hard. As things stand right now, trading in most of those assets is halted and foreign investors are left in limbo.

The exact same thing could happen with all investment assets that are directly tied to China, whether individual stocks or ETFs, in case of a conflict between China and Taiwan. One could argue that China’s economy is about ten times larger than Russia’s therefore we would be less eager to go to economic war with China than we were in Russia’s case. Having said that, within the context of an already established commodities boom market, our sanctions on the world’s largest commodities net exporter are set to have an outsized effect on the global economy, which we are just starting to understand now, with growing worries of global shortages ranging from food, fertilizers, and energy, to neon & palladium, which could greatly impact the output of the global high-tech industries. And yet we still seem willing to not only prolong these sanctions but add to the existing economic pressures on Russia, even as the recent recovery of the ruble may suggest that beyond the initial short-term impact, those sanctions might end up becoming equally or even more damaging to those implementing those sanctions than they may end up being for the Russians in the long term.

The argument then might be that in the event of a Chinese military adventure against Taiwan, the Western World might act accordingly and impose the same kinds and intensity of sanctions on China as it did on Russia. The one probable outcome that might make such an outcome unlikely to play out is the fact that Europe especially will likely come out much-weakened economically in the aftermath of the current conflict in Ukraine, and the resulting economic confrontation with Russia. In my view, by this time next year, there will be very little appetite for further economic confrontations in Europe. None of these calculations will matter if China will not attack Taiwan, but the simple fact that there is such a threat in place will always keep the risk premium for CNYA higher.

Another major, more immediate, and the more real risk factor is China’s continued zero COVID policy. Recent data for Q1 GDP and other metrics suggest that China’s latest lockdowns meant to eradicate the spread of the virus through very aggressive population movement control measures did cost its economy dearly. Q1 GDP held up alright with 4.8% annual growth, but retail sales declined by 3.5% in March. International trade is set to suffer in the current quarter, which will most likely lead to a further deceleration in China’s economic growth. Any further aggressive lockdown measures in the future will further damage China’s economic trajectory and it could inflict permanent damage on its private as well as public sectors. There is always hope that China will abandon the zero COVID policy, which is increasingly out of step with much of the rest of the world. I suspect that at some point China will realize that the economic self-harm is not worth continuing with this approach.

There are other risks of note, including America’s increasingly aggressive efforts to contain China’s economic and technological rise. The takedown of Huawei was a perfect example of what a powerful tool the US, EU, and other developed economies have in countering China’s rise. At the same time, financial and tech sanctions are pushing major developing nations like China and its BRICS partners to seek more technological and financial independence or diversity of supplies. This may also end up becoming a long-term benefit for China and its continued economic expansion as more and more countries will no doubt seek an alternative to a Western-dominated global tech monopoly as well as our near-monopoly on the control of the global financial system.

As is increasingly the case, the risk factor is becoming something we need to become more and more accustomed to when weighing any investment choices. As I have been saying for some time now, we are in a period of transition away from the post-WW2 world order, which will be a theme that will dominate the current decade. We do not know what will be on the other side. The recent experience with the Russian situation may have prompted many investors to feel like retreating from developing world investment assets, mostly on geopolitical fears. As I pointed out in a recent article, most developed world stock indexes may struggle to provide average yearly returns that will keep up with inflation in the coming years. There may be higher risks involved when one is gaining foreign exposure, but it may be the only way for most investors to try to have their portfolio beat inflation this decade. The CNYA ETF has the potential to help investors to do just that.

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