Sticking to the Fundamentals
China’s economy had a strong first quarter with GDP numbers beating expectations, however, the recent trends are starting to tell a different story and a few issues of concern and the ongoing trade tiff with the US. Medium to long-term though the outlook for China remains bright with increased business activity and the recent inclusion to the MSCI’s benchmark index a vote of confidence.With May concluded we look at updates on various economic gauges to see how the world’s second largest economy is stacking up.
Ahead of the economic updates, the most salient development recently is the ongoing trade disputes with the US. This started out with a spark when US President Trump signed safeguard tariffs on washing machines and solar cells in January this year and exploded into a bigger issue when in early March, President Trump signed tariffs on imported steel and aluminium from nations including China.
The trade tiff has then proceeded to escalate with several flash points. Is this part of President Trump’s hard line negotiating tactics? Is this ultimately part of a plan to address the trade deficit and boost domestic employment? Perhaps so, but the back and forth continues to influence market sentiment. It is likely in our view, that there will be more ups and downs.
Pictured below is the recent meeting at Beijing held on 3 June 2018 with US Commerce Secretary Wilbur Ross (pictured left) and Chinese Vice Premier Liu He (pictured right):
Source: Reuters
Now looking at the most recent economic numbers and early data for the 2Q is suggesting that economic activity is starting to lose steam. This is due to a weakening property sector amidst the government’s campaign to curb housing prices in tier-1 cities.
However, it’s not all negative as there are some positive signs with Chinese Vehicle Sales accelerating 11.5% year-on-year from the March number (+4.7% yoy) despite reduced financial incentives to buy cars.
Another positive is that manufacturing output continues to perform well as per the latest report from China’s National Bureau of Statistics (NBS). Industrial Production expanded 7.0% annually in April and accelerated from the 6.0% rise in March. This result also beat the consensus expectation for a 6.4% increase.
Source: FocusEconomics, National Bureau of Statistics (China)
According to the report, most of the gains were driven by the manufacturing sector which ramped up its output to its fastest clip in 7 months while new orders hit an 8-month high.
Going forward, we expect this pace to be sustained considering the May data from Caixin Purchasing Managers’ Index (PMI) indicating that manufacturing continued to expand. The index showed that the PMI in May remained unchanged month-on-month at 51.1 – a measure above 50 indicates growth – as operating conditions have continued to improve each month for the past year.
Source: IHS Markit
According to the survey, new orders continued to flow in as client demand improved while production levels picked up incrementally. The only detractor this time around was that new export orders fell for the second month running, indicating that most of the buying was domestic. This, in our view, reflects the fears of a trade war with foreign buyers waiting on the sidelines until the dust settles.
That said, it is notable that inventory levels of finished items have dropped for the first time in 4 months indicating that local demand can sustain the declines from export orders. Furthermore, manufacturer sentiment remains optimistic that output will continue to rise given forecasts of rising client demand and the launch of new products. Industrial profits were also on the rise, up 15% year-on-year in April and accelerating from March’s 11.6%.
Another positive development for Chinese stocks was a landmark move by the Index provider, MSCI, last week when it included 226 large-cap A shares – which have historically been only easily available to Chinese investors – in the MSCI Emerging Markets Index. This index tracks over US$2 trillion worth of stocks or 85% of all emerging market equities in the region.
We see this as a highly positive development for equities in the region as this imprimatur indicates that Chinese equities are investible for global investors, at least at the structural level as MSCI keenly looks at whether the market is liquid, if investors can pull their money out and if there are appropriate forms of investor protection in place prior to inclusion.
This has been years in the making. The first step, however, was taken last year was when China improved market access for global investors by letting foreigners buy shares on the Shenzhen stock exchange.
However, the overall impact for now, in our view, is more symbolic as only 5% of the stocks’ market capitalisation are factored in and broken down in two phases: (i) the first was last week after the close of May 31 and (ii) the second on 31 August which will take effect on 03 September.
This means that A shares will initially represent about 0.39% of the weighting on the MSCI Emerging Markets Index in June before increasing in the second phase. In dollar terms, this impact is not substantial as capital inflows with the inclusion are estimated to be between US$18 and $22 billion whereas the A-share market has a market capitalisation of US$4.965 trillion as at 4 June 2018.
Going forward, after phase 2, China would comprise 31.3% of the MSCI Emerging Markets Index at 5% inclusion as of August 2018 (left panel) which combines both H- and A- shares. Provided China makes improvements in the structure of its equity markets, with a hypothetical 100% inclusion (which may or may not occur in the future), China would comprise a whopping 42% of the index, based on the current market capitalisation and would also include mid-cap stocks when MSCI expands the universe of eligible shares.
Source: MSCI website
Overall, the trends look positive for Chinese stocks as the economic transition in the world’s most populous nation makes for a compelling story, although the transition in China is unlikely to be a smooth one. We remain bullish on China over the medium-to-longer-term, however we note that the market remains volatile in the short term.
Accordingly, we retain a ‘HALF BUY’ on the China A-Shares for Members without exposure. This is as we continue to acknowledge that the Chinese market has a volatile backdrop with associated risks.
We recommend Members without exposure allocate half their normal position capital to this recommendation.
The Fund
The VanEck China A-Shares ETF (ASX:CETF) seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the CSI 300 Index (CSIR0300).
The Index is comprised of the 300 largest and most liquid stocks in the Chinese A-share market.
As at 1 June 2018, the fund had a Net Asset Value (NAV) of A$81.5 million with 303 positions. The Annual Management Fee remains at a very reasonable 0.72% and distributions are made annually at the manager’s discretion. The latest distribution amounted to A$0.666751 paid last 17 January 2018 giving a yield of circa 1.04% based on purchase cost of $64.21.
As at 30 April 2018 (latest fund report) the entire portfolio is in equities with a 1.3% position on leverage
. And looking at the breakdown, the ETF is concentrated mostly in large cap stocks with 90.98% (previously in September 2017 95.08%) in companies with a market capitalisation of greater than $5 billion, a 10.29% (previously 10.63%) allocation for stocks worth between $1 billion to $4.99 billion or mid-caps and a tiny 0.02% position to stocks with a market capitalisation of less than $1 billion.
Source: VanEck
Performance
The fund currently trades at a slight premium to NAV at $60.51 vs $60.34
(as at 1 June 2018). Given that the fund tries to replicate the benchmark it is expected that it will underperform the benchmark index slightly due to the impact of rebalancing costs, tracking error and the Annual Management Fee. Over the last year, the fund has returned 17% compared to the benchmark’s 20.4%.
We also note that the benchmark index is traded on the Shanghai and Shenzhen stock exchanges where overseas investors have just been recently allowed to invest, though since it is recent we still view the CETF is a strong proxy to benefit from the growing Chinese market over the medium-to-longer-term.
Source: VanEck
Sector Weightings
Since our last review in October 2017 (covering September 2017 updates), there have been some changes to the ETF’s allocation likely owing to the price movements of the underlying shares.
The most notable change we saw was with the Health Care sector exposure which rose 160 basis points in weighting to 6.6%. The sector is benefitting from an aging population and above average profit growth. The sector is also benefitting from faster approvals for new drugs and the rising incidence of diabetes, with only 15% of diabetes cases are being treated, compared to over 50% in developed countries. The fund is only marginally overweight here by 20 basis points relative to the index.
The ETF still has a significant weighting of 33.6% in financials (previously 36.8%) and has a 38.9% exposure if including real estate companies like how the index reports. This overweight position in the Chinese financial sector creates a certain level of concentration risk in the portfolio but we are comfortable with this given the financial system is one of the fundamental building blocks for the nation’s economic development. The ETF is only marginally overweight here as well with 70 basis points more (including real estate) than the index.
Source: VanEck
The fund also has significant exposure to the Industrials and Consumer (both discretionary and staples) sectors with a third of the portfolio allocated to those sectors. Over the longer term, these sectors are likely to benefit from China’s shift into a more consumer-centric economy from the previous manufacturing-export-investment based economy. The ETF is overweight here by 30 basis points relative to the index.
We also hold the view that the consumer sectors (both staples and discretionary) are likely to be significant beneficiaries of rising household income and as such we are happy with these combined sector weightings making up 19.2% of the portfolio.
Another interesting difference we see is the higher weighting in the IT sector with a 120-basis point overweight to the Index at 9.2% (previously 9.6%).
The increasing focus of the government on high tech over the foreseeable future has led to the shares (and likewise weightings) to appreciate and we believe this gap is mainly due to rebalancing taking more time.
The smaller allocations are to utilities (2.7%), energy (2.4%), and telecom (0.7%).
Top 10 Holdings
The China A-Shares ETF’s current top-10 portfolio holdings are shown below. The top 10 holdings make up 23.88% of the fund’s net assets at end of April 2018, with this comparing to 23.51% as at 30 September 2017 in our previous coverage.
The fund remains well diversified at the stock level, with no single investment exceeding five percent of the total fund value, stemming from the replication style of the fund.
Source: VanEck
There haven’t been any significant changes to the underlying index since our last review, except for some re-ranking. Specifically, the most notable change is the inclusion of Citic Securities into the top 10, replacing China Vanke in the latest round of the fund’s rebalancing.
Summary
The latest economic data shows that China’s economy has maintained much of its momentum and built further on a strong start to the year. The economy is successfully transitioning towards one that is less reliant on credit and investment to sustain its elevated growth and is instead spurred on by domestic consumption. That said, trade tensions between China and the U.S., fears of abrupt financial deleveraging and a cooling housing market threaten to derail an otherwise still robust growth trajectory.
Although the economic transition in the world’s most populous nation makes for a compelling story, the reality is that the transition in China is unlikely to be a smooth one. We remain bullish on China over the medium-to-longer-term, however we note that the market remains volatile.
Accordingly, we retain a ‘HALF BUY’ on the China A-Shares ETF (ASX:CETF) for Members without exposure. This is as we continue to acknowledge that the Chinese market has a volatile backdrop with associated risks.
We recommend Members without exposure allocate half their normal position capital to this recommendation.
