By Jeremy Schwartz
China, China, China. During the last nine months, the market's volatility and cues are all stemming from data coming out of China. This even includes testimony from the Federal Reserve (Fed) chairman, Janet Yellen, who apparently is tailoring U.S. monetary policy to global growth concerns that have emanated from China.1
Investors are especially anxious that a slowdown in China's economy may lead to policy missteps and a large currency devaluation that could send shockwaves of deflation pressure around the globe and touch off currency wars across Asia.
We do not believe China intends to spark an Asian currency war, WisdomTree Japan CEO Jesper Koll has written. Rather, we see China working toward its long-term goal of making the yuan Asia's reserve currency of choice-and to achieve that goal, it most likely will defend the yuan as a strong and stable currency against a basket of its trading partners. In contrast to U.S. politicians who think China is manipulating its currency too low, we see China actually intervening to keep its currency stable. Why?
China Is No Longer Powered by Exports
China's economy is shifting toward a consumption- and services-based economy, not one powered by infrastructure and investment-led growth.
The vast majority of what China produces for industrial output is actually consumed in China.2 This is one of the reasons we see China's interest in keeping a stable currency. Over time, imports to China are going to play larger role, and a strong currency will give the country's consumers more purchasing power.
The Old vs. New Economy in China
With these long-run economic goals in mind, it is worth asking if investors in Chinese equity markets are positioned appropriately.
Traditional indexes (and the popular China equity exchange-traded funds [ETFs] that are designed to track them) largely comprise state-run banks, communication stocks and energy companies. In fact, about 75% of the traditional index3 is made up of state-run companies.
Old-Economy Domination by State-Run Banks: FTSE China 50 Index
WisdomTree believes these old-style indexes are not at all positioned to capitalize on China's economic rebalancing initiatives.
The growth in China's economy is better represented by a consumer-oriented or service-led economy. Those are companies in the technology sector (such as Alibaba (NYSE:BABA), JD.com (NASDAQ:JD) and Tencent (OTCPK:TCEHY)), automakers (Great Wall Motors (OTCPK:GWLLY)) or travel and tourism companies (Ctrip.com (NASDAQ:CTRP)).4
The WisdomTree China ex-State-Owned Enterprises Index was designed with this theme in mind.
Removing the traditional state-run companies5 leaves a very different sector profile of the Chinese markets. Technology and consumer sectors dominate (making up almost two-thirds of exposure), compared to the traditional index focus on large banks and energy companies.
New Economy: WisdomTree China Ex-State-Owned Enterprises Index
Since the inception of this Index, now just about hitting its one-year-live anniversary, the relative performance difference versus the major China indexes has been rather large. Click here for the standardized performance of the WisdomTree China ex-State-Owned Enterprises Index.
Reallocating to China
China has been a source of global concern, but we believe much of the anxiety over the currency devaluation is misplaced. If you share our view that China will remain committed to growing its consumer-driven economy, we believe the WisdomTree China ex-State-Owned Enterprises Fund, (NASDAQ:CXSE) which is designed to track the performance of the WisdomTree China ex-State-Owned Enterprises Index discussed above, could be one of the best positioned vehicles for rebalancing the Chinese economy away from infrastructure and toward consumption and services.
On a tactical basis, one argument for repositioning now is that many investors in legacy China positions are likely facing a loss-with the sell-off in China over recent years. The time could be ripe for tax-loss harvesting out of those older positions into a strategy that is better positioned to reflect China's economic growth goals going forward.
- Howard Schneider and Lindsay Dunsmuir, "Yellen: Fed Not Likely to Reverse Course on Rates Despite Risks," Reuters, 2/11/16.
- Andy Rothman, "What to Trust? Measuring the Chinese Economy," Sinology, 3/8/16.
- Traditional index: Refers to the FTSE China 50 Index universe, as of 3/31/16.
- For current holdings of the WisdomTree China ex-State-Owned Enterprises Index. For current holdings of the WisdomTree China ex-State-Owned Enterprises Fund.
- State-owned enterprises: Government ownership of more than 20% of outstanding shares of companies.
Important Risks Related to this Article
There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. The Fund focuses its investments in China, thereby increasing the impact of events and developments associated with the region, which can adversely affect performance. Investments in emerging or offshore markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. The Fund's exposure to certain sectors may increase its vulnerability to any single economic or regulatory development related to such sectors.
As this Fund can have a high concentration in some issuers, the Fund can be adversely impacted by changes affecting those issuers. Please read the Fund's prospectus for specific details regarding the Fund's risk profile.
Jeremy Schwartz, Director of Research
As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.