Ignore The Media And Buy China On Trade Deal Rumors

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Includes: BABA, FXI, MCHI, TCEHY
by: First Floor Finance
Summary

The media is taking no news as bad news and China headlines have become increasingly negative.

There has been an overreaction in the market and China looks cheap.

China's leadership has motivation to get a deal done given recent weak GDP growth projections and their goal of economic stability.

Use MCHI to get cheap, broad exposure to Chinese companies.

Introduction

Saying China has been in the news a ton lately would be an understatement. Over the past two years it’s hard to go a day without hearing a story about trade relations between U.S. and China. Since the “Trade War” began, China’s stock market has significantly underperformed the U.S., as you’ll see in the chart below.

Chart Data by YCharts

As uncertainty continues to stir surround the U.S. and China trade relationship, now is a good time to buy a broad China ETF, specifically the iShares MSCI China ETF (MCHI).

MCHI Details

The iShares MSCI China ETF tracks a cap-weighted index of investable Chinese shares and stretches across all market-cap sizes. With an expense ratio of only 0.59% this is one of the most cost effective ways to get broad exposure to Chinese securities.

One major concern with investing in emerging market securities is getting good pricing on your transactions. There’s nothing to worry here. As you can see from the charts below, MCHI’s premium/discount typically hovers around 0.00% and its spread is fairly consistent around 0.016%.

(Source)

Why the Opportunity Exists

The media is currently suckering investors and markets into believing talks between China and the U.S. are souring or moving slower than expected. I would be so quick to buy what they’re selling, as we’ve seen this before.

Only a few short weeks ago during China’s Lunar New Year, due to a lack of news given the holiday, some media outlets began to focus on negative data points to produce headlines and garner attention. We say a flurry of negative stories surrounding the US-China trade discussions, but it is clear now that progress occurred during this period.

What’s happening now? Well China is currently involved in its biggest parliamentary event of the year, the People’s National Congress. It started earlier this week and runs for the next 10 days. All the major party members and decision makers are tied up with the event, so unexpectedly, there’s been a lack of headline news out of China. Classic case of no news becoming bad news.

Why you Should Take Advantage

If you can ignore the sensationalized headlines and focus on what’s really going on, you’ll find some details that run contrary to what is currently being published. For example, earlier this week the Wall Street Journal reported that as part of the Chinese government’s communications to the public today regarding their economic plans, the controversial “Made in China 2025” language was surprisingly nowhere to be found.

“During a nearly 100-minute speech to China’s legislature Tuesday, Premier Li Keqiang dropped any reference to the plan that the Trump administration has criticized as a subsidy-stuffed program to make China a global technology leader at the expense of the U.S. The policy had been a highlight of Mr. Li’s State-of-the-Nation-like address for three years running.”

This is an important development. “Made in China 2025 is (or was) a big initiative by China’s government to move away from being the world’s leading producer of cheap goods to producing goods of higher value. Also, the government wanted the nation to produce and consume more of its own goods by 2025, reducing its dependency on foreign entities.

This policy isn’t inherently bad, and while it makes complete sense for an economy that has become the second largest in the world and wants to dominate the planet, it is not hard to imagine why the U.S. would take issue with it, given that the U.S. is actively seeking to negotiate better terms for its companies doing business with China.

In my opinion, the removal of this messaging shows China’s government is sending a clear message that it’s sincere in its desire to complete a trade deal that satisfies all parties involved.

And, if you’re looking for another sign, U.S. Secretary of State Mike Pompeo, who has made it a point to stay out of the spotlight during these negotiations, told farmers in Iowa earlier this week that a trade agreement could be reached in a only a couple weeks from now.

China's Recent Economic Numbers

Another reason why China is likely ready to deal is somewhat weaken economic data. Reduced domestic demand and the aforementioned trade war with the United States contributed to China’s economic growth reaching its lowest point since 1990. China is targeting 6 to 6.5 percent of growth in 2019, which is the first time the number has been ranged bound, and less than the 6.6 percent GDP growth the country reported in 2018.

This disappoint growth numbers are a concern, but Premier Li Keqiang outlined some policies that should help spur growth. Li said China’s fiscal policy will become “more forceful.” The government plans tax cuts of about 2 trillion yuan, which translates to about $298.3 billion in taxes and fees for companies.

Li went on to say that Beijing will increase cuts in reserve requirements for smaller and medium-sized banks with the goal of boosting lending to small companies by large banks. To boost infrastructure investment, China’s finance ministry raised the special bond issuance quota for local governments to 2.15 trillion yuan from 1.35 trillion yuan in 2018, according to Reuters.

China’s government cares deeply about political stability and understands one of the easiest ways to disrupt that is an economic downturn. They’ll do everything in their power to keep the economy moving in the right direction, and one of the easiest ways to do that would be a completed trade deal with the United States. Their motivation to get a deal done and their move to more accommodating fiscal policy presents a buying opportunity for broad China exposure. Take advantage of the recent market overreaction.

Risks

Unfortunately, no one really knows what’s going to happen with the US-China trade negotiations. Add in someone as volatile as Donald Trump, and the perceived progress that’s being made could all be unraveled in a second. This would be bad for China (and likely the U.S. too). I believe a deal being reached is much more likely than the market is pricing in, but the alternative is always a possibility.

Also, MCHI holds large positions in Tencent (OTCPK:TCEHY) and Alibaba (BABA) at 14.4% and 13.9% respectively. If you already have exposure to these names, this investment might not make sense in the context of your entire portfolio and could expose you to some company-specific risks.

Why MCHI Over FXI

You should use MCHI over the iShares China Large-Cap ETF (FXI) for two main reasons. The first is that MCHI is 20% cheaper to own than FXI, while this wont make much of a difference if you're planning a short-term trade, over the long-term this cost difference can be a huge drag on fund returns.

The second reason is MCHI is much more diversified than FXI. FXI only holds 77 different securities compared to MCHI's 317. You're getting much broader exposure to China's market through MCHI, which is the point of this trade. We're not trying to pick which individual securities will increase.

Author's note: Thanks for reading! If you enjoy daily financial and investing content follow me on Instagram @FirstFloorFinance. I enjoy interacting with my followers so feel free to comment or shoot me a message!

Disclosure: I am/we are long TCEHY, MCHI. 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.