FXI: China In 2023? Yes, Please

Summary

• Chinese equities (FXI) have performed well recently. While it may make sense to be cautious, I see continued gains ahead in 2023.
• With recession fears plaguing the U.S. and the E.U., China offers a recovery story. That entices me as a developed world equity hedge.
• There is a lot of bullish momentum and investor interest in this space. This could help deliver more upside.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

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Main Thesis & Background

The purpose of this article is to discuss the iShares China Large-Cap ETF (NYSEARCA:FXI) as an investment option at its current market price. This is a fund with an objective to "track the investment results of an index composed of large-capitalization Chinese equities that trade on the Hong Kong Stock Exchange". Thus, this is a good way for U.S. investors to own exposure to large Chinese companies.

As my followers know, I am predominately a U.S. and developed world investor. But Asia, specifically China and India, are areas where I see a lot of potential in the years to come. This was a story I told in Q2 last year, when I suggested buying FXI made sense. Since that review, this ETF has vastly out-performed the S&P 500, vindicating this "buy" call:

Fund Performance (Seeking Alpha)

Given this backdrop, it makes sense to re-evaluate FXI to see if buying it still has merit here. I believe it does, driven primarily by the re-opening story and its usefulness as a hedge against domestic equities. While geo-political risks concern me, that is part of the challenge of investing in any EM region, China, or otherwise. Therefore, I believe a "buy" rating is the right move for 2023, and I will explain why in detail below.

A Little Clarity First

Right out of the gate I want to manage expectations. This is not meant to be contradictory because I will stand behind my bullish call in this review. But I want to emphasize that the market as a whole has been rallying lately, with Chinese equities leading the charge. This means investors who are perhaps new to this space would probably be wise to ladder in, or at least start small. It is unlikely such broad market strength is going to last uninterrupted, so be smart with your purchases going forward.

The reason for this disclaimer is because during the past three months almost everything has been rallying! But one sector theme that stands high above the rest is Chinese equities:

Recent Performance (Various Sectors) (Bloomberg)

There are two ways to look at this. One is that the gains are overblown and a sharp correction is coming. I would push back against this narrative because Chinese equities had seen a massive drawdown going in to this rally. So the sector is not really an expensive one despite rising 60%. Two, the gains are supported by the re-opening story (more on that below). While I wouldn't expect another 60% gain from here, the point is that stocks are rising for valid reasons. As long as that dynamic remains in place, a buy rating makes sense.

The Re-Opening Story Is A Big One

A key reason for my bullishness here is the recovery story for China. This is in stark contrast with my developed world view - where I expect both the U.S. and the EU to enter recessions later this year. I am using Canadian equities as a hedge, where the recessionary outlook is more unclear. But the bottom-line is my traditional equity positions will be facing some pressure in the later stages of 2023.

By contrast, China looks set for strong growth. This is due to the ending of a strict zero-COVID policy that resulted in lockdowns that depressed China's economy last year. This led to protests and an eventual easing of some of the world's toughest restrictions a few years after the pandemic began. The expectation of a return of growth in China has raised my expectation for gains in equities in that territory, and are largely responsible for the rapid rise in share prices these equities have already been enjoying of late.

Of course, the Chinese are not out of the woods yet. The government could re-institute lockdowns again and growth may not turn out to be quite as strong as hoped. But even with rising COVID infections recently, Chinese consumers are re-emerging. They are starting to travel and spend again, and this is boosting sentiment across the country and in investor's minds. Supporting this sentiment are metrics that show metro ridership is up, Tech confidence has rebounded, and property prices are rising again:

Chinese Economic Metrics (World Bank)

What this shows to me is that there are macro-forces at work that signal the recovery is taking hold. These show discretionary areas like travel, Tech, and property investment are re-emerging. This is good news overall, and especially for FXI, since the fund is heavily weighted towards discretionary sectors:

FXI's Sector Exposure (iShares)

The simple fact is I view this entire backstory positively. It bodes well for the Chinese economy and for Chinese-oriented investments. Therefore, I see merit to owning FXI going forward.

By Comparison, There Are Worrying Signals Domestically

The next topic regards relative value. The key for me in buying any foreign investment - Chinese stocks or otherwise - largely rests with how I view domestic assets. My portfolio is always U.S.-centric, but I shift resources to foreign stocks when I see a favorable relative proposition. This scenario exists right now, in my opinion, with respect to China. But it is important to understand the why in how I got here.

Primarily this concerns earnings. While U.S. stocks have also had a great 4-6 weeks, corporate earnings for large-cap U.S. companies have been mixed. Worse, earnings revisions for 2023 keep on getting lowered. This means analysts see trouble ahead in the next few quarters while at the same time stock prices are rising. That is not a good dynamic.

This concern is amplified for me at the moment because earnings estimates are sharply down for the calendar year. To be fair, they have been declining consistently for the past 6 months, but the most recent revision was the worst yet:

S&P 500 net earnings revisions (FactSet)

This is key to why I am shifting to a more neutral outlook for U.S. stocks currently. Similarly, this earnings story is consistent across much of the developed and emerging market world as inflation and high interest rates take their toll. By contrast, the consensus on China is earnings are going to grow markedly in 2023:

Earnings Estimates - 2023 (Goldman Sachs)

I should reiterate we need to take estimates with a grain of salt. A lot can happen to change expectations from becoming reality. But I think there are good reasons why this disparity exists - such as the re-opening theme I discussed above. At the very least, the Chinese economy is at a different place in the business cycle than the West (U.S. and Europe) and that gives it merit as a hedge. Perhaps the U.S. and EU will out-perform and beat expectations this year. If that occurs, great, but that doesn't mean China will not also have a good year. That is why I think FXI still looks good.

Fear Of Missing Out?

The last topic to focus on is that "China" is becoming a trending play with non-Chinese investors. For perspective, foreigners are returning to China’s stock market in a big way, buying more shares in January (as of 1/30) than they did for the whole of 2022:

Foreign Inflows & Outflows Into Chinese Shares (Yahoo Finance)

As with most attributes, this can be interpreted in a couple ways. One would be the contrarian method - which is what I usually prescribe to. The logic here would be that if everyone is rushing into this sector that it isn't the place to be. The other side of the coin is that this could spark a FOMO rally that continues for a while. I believe this is what will be the case, as the strong performance of late is going to bring in retail and professional investors who don't want to miss out on a major winning theme of the year (it is hard to explain that to clients!).

Supporting this idea is that Chinese equities were out of favor for a while. Last year saw quite a bit of back and forth with respect to inflows and outflows. So it isn't as if this sector has been running on peak optimism for a long time. While any short-term burst could be ripe for a correction, I think the fundamental story is positive enough that more cash is going to flow in to China. Investors are often overweight in their home country, and when looking for non-domestic exposure they may feel partial to the recent trend. China is that trend currently, so I will more gains ahead in Q1.

Bottom-line

Large-cap Chinese equities had a rocky 2022 overall. This made investments in FXI volatile by extension. Yet, looking back, when all the dust had settled, this turned out to be a winning play. Losses were big at some points, but over the past nine months FXI has delivered a double-digit gain while the S&P 500 has simultaneously dropped. This relative performance speaks to the usefulness of this ETF as a hedge for U.S.-focused investors.

Beyond just past performance, I see some bright spots ahead as well. The Chinese economy is re-opening and growing at a time when other parts of the world are expected to see economic growth slow. Further, earnings estimates across the country are anticipated to grow sharply. This is always a positive, but it is especially beneficial now when earnings estimates are on the decline in other parts of the world. As a result, I think a "buy" case for FXI still exists. I would recommend readers give this idea some thought as we push deeper into the new year.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in FXI 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.