Beginning in late 2019 through the first half of January, stocks in Asia (excluding Japan), led by the Chinese market, rallied, outperforming most other equity markets. However, the region is now challenged by the spread of a new coronavirus originating in China.
With an exponential increase in the number of infected cases in China and cases spreading to a number of countries around the world, this is clearly a major public health concern. The increasingly strict measures being taken to minimize the proliferation of the disease mean that the economic effects of this outbreak will be significant, most directly in China but also in Asian emerging markets. The full effects on global growth will not become clear until the extent and duration of the outbreak is known. This uncertainty presents significant downside risks to economic growth and to the Asian equity markets.
Thus far the rally in Asian stocks that was so strong early in January has experienced a relatively modest drawback, suggesting that investors expect the economic effects of the virus outbreak to have only a temporary effect on the projected economic recovery in Asia’s emerging markets. In this note we examine the factors that have led to the rally in Asian equity markets and the new risks that now hang over the previously very positive outlook for the region.
The iShares MSCI All Country Asia ex Japan ETF, AAXJ, trended upward during the second half of 2019 and continued to advance in the opening weeks of this year, increasing 3.7% year-to-date January 17 and 16.7% over the past one year. The US market was closed on Monday. On Tuesday, January 21, markets reacted to the news of the coronavirus, with AAXJ retreating some 2.8%. By February 4, the positive year-to-date return had reversed to -2.42%.
In the AAXJ ETF China has by far the greatest country weight, at 40.7%. The next four market weights are South Korea, 13.8%; Taiwan, 13.4%; India, 10.1%; and Hong Kong, 10.0%. China’s and Hong Kong’s stocks led the rally in early January – each were up over 5% year-to-date as of January 17.
The Chinese economy, the second largest in the world, is the dominant economic force in the region. Growth has stabilized, registering a 6.1% pace in 2019. A similar rate had looked likely in the current year. In December, industrial production, retail sales, and fixed investment all exceeded expectations. Going forward, the phase one trade agreement between China and the US has strengthened market sentiment and confidence. More difficult trade negotiations lie ahead, and sluggish global trade will continue to be a headwind for China’s exports. Consumption and service-sector growth will continue to underpin the economy. It is important to note that services account for 51.9% of the output of the Chinese economy, compared with 40.5% for industry.
The positive macroeconomic outlook was coupled with improved earnings expectations. Industrial profits rose some 5.4% in December as compared with a year earlier. The Mainland Chinese market will also be helped by the schedule for increasing the weight of China A-shares in MSCI Indexes that are tracked by international investors. When this process is completed, China A-shares will account for 17.4% of the widely used iShares MSCI Emerging Market Index, compared with their 4% share in 2019. That index is tracked by an estimated $1.8 trillion in managed assets.
The Chinese economy is now being significantly impacted by the disruption to activity due to factory and business closures and travel bans. In the services sector, retail sales, transportation, and tourism are being hit. Industrial activity is likely to experience supply-chain disruptions. Chinese cities containing some 61 million people are facing lockdowns. Airlines are severely restricting travel in and out of China. While such aggressive measures will impact economic activity both within China and globally, they may be able to bring the rate of new infections down sharply by the end of the current quarter. Should this happen, estimates by Goldman Sachs and Barclays indicate the Chinese economic growth rate in the current quarter would be disrupted by 0.8 to 1.0 percentage points in year-over-year terms, most of which would be recovered in the subsequent three quarters of 2020. Oxford Economics estimates that the hit to the first quarter could be twice as large: 2.0 percentage points.
The Chinese government has made clear that it will take measures to mitigate the slowdown, including broad monetary easing, fiscal spending, targeted tax easing, and credit support. On February 4, the People’s Bank of China provided an additional $71 billion of banking liquidity. Moreover, the so-called “national team” of state-run institutional investors has begun to support the stock market and stands ready to do more if needed.
US-based investors have available a great variety of China equity market ETFs listed in the US. In addition to broader-based ETFs that include China, there are some 47 China equity market-specific ETFs, including 13 with more than $100 million in assets under management (AUM). The two largest are quite different in their holdings and performance. The iShares MSCI China ETF, MCHI, with $5.02 billion AUM, seeks to cover the total market and tilts towards financials and technology and away from industrials. Its one-year return through January 17 was 21.33% on a total return basis. This included a 3.7% gain over the year-to-date January 17. Then the market’s drawback in response to the coronavirus outbreak turned that gain into a loss of 1.22% year-to-date February 4. The iShares China Large-Cap ETF, FXI, with $4.08 billion AUM, invests in 50 of the largest H-shares (Chinese stocks traded on the Hong Kong Stock Exchange). It does not include any Mainland-listed A-shares or US-listed Chinese stocks like Baidu. It has a heavy concentration in financials, particularly in China’s big state-run banks. Its one-year return to January 17 was 13.28%. Its year-to-date February 4 performance is -5.55%.
The third-largest China equity market ETF, KraneShares CSI China Internet ETF, KWEB, with $2.56 billion AUM, is narrowly focused on overseas-listed internet-sector software and service companies. Its one-year return was a noteworthy 32.20%. Despite the broad market drawback, this ETF has been able to achieve a positive year-to-date February 4 gain of 5.67%. The Invesco China Technology ETF, CQQQ, with $668.02 million in AUM, tracks an index of investible Chinese tech firms and includes Mainland-listed A-shares and US listed N-shares as well as other share classes. Its one-year return was 36.98%. Its year-to-date February 4 return is 4.85%. The largest of the ETFs focused on Mainland-listed A-shares is the Xtrackers Harvest CSI 300 China A-Shares ETF, ASHR, with $2.48 billion AUM. It tracks an index of the 300 largest A-shares, which gives it a bias towards large caps and financials. Its one-year return was 32.23%. Because of its Mainland market focus, this ETF has been hit hard by the virus outbreak, with a year-to-date February 4 loss of 6.98%.
With the exception of FXI, the above one-year returns prior to the virus outbreak are impressive. Keep in mind that they follow a steep decline in late 2018. Going forward, the outcome of the coronavirus health scare is an important risk hanging over the market. The eventual duration and extent of the outbreak is not known. A relatively mild outcome with the main economic disruptions happening in just the first quarter would permit the economic and market recovery to resume in the second quarter. However, should the economic impact prove to be more extended and severe than the market currently appears to expect, the corrections in Chinese equities could well become more substantial despite likely government efforts to shore up the market.
The Hong Kong and Taiwan economies and stock markets are closely related to those of Mainland China but have individual characteristics as well. The Hong Kong domestic economy has been significantly affected by the serious and long-lasting political unrest there, which may have negative effects on the reputation of Hong Kong’s financial market. The phase one US-China trade agreement should ease the external headwinds for this economy, but the political unrest together with the spill-over economic effects of the China virus outbreak are likely to result in a decline of over 2% in Hong Kong’s GDP this year. The main US-listed Hong Kong equity market ETF is the iShares MSCI Hong Kong ETF, EWH, with $2.17 billion AUM. Its one-year return as of January 17 was 10.51%. Its year-to-date February 4 return is -3.45%.
Taiwan is more independent than Hong Kong is, and its economy is more closely related to the US economy, particularly the US technology sector. Following the recent strong election results, the government is expected to accelerate public spending. Yet Taiwan’s open economy makes it vulnerable to the China slowdown. Taiwan’s main US-listed ETF is the iShares MSCI Taiwan ETF, EWT, with $3.75 billion in AUM. Its heavy technology focus and links with the US help explain its lofty one-year return as of January 17 of 33.02%. Its year-to-date February 4 return is -3.40%.
Like Taiwan’s, the South Korean economy is open, and its equity market had a difficult year in 2019 because of the effects of the US-China trade war and a political dispute with Japan concerning World War II reparations. Positive developments in both areas aided a recovery in the fourth quarter. Valuations are relatively inexpensive, and earnings appear to be improving, following a steep decline. The economy is being helped by the government’s fiscal stimulus policy. Yet it also is being hit by the effects of the China virus, including disruptions to supply trains. The main US-listed Korean equity market ETF is the iShares MSCI South Korea ETF, EWY, with $4.78 billion in AUM. Its one-year return as of January 17 was only 7.03%. Its year-to-date February 4 return is -3.14%.
The Indian economy and equity market also suffered in 2019, with economic growth slowing to 4.5% in the third quarter, its slowest pace in six years. The rate may have slipped further in the final quarter. The estimated full-year growth of just under 5% represents a sharp slowdown from the 2018 rate of 7.4%. Demands for increased fiscal stimulus are likely to result in further government action, although the government is expressing strong concerns about the fiscal deficit. Monetary policy may well be eased further. The Indian economy is projected to recover in 2020. Earnings momentum has improved, but valuations remain relatively high.
There are 11 US-listed Indian equity-market ETFs, with 7 that have AUMs in excess of $100 million. The largest by far is the iShares MSCI India ETF, INDA, with $5.63 billion AUM. It is cap-weighted and covers the total Indian market. Its one-year return as of January 17 was 10.71%. Its year-to-date February 4 return is -0.80%. The second largest India ETF is the WisdomTree India Earnings ETF, EPI, with $993.20 million AUM. It takes a different approach, tracking an index of Indian companies selected and weighted by their earnings. Its one-year return as of January 17 was 5.88%. Its year-to-date February 4 return is -2.17.
In sum, the main factors underlying the rally in Asia’s equity markets that began in the second half of 2019 appear likely to reassert their positive effects on Asian stocks later in 2020 if the current measures to control the spread of the coronavirus prove to be effective. The eventual duration and extent of coronavirus is the greatest downside risk to this outcome. We continue to maintain positions in China, Taiwan, South Korea, and Hong Kong in our International and Global ETF Portfolios. Close monitoring of developments remains essential.
Cumberland holds MCHI, EWH, EWY and EWT in our International Portfolio. I do not own any of the ETFs mentioned.
Sources: Financial Times, Goldman Sachs Economic Research, Barclays,Oxford Economics, CNBC.com, capitaleconomics.com, kraneshares.com, etf.com
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