FXI ETF: Chinese Economy To Benefit From A Rising Dollar (NYSEARCA:FXI)

The rising U.S. dollar is pushing inflation up in many third-world and developing countries. It is leading to escalating commodity prices as most imported goods are paid for in dollars, with the situation being exacerbated by historically high oil prices. The unfortunate events in Sri Lanka where people took to the streets to demonstrate their anger against surging prices due to a depreciating rupee is an example of how things can degenerate into chaos, but there are many other cases where a rising dollar is leading to people having more local currency in their wallets but lesser food in their stomachs.

Now, Sri Lanka’s third-largest creditor is China, which should benefit the most from a rising USD and America’s effort to bring its supply chains back home. For investors willing to profit from these two developments, there is the iShares China Large-Cap ETF (NYSEARCA:FXI) as I will show in this thesis.

First, before going into details, my reason for choosing FXI is that, with a performance of -27.8%, it has suffered relatively less than peers iShares MSCI China ETF (MCHI) and Invesco China Technology ETF (CQQQ) during the last one-year period.

The Rising Dollar Problem

While not necessarily harnessed, inflation appears to be more or less under control by the U.S. Federal Reserve, in turn creating optimism in the wider economy and resulting in gains for the stock market. With favorable job numbers, this in turn breeds prosperity for Americans, as a strong dollar mitigates the effects of rising commodity prices. On the other hand, the highly valued greenback signifies rising costs of living for many in developing nations, with rebellions brewing in the streets of some underdeveloped nations.

For investors, companies like Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX), and NIKE (NKE) have already raised the alarm about how the currency issue can hit their earnings. Now, with America increasingly focused on onshoring and higher interest rates likely to keep the dollar on the high side for the foreseeable future, even Europe and Japan may find it hard to import from the U.S. which is gradually becoming too expensive for the rest of the world.

This constitutes a boon, not only for Chinese manufacturers, but also for other sectors of the economy like consumer discretionary and banks. As shown in the figure below, the uptrend in China’s GDP during the last five years has been closely accompanied by growth in the annual revenues of FXI’s top six holdings.

To be realistic, it can be argued that with the eventual loss of U.S. market share due to “deglobalization” and the resulting shortfall in dollar revenues, Chinese companies may suffer. However, as evidenced by their rising sales figures since 2019 when the U.S. Commerce Department started to impose higher tariffs on Chinese goods, trade restrictions have done little in subduing the topline growth of China’s main companies.

On the contrary, they appear to have found alternative markets, which should in the future get more traction in the developed markets of Europe as I will elaborate upon later, in addition to many developing countries where they are already strong.

However, despite their strength, Chinese stocks remain a risky bet.

High Volatility Risks

The reason is that just like the U.S., China also has ambitious goals to produce sophisticated semiconductor technology, to compete with those made in Taiwan and South Korea. However, Chinese efforts which date back to more than 20 years have largely failed as the country mostly produces low-end chips, not the sophisticated ones designed by U.S. companies for which they outsource manufacturing to foundry plays like Taiwan Semiconductor (TSM) or Samsung Electronics (OTCPK:SSNLF).

As a result, both the U.S. and China have to rely on semiconductor and electronics manufacturers in Taiwan, leading to geopolitical tensions between the two countries with the effects spilling over to the stock market in Hong Kong. Tensions went up a notch after House Speaker Pelosi visited Taiwan, with both Chinese and Taiwanese stocks now being subject to additional risk premiums.

Another reason for the volatility, especially for companies operating in the tech sector, is China’s regulators imposing strict regulations and big fines on companies without having a clear plan of action on regulations. Furthermore, woes impacting the property sector have dragged down the performance of financial companies. Thus, whether it is the one-month, or one-year performances, these are all negative as shown in the table below.

However, there are some positives when looking at the three-year returns.

Thus, looking at the broader picture, according to the International Monetary Fund, China accounts for around 18.8% of the world’s GDP based on PPP or purchasing power parity.

Consequently, in addition to a rising dollar, the country’s share of the world’s manufacturing should increase as it benefits from the slump in the German economy where corporations pay more for energy from Russia, while counterparts in China pay less. With Europe’s economic powerhouse being in trouble, it is more likely for industrialists to shift production activities to China.

Returns Outweighing Risks

Consequently, with the United States keen on bringing supply chains for key components back to its territory amid intensifying geopolitical risks and a war impacting Europe’s main economies, China is set to take advantage of opportunities that come along. However, the country has its own problems like the highly restrictive Covid zero policy which has adversely impacted the supply of electronic components to the world’s top networking manufacturers like Cisco (NASDAQ:CSCO) or finished products to Apple (NASDAQ:AAPL).

These are large multinationals that have the means to redesign their supply chains to include countries like Vietnam, India, and Mexico. However, this is not the case for thousands of smaller companies in the U.S. or Europe, for whom moving away from cheaper Chinese supply chains can imply a loss of competitive advantage. For others in developing countries, reducing goods inflows from China can result in an existential threat.

Thus, after the Covid episode, China’s role in global supply chains should see renewed momentum, thereby benefiting its manufacturing base. This should in turn result in more financial transactions for its banks and sales for the eCommerce ecosystem.

Now, unless you have access to research data pertaining to individual companies from some China-based firms, FXI with management fees of 0.74% provides access to fifty of the largest Chinese stocks in a single fund. To this end, it tracks an index composed of large-capitalization Chinese equities that trade on the Hong Kong Stock Exchange.

This is different from buying the shares of listed stocks on the Chinese mainland that trade on the Shanghai or Shenzhen Stock exchanges. These more domestic equities form part of the iShares MSCI China A ETF (CNYA). Again, coming back to the volatility rhetoric, investors will note that CNYA has underperformed less than FXI as shown in the chart below.

This is due mainly to the fact that these two ETFs do not hold the same stocks, but, the fact that they both hold Chinese companies shows that Hong Kong-listed securities carry additional geopolitical risks, which should continue to prevail at least till the Chinese Communist Party meeting in October when key decisions are normally taken.

However, in the longer term, returns outweigh risks.

Conclusion

Looking at the long term, China should continue to expand its economic influence beyond Africa and take advantage of the fact that the rising dollar is stifling the economies of many countries throughout the world. With the U.S. focused primarily on controlling domestic inflation resulting in a stronger currency, more supply chains are likely to find their sources in China, in turn benefiting the country’s larger corporations which form part of FXI. Now, there are Covid-related risks, but, already faced with higher food and energy prices, more political leaders throughout the world are likely to forge partnerships with China in order to protect their populations against surging inflation inflicting on their economies.

In these circumstances, for those who have been too late in buying the dip in the S&P 500 and who have some spare cash, it is worth partly diversifying in FXI. The ETF pays dividend yields of 1.97% while waiting for an upside. In this case, after a one-year dip of 26%, FXI could again flirt with the $33-34 range after a 10% rise based on its current share price of $30.24. Another of its advantage is that it provides a single country’s view of the world’s second economy.