FXI: Chinese Stocks Are Down 50% And May Continue To Slide

Markets have experienced a considerable rise in volatility over the past few weeks. Commodities have been the focal point of most analysts as shortages threaten to exacerbate inflation further. The Russian invasion of Ukraine and the counteractions from other nations will have immense repercussions depending on how long the crisis lasts. However, one critical trend that seems to have garnered minimal analyst attention is the breakdown of Chinese equities. This trend has struck the large-cap ETF (FXI), the total China ETF (MCHI), and the Chinese technology funds (CQQQ) and (KWEB). Additionally, investors may want to watch the country’s largest property developer Country Garden (OTCPK:CTRYY). See below:

Looking only at China’s equity market, it would appear the country is headed into a significant recession based on its ~50% total equity market decline since last February. Over the past month, most major Chinese equities have declined by 25-45%. This shift comes after a negative year in 2021, leaving most of these equity funds at half or less of their 2021 peak values.

China’s Economy Has Been Loaded For Years

The Chinese equity market has crashed despite massive liquidity injections from the PBOC – made to stave off such a crash. This “plunge protection team” stimulus effort temporarily lifted Chinese stocks precisely a month ago but was quickly followed by one of the most significant declines on record. Though the crash began before recent changes, a mass COVID-related lockdown in Shenzhen and China’s potential friendliness with Russia has likely exacerbated the country’s economic risks.

I have been keeping an eye on the Chinese economy for years as its sheer size and close economic ties to the U.S will cause ripple effects throughout the world. China has the world’s most giant property market bubble by essentially any objective measure. Over the past year, this bubble has shown strong indications of popping in a very tumultuous manner. This issue is explained in more detail in “China’s Evergrande Crisis Is Just The Tip Of The Iceberg.” Still, it can be indicated in the country’s 30X+ home price-to-income ratio and extensive (and growing) supply of unsellable ghost towns.

As the Chinese financial system comes under immense pressure, despite significant stimulus efforts from the PBOC, I expect China’s economic struggle will become far more apparent and impactful for the rest of the world. China’s economy is not built on firm ground with extreme private debt burdens, weak domestic commodity resources (a key inflationary issue today), and unsustainable property valuations. Honestly, these economic instabilities were already surfacing before the recent lockdown in Shenzhen, but restricting the movement of 17.5M people in a crucial production hub will undoubtedly quicken the financial crisis.

Are Chinese Stocks A Value Trade Yet?

In my view, almost certainly true that China is headed into a significant economic recession, one that may easily last for multiple years. Indeed, given that we cannot fully trust figures from the Chinese government, the country’s recession may have already begun. The decision to pursue a mass lockdown in Shenzhen is merely the nail in the coffin. It may be the case that the Chinese government needs a good scapegoat, such as COVID, to justify its economic shock and avoid further growth of social discontent among its young adults. This may also be true regarding potential moves from China’s policymakers to dismount “forever president” Xi Jinping due to his perceived economic failures. Investors need to consider such potentials when looking at countries such as China to avoid deliberate attempts to mislead.

At any rate, significant economic crises can be great buying opportunities as stocks usually lead the economy by ~6-18 months. Narrowing in on the Chinese large-cap ETF (FXI), I can only imagine many investors are considering the fund’s discount-buying potential. The ETF currently carries a very low weighted-average “P/E” of 11.2X with a moderate dividend yield of 1.7%. Of course, most of these firms have seen their earnings decline over the past year, and many have cut dividends, so FXI’s TTM-based valuation may not be representative of its forward valuation.

Compared to popular Chinese technology-centric funds like KWEB, FXI has far more exposure to the country’s financial sector. Currently, ~33% of the fund is allocated toward financials, including major banks like China Construction Bank (OTCPK:CICHY) (its largest holding at a ~9% allocation). While only 3% of FXI is allocated directly to real estate, there is not necessarily a significant difference between its financial and real estate economic sectors, as property financing, construction, and investment are all very closely interlinked. This is similar to the situation in the U.S in ~06′-07′. However, I would argue that the bank-real state linkage is stronger in China due to immense municipal involvement in property financing.

In most cases, I believe these bank stocks carry far more total downside risk than does technology, communication, or consumer discretionary, which collectively make up ~50% of FXI’s allocation. Banks hold high leverage and potentially very high bad debt levels, meaning a shock to China’s highly levered property sector could quickly technically bankrupt many large Chinese banks. Of course, the Chinese government seems to pursue efforts to obfuscate risks to its banking system by punishing those who voice concerns. However, given the many knock-on effects that have come out of the Evergrande crisis, it seems very likely there are many hidden liabilities within China’s banking system.

For this reason, I believe investors would be wise to avoid investing in FXI today despite its discount potential. The reality is that we have such little information on China’s property and financial system risks, and the minimal data that does surface implies its situation is likely more complex than the U.S’s situation leading up to 2008. While some of China’s more-resilient segments can probably weather this storm, I believe many of the banks in FXI may see their equity value be entirely wiped out. In the meantime, the potential mass-liquidity freeze that usually occurs when banks race to save their equity may shock the more resilient segments in FXI.

Of course, whenever I voice concerns regarding China’s economy, many readers reply, stating that the Chinese government will take all measures to stop an economic crisis. This would seem true given the CCP’s command economy. Still, as in the U.S, liquidity injections do little besides “kicking the can down the road” and can often make debt issues even worse by providing financing to already insolvent entities (see “zombie corporations”). Even more, China’s stock market has crashed despite a relatively large series of liquidity injections almost every month since September of 2021, as well as consecutive reductions in bank reserve ratio requirements. While the Chinese government may have a few more tricks up its sleeve, it seems they’ve already played their best cards to no avail.

The Bottom Line

At this point, I do not believe FXI’s declines will end anytime soon. The Chinese government may soon implement protocols to provide even more stimulus, but again, it seems they’ve already exacerbated their economic toolkit. In light of China’s struggle to secure commodities, I can only imagine its inflation will rise, potentially weakening the Yuan’s value against the dollar and thereby creating excess losses for overseas investors. Additionally, with Chinese manufacturers and construction firms struggling to obtain commodities inexpensively, the country’s renowned manufacturing capacity has been jeopardized.

Inflationary Ripple Effects In The West

The growing economic crisis in China will have ripple effects felt throughout the world. There are direct financial-system ties between the West and China, but these are likely not large enough to directly hamper Western economies. In my view, the most significant impacts will likely be in the geopolitical and international trade realms. As the West backs away from Russia, China has made indications of filling the economic gaps. Considering that Russia has immense commodity exports and China requires significant commodity imports, this situation may benefit China’s economy as long as it does not result in Western sanctions on China. The same is true with Russia and India and China and Saudi Arabia regarding the “PetroYuan.”

If Asian economic powerhouses react to their financial crisis by creating a sort of “economic alliance,” it would almost certainly result in further inflationary pressures in the West. The U.S, and Europe in particular, are very dependent on Russia, China, Saudi Arabia, and India for commodities and manufactured goods. However, it has become apparent that this dependence is becoming burdensome as these countries ban exports. Overall, while China’s economic crisis may not directly harm the U.S financial system, a decline in China’s production or concerted efforts to dehegemonize the U.S dollar will certainly exacerbate inflation issues.