PGJ: China Faces Headwinds, But Long-Term Picture Is Intact (NASDAQ:PGJ)

Investment Thesis

In my last article on the Invesco Golden Dragon China Portfolio ETF (NASDAQ:PGJ), I discussed how it was better to buy individual Chinese stocks rather than the index. However, Chinese stocks delivered a terrible return over the last couple of months compared to the S&P 500 and to other emerging markets. The Chinese economy is now at a tipping point where growth seems to be slowing down, which should put further pressure on equities. That said, I still believe Chinese stocks are cheap and the country has a good long-term economic outlook. Given the short-term uncertainties, call options are in my opinion the best way to get exposure to the Chinese market at the moment since the risk of losing is only limited to the premium paid for the option.

PGJ’s Performance Since My Last Article

As a reminder, PGJ tracks the performance of the NASDAQ Golden Dragon China Index, which is composed of US exchange-listed companies that are headquartered or incorporated in the People’s Republic of China. You can read more about the strategy and the portfolio in my previous article.

I have compared below PGJ’s price performance against the Vanguard Total World Stock ETF (VT) over the last 4 months to assess which one was a better investment. Since my previous article, PGJ underperformed VT by an 18-percentage-point margin. This is unarguably a terrible performance, both from a relative and absolute perspective.

If we now compare PGJ’s performance against a basket of emerging market stocks represented here by the Vanguard FTSE Emerging Markets ETF (VWO), we can see that the results don’t change much and China is among the worst performers year-to-date.

Unsurprisingly in the face of such poor returns, foreign inflows into Chinese stocks were modest in January and February, before turning negative in March and April 2022. In my opinion, the war in Ukraine only accentuated the trend that started in Q4 2021, and foreign investors are now increasingly reluctant to hold Chinese ADRs in light of what happened to Russian stocks listed in New York and London.

However, this is part of a much larger trend where capital outflows also affect other asset classes. Chinese bonds for instance suffered record-high outflows as US yields offer now a better risk-reward trade. You can read more about it in this recent article from SCMP.

Where Are We Now?

The Chinese economy expanded 4.8% YoY in Q1 2022, above the market consensus of 4.4% and slightly faster than in the previous quarter. However, the risk of a sharp slowdown in the coming months is now very important, and I believe this will ultimately define Chinese stock returns going forward.

Real Estate

Depending on the source, housing accounts for anywhere between 15-30% of China’s GDP and has reached a tipping point in recent months. As it is now well known, a number of developers have defaulted on their loan payments, including China Evergrande Group, one of China’s major real estate developers, and Kaisa Group Holdings. According to Bloomberg, housing sales fell 22% YoY in the first two months of 2022. The lower demand put pressure on sellers which in turn led to a decrease in house prices. For instance, prices declined for 6 months in a row in February 2022. However, conditions are slowly improving in the secondary market thanks to monetary stimulus, if you trust the Chinese official data.

Retail Sales and PMI

Retail sales are a leading indicator that shows how much money consumers spend on various goods and services in the economy. Retail sales have been on a declining trend for the last 5 months, and are now approaching a level last time seen during Q1 2020. Due to the re-imposition of COVID-19 restrictions since early March 2022 following an outbreak in a number of cities across the country, I don’t expect retail sales to improve until the country drops restrictions. In my opinion, this is unlikely to happen at a nationwide level anytime soon since it seems even the city of Beijing is preparing for a lockdown.

Signs of the economy slowing down are also found in the latest PMI numbers. This index is used to measure the level of activity of purchasing managers in the private and public sectors. The index is now at a record low YTD and has reached levels last seen during the COVID-19 pandemic in Q1 2020.

Unemployment Rate and GDP

The official unemployment rate increased from 5.4% in January to 5.8% in March 2020. This is now exceeding the government’s 5.5% objective for the year. I think it will be interesting to see how unemployment evolves going forward given the recent lockdowns imposed on major industrial cities in China.

Furthermore, a number of banks and rating agencies have reduced their 2022 projections regarding China’s GDP growth rate in recent weeks. In my opinion, the pain for Chinese equity might not be over yet and there could be further selling in the coming months until some good news emerges. For more on China’s GDP growth, this article from the FT gives a good summary of the situation from a VC perspective.

Positive Developments

On the bright side, the Chinese government is trying to stimulate the economy by conducting an expansionary monetary policy. As a result, interest rates are at the lowest level over the last decade. The People’s Bank of China kept its benchmark interest rates unchanged for corporate and household loans at its April fixing although investors were betting on a rate cut. The one-year loan prime rate (LPR) was left unchanged at 3.7%. As we have seen in the US over the last decade, an expansionary monetary policy is generally favorable for long-duration assets such as stocks. Although the results of this policy are not yet visible in the prices of Chinese stocks, it’s possible the benefits of it will start showing up over the next few months.

At the same time, the official number of new COVID-19 cases is also decreasing, which is another good development for the economy. In my opinion, the faster people can go back to work, the better it will be for the Chinese economy. That said, I think it is hard to assess the level of damage caused by the zero-COVID policy on the economy at the moment and we might only learn about how good or difficult the situation is in the upcoming months.

Lastly, China continues to be among the cheapest markets in the world. According to JP Morgan, Chinese equities trade at ~11x forward earnings, which is way below the 25-year average multiple. Given the short-term risks in the Chinese economy, I believe that long-dated call options are the safest strategy to gain exposure to the Chinese market at the moment, as the downside risk is limited only to the premium paid for the option.

Key Takeaways

Despite the abysmal performance of Chinese stocks in the last months and the economic headwinds the country is facing at a moment, I believe there is still value to be extracted from Chinese stocks. Chinese equities trade at ~11x forward earnings, which is way below the 25-year average multiple, and much cheaper than what you can find in developed markets at the moment. Moreover, China is now pushing for an expansionary monetary policy, which should be favorable for equities in the future. Given the short-term uncertainties, long-dated call options are in my opinion the best way to get exposure to the Chinese market at the moment since the risk of losing is only limited to the premium paid for the option.