The key surprise out of China in recent weeks was the lack of policy stimulus, with the latest series of rate cuts falling well short of lowered expectations. And with almost all of last month’s economic data already missing expectations by a considerable margin, China’s path toward hitting its +5% growth target this year is now under scrutiny. Structurally, concerns about a reversing demographic tailwind are also top of mind, along with the scale of deleveraging required at the local government level and for property developers following recent defaults. Alongside geopolitical headwinds, a key driver of foreign direct investment declines in Q2, fixing the Chinese growth model is no mean feat and now looks likely to entail a multi-year, if not a multi-decade project.
While equity valuations in China have de-rated in tandem, with the Franklin FTSE China ETF (NYSEARCA:FLCH) now on offer at a wider P/E discount to its emerging market counterparts than when I last covered the name, the underlying earnings base could still be subject to more downward revisions. With no clear catalyst for a fundamentals-driven re-rating or an easing of the Chinese geopolitical equity risk premium, I would favor a more targeted approach to Chinese exposure (see my coverage of the Global X MSCI China Consumer Discretionary ETF (CHIQ) over broad-based ETFs like FLCH).
Fund Overview – Still the Lowest Cost Vehicle for Chinese Large-Cap Exposure
The Franklin FTSE China ETF, which tracks the Chinese large-cap universe via the market cap-weighted FTSE China Capped Index (subject to weighting caps), continues to be a popular ETF option. Its net asset base held steady at ~$107m despite ongoing Chinese equity weakness. Also standing out is the fund’s 0.19% expense ratio, placing it at the top of cost-effective Chinese ETF options listed in the US.
On the back of relative consumer outperformance in recent months, the fund’s sector allocation has skewed further toward consumer discretionary at 30.0%. Similarly, the communication services sector has also seen its relative portfolio contribution rise to 19.4%, gaining share from financials, a net decliner amid ongoing property concerns.
FLCH’s single-stock composition reflects its sector-level shifts, with Chinese tech leader Tencent (OTCPK:TCEHY) gaining share at 12.7%, along with other Chinese tech/consumer leaders like Alibaba (BABA) at 9.7% and Meituan (OTCPK:MPNGF) at 4.7%. Of note, seven of the fund’s ten largest holdings are Chinese tech/consumer companies, with the rest of the portfolio comprising financial services leaders like China Construction Bank (OTCPK:CICHY), Ping An Insurance (OTCPK:PNGAY), and Industrial and Commercial Bank of China (OTCPK:IDCBY). The ETF’s 970-stock portfolio is mainly invested in domestic and Hong Kong-listed Chinese shares (i.e., A and H-shares), so investors looking to mitigate regulatory risks associated with foreign depositary receipts will find a lot to like with FLCH.
Fund Performance – Decent Yield but Headed for Another Year of Negative Returns
Since I last covered FLCH, its YTD return has further decayed to -7.5%, reflecting the continued downward earnings revisions and worsening investor sentiment on Chinese equities in recent months. On an annualized basis, the fund has now returned -2.6% in NAV terms (-2.5% in market price terms) since its inception in 2017, implying a cumulative NAV return of -14.1% (-13.4% in market price terms). While the returns don’t make for great reading on a standalone basis, FLCH has still outperformed comparable China funds, such as the Invesco Golden Dragon China ETF (PGJ), while also maintaining minimal tracking error and an industry-low expense ratio.
The distribution is also tracking well, with the $0.19/share H1 2023 payout outpacing last year’s numbers and implying a potential upside to the current ~3% yield this year. The sustainability of this payout, on the other hand, is in question, given the ongoing troubles in the property sector and their knock-on effect on the profitability of key FLCH holdings. Given many of FLCH’s largest holdings also continue to favor reinvestments and buybacks over dividends, I continue to see better options out there for income-focused investors.
Deteriorating Economic Data Signals More Downgrades Ahead
China’s disappointing post-reopening progress has lowered expectations significantly, but if the latest round of data is anything to go by, there could still be more disappointments in the pipeline. Both consumer and producer inflation remain deflationary amid broad-based demand weakness, while credit growth has also decelerated YoY despite a favorable base effect. Perhaps most importantly, China’s property woes appear to be far worse than initially expected. And given the vast majority of Chinese wealth is tied to real estate, the knock-on effects threaten to derail trend growth for years to come. So even with Chinese households still sitting on significant excess savings built up through the pandemic, we could see a decreased appetite to spend and invest, weighing on growth. Alongside the structural headwinds posed by elevated local government debt levels, an unwinding demographic dividend, and a shift toward anti-capitalist ‘common prosperity’ ideals, China may now be set for a prolonged malaise.
The economic negatives have begun to hit earnings – after a short improvement in earnings revisions following strong tech earnings reports in May/June, recent Q2 numbers have triggered a new round of earnings downgrades. While Chinese large-caps are still estimated to grow earnings at a mid to high-teens rate through 2023/2024, it seems likely that the recent deterioration of property activity (most notably Evergrande’s (OTC:EGRNF) recent bankruptcy filing) hasn’t yet been fully captured either in the earnings base. Nor have the potential second-order impacts of a faltering property market or balance sheet repair, in my view, both of which could hit the financial channel hard (note financials is FLCH’s third-largest sector exposure). The only saving grace is Chinese consumption, likely to be the primary growth driver this year and a key beneficiary of future stimulus measures. While FLCH is heavy on consumer/tech, the rest of its portfolio remains exposed to the broader slowdown; at ~14x earnings, the fund likely hasn’t hit bottom just yet.
Elevated Risks as the Chinese Growth Engine Slows
A ‘slower for longer’ China has become the consensus narrative over the last month as the country’s economic data releases continue to deteriorate. Any initial hopes of stimulus reigniting growth post-Politburo meeting are starting to fade as well, given the lack of meaningful fiscal and monetary support thus far. This leaves China on track to potentially miss its 5% growth target for this year – despite a favorable YoY comparison due to last year’s COVID-impacted base. And over the mid to long-term, the pending hit from a secular balance sheet repair trend, as well as geopolitical-driven ‘re-shoring’ of supply chains, threatens to reverse a lot of China’s gains in recent decades.
Plus, FLCH’s current ~14x P/E isn’t all that cheap, particularly given the earnings revision path is likely headed lower from here. All in all, I am now more cautious about a broad-based capital allocation approach to China in light of recent developments. Instead, a more targeted approach via ETFs like CHIQ, with exposure to relatively resilient sectors like consumer/tech, seems more prudent.