The guns have gone quiet on the Eastern Front…for now.
The U.S. and China agreed to a temporary truce in the developing trade war after a meeting at the G-20 conference last month. The agreement is light on details but at least keeps the two sides from escalating tensions with new tariffs.
However it all plays out, there’s no denying that China is becoming a dominant player both geopolitically and economically. Just as the 20th century belonged to American exceptionalism that saw the U.S. economy surge, the 21st century may belong to China.
Investors may see the trade war as a headwind to returns now, but it could turn out to be one of the best opportunities for positioning in the Chinese century.
A Temporary Truce In The Trade War
The 90-day agreement reached in Argentina takes tariff escalations off the table for the period as the two sides negotiate a longer-term deal. China has also, in spirit at least, agreed to buy more U.S. products, especially agricultural goods.
The market welcomed the deal initially with a 1% jump on the S&P 500 the first trading day after the truce was announced, but a more pessimistic interpretation has taken hold since with investors skeptical the deal amounts to anything more than a headline. The index tumbled over the next few days to end the week 6% lower and is now firmly in a correction.
Slowing economic growth and the escalating trade war have battered Chinese stocks this year with the SPDR S&P China ETF (NYSE: GXC) tumbling 27% from its 52-week high.
This year’s weakness masks a longer-term trend to Chinese economic and geopolitical dominance. While the International Monetary Fund expects economic growth in the country to slow to 6.3% next year, that still amounts to $819 billion added to the $13 trillion economy. The U.S. economy would have to grow by nearly 4.2%, almost double the forecasted rate, to match that kind of absolute growth.
Even on slower growth expectations, China is expected to overtake the United States as the world’s largest economy sometime around 2030. It has already started playing a significant role in emerging Asia, Latin America and Africa.
The fact is, the 21st century will belong to China. Just as American economic dominance in the 20th century drove the U.S. market to outperform all 39 markets studied by Yale finance professor William N. Goetzmann from 1921 to 1996, China’s coming hegemony could drive its own markets to outperform. In Goetzmann’s study, the U.S. market produced a 4.3% annualized real return over the period versus just 2% real return for markets in Germany and the United Kingdom.
Positioning For A Chinese Economic Future Now
Low investor sentiment might make it an opportune time to get exposure to Chinese stocks, but the evolving trade war may mean there’s still pain to come for early investors. Consider positioning in companies with relatively little risk to Sino-American trade until geopolitical risks subside and investing more broadly.
Financials have been relatively less affected by the trade war, though they’ve been caught in the de-leveraging campaign by the Chinese government. It’s this fact that has helped the financials-heavy iShares China Large-Cap ETF (NYSE: FXI) outperform the broader SPDR S&P China Fund by 4.5% this year. Within other sectors, look for best-of-breed names in consumer services and education.
China Telecom Limited (NYSE: CHA) is one of only three telecom operators serving an immense market, and the government may be hesitant to issue new licenses in the strategically-important telecommunications sector.
The company has grown its wireless subscriber base to 282 million, which makes it almost twice as large as the biggest U.S. wireless company Verizon with 154 million subscribers. It also counts 141 million broadband customers and expects to launch 5G service in 2020.
The downside to China Telecom is that the government is the majority shareholder in all three operators and is unlikely to give up control. It practices significant control on the sector but has allowed the company to post solid profits.
China Telecom trades for 14 times 2018 earnings, which are expected to grow 10% next year and pay a 2.5% dividend yield. Shares have returned 8.2% this year, outpacing the S&P China Fund by almost 27% over the period.
TAL Education (NYSE: TAL) provides K-12 tutoring services in China across four brands and through its online platform. The company also conducts entrance examinations for preschool through graduate programs.
The company operates 648 learning centers with 88% concentrated in just 15 cities. That leaves a lot of room for growth with current plans to expand to four cities each year. Student enrollments have increased at an annualized pace of 163% since 2011 with 48% annualized revenue growth over the period.
TAL Education trades for a hefty 67 times trailing earnings but is expected to grow profits by 16% to $0.50 per share on 38% revenue growth over the next four quarters. The company regularly beats expectations, topping earnings forecasts by an average of 26% over the last year. Shares have fallen 9.3% this year but still outpace the broader China Fund by more than 9% over the period.
Autohome Inc (NYSE: ATHM) operates two online informational platforms for automobile consumers in China as well as advertising services for dealers and an online transactions platform for buyers and sellers.
The company is the leader in its space and expanded to auto-financing and data services this year. Revenue has grown by an annualized 47% since 2013 and the company’s used car platform covers more than 34,000 dealers in 160 cities.
Autohome trades for 24.8 times trailing earnings, which are expected to grow 15.7% over the next four quarters on 22% revenue growth. Shares are higher by 20% this year, outperforming the S&P China Fund by more than 40% over the period.
Risks To Consider: The trade war isn’t the only thing weighing on Chinese stocks and factors like planned de-leveraging by the government could limit returns for some companies.
Action To Take: Position in China stocks ahead of the country’s rise in world economic dominance with shares of companies that are relatively safer from the current trade fears.
— Joseph Hogue
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Source: Street Authority