iShares MSCI China A ETF: China May Be Headed For A Lower Growth Regime (BATS:CNYA)

Following a promising start to the year, investor concerns about China have returned following a wave of negative economic data in recent months. Having been bullish about the prospect of a cyclical rebound in growth initially, I suspect a disappointing outcome is now on the cards – not only cyclically but structurally as well. With the tailwinds that propelled China to high-single-digit % growth now reversing (think debt, demographics, and trade) and its leaders increasingly prioritizing security and equity (‘common prosperity’) over growth, I am concerned that the country may be headed for structurally lower growth rates over the mid to long-term.

Even with a fiscal easing catalyst likely at this month’s Politburo meeting, I’m not sure it’ll be enough to counter the many drags on growth ahead of the country. Expectations are low, but if the scale of the stimulus disappoints (likely given the debt issues at the local government level) or additional tail risks emerge (likely given record-high US-China tensions), a further de-rating from the current low-teens P/E valuation is very possible. As a proxy to the underlying Chinese economic growth, the iShares MSCI China A ETF (BATS:CNYA) could underperform from here.

Fund Overview – Competitively Priced A-Share Investment Vehicle

The US-listed iShares MSCI China A ETF seeks to track (pre-expenses) the performance of the MSCI China A Inclusion Index, comprising a basket of Chinese stocks traded on mainland exchanges (A-shares). The ETF maintains a 0.6% expense ratio (gross and net) and a net asset base of $310m, making it a competitively priced China ETF for US investors looking for direct access to the mainland. A summary of key facts about the ETF is listed in the graphic below:

From a sector allocation perspective, the fund is less diversified than its closest comparable, the Xtrackers Harvest CSI 300 China A-Shares ETF (ASHR), though no single sector crosses the 20% threshold. The largest CNYA sector exposure is to Financials (17.8%), followed by Information Technology (15.9%) and Industrials (15.7%). The other sector exposures over the 10% threshold include Consumer Staples at 14.3%, along with Materials (11.2%). On a cumulative basis, the top five sectors contribute ~75% of the total portfolio, so investors will need to be comfortable with the sector concentration risk.

At 542 holdings, the size of CNYA’s book stands out – by comparison, ASHR only has 289 holdings. The single-stock portfolio allocation is similar to ASHR, though, with Chinese spirits giant Kweichow Moutai leading the way at 5.4%, followed by lithium-ion battery manufacturer Contemporary Amperex Technology Co., Limited (2.5%) and commercial banking giant China Merchants Bank (OTCPK:CIHKY) at 1.7%. Rounding up the top five list are alcoholic beverage company Wuliangye Yibin (1.6%) and utilities company China Yangtze Power (1.3%). With the five largest holdings contributing 12.6% of the overall portfolio (slightly below ASHR), CNYA is one of the most diversified China ETFs from a single-stock perspective.

Fund Performance – A Worthy Defensive Option Despite the Recent Turbulence

On a YTD basis, the ETF has declined by 4.9% in NAV terms, underperforming its key peer ASHR. Zooming out, the fund has compounded at an unremarkable 1.3% pace over the last five years, also trailing ASHR (+2.2%). Since inception, however, the fund has annualized at +4.8%, boosted by strong returns in the early years of the fund’s launch. But given its 2016 inception date, CNYA has a relatively short track record – even by US-listed A-share ETF standards (note ASHR was launched in 2013). Also positive is CNYA’s tracking error – after accounting for fund expenses, the annualized delta since inception is minimal vs. its benchmark.

At 2.8% on a trailing twelve-month basis, the fund’s distribution yield is another key differentiator vs. comparable China ETFs – by comparison, ASHR offers a 1.2% yield. The slow start to 2023 has brought the 30-day SEC yield down to 1.9%, however, so I would expect a <2% yield this year. Still, the fund’s exposure to cash-generative names in the financial sector bodes well for steady through-cycle income, and thus, income-focused investors looking for diversified China exposure will find a lot to like here. Alongside an equity beta of 0.37 to the S&P 500 (SPY) and a relatively low standard deviation of 23.7%, CNYA screens favorably as a defensive option.

China’s Growth Sustainability Under Threat

Chinese equities outperformed in recent decades on the back of consistent high-single-digit % GDP growth under the Deng Xiaoping regime (i.e., the ‘opening-up’ of the Chinese economy) and the increasingly crucial role the country has played in global trade. In recent years, however, the Chinese economic growth engine has slowed amid a reversal of these tailwinds. In addition to the fading ‘demographic dividend’ (a result of lower birth rates and an aging population), geopolitical tensions with the West have led to trade barriers and supply chain ‘diversification’ or a proactive shift away from China. Also concerning has been the steady buildup of debt for the private and public sectors (on and off-balance sheet), a result of rampant capital misallocation throughout the ‘miracle growth’ years (e.g., the many ‘ghost cities’ throughout China).

Recent data hasn’t been encouraging either – official manufacturing PMI came in at 49.0 in June (a <50 PMI print indicates contraction), largely in line with April and May numbers. The non-manufacturing PMI was comparatively better at 53.2 (i.e., still in expansion territory), but the MoM deceleration indicates activity improvement is happening at a slower pace. So even in the likely scenario that the upcoming Q2 GDP print comes in >6% due to a favorable base effect, the sequential deterioration in June macro data points to underlying growth weakness once we move past the COVID-impacted base. The government likely won’t be resting on its laurels, with recent news flow indicating fiscal stimulus may be on the horizon at the upcoming Politburo meeting in late July. But predicting policy outcomes is challenging, and with local governments already bumping up against balance sheet constraints, stimulus disappointment is likely on the cards.

China May be Headed for a Lower Growth Regime

Chinese equities haven’t been a great place to be in recent years, and despite the promise of the reopening, this will likely remain the case in the years ahead. In addition to the fading hopes of a cyclical rebound in growth, the structural GDP growth outlook will also be impacted by a reversal of the very tailwinds that enabled China’s rise over the last few decades. From demographics and geopolitics to the regulatory shift away from market-based economic ideals, the case for a ‘higher for longer’ China equity risk premium is compelling. Fiscal easing is likely on the horizon but will do little to change the long-term growth path; even in the near-term, elevated leverage levels within the Chinese system could constrain the scale of the stimulus package. Despite the YTD underperformance, CNYA isn’t all that cheap at ~14x P/E and could still see more downside should the Politburo meeting this month disappoint or US-China tensions ramp up further.