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The rising US dollar is driving up inflation in many third world and developing countries. This is leading to rising commodity prices as most imported goods are paid for in dollars, with the situation being exacerbated by historic highs oil prices. The unfortunate events in Sri Lanka, where people took to the streets to show their anger at rising prices due to a falling rupee, is an example of how things can descend into chaos, but there are many other instances where A rising dollar means people suffer more local currency in their wallets but less food in their stomachs.
Now Sri Lanka’s third largest creditor is China, which should benefit most from a rising USD and America’s efforts to bring its supply chains back home. For investors looking to benefit from both of these developments, there is the iShares China Large-Cap ETF (NYSEARCA:FXI), as I will show in this work.
Before going into details, I would first like to pick the FXI because it has suffered relatively less than its peers iShares MSCI China ETF (MCHI) and Invesco China Technology ETF (CQQQ) with a performance of -27.8% over the last year. year period.
Comparison of FXI and competitor performance (www.seekingalpha.com)
The problem of the rising dollar
Inflation, while not necessarily being exploited, appears to be more or less under control by the US Federal Reserve, which in turn is fueling optimism in the broader economy and leading to gains in equity markets. In turn, when jobs are favorable, this translates into prosperity for Americans as a strong dollar mitigates the impact of rising commodity prices. On the other hand, the prized greenback means rising living costs for many in the developing world, while rebellion is brewing on the streets of some underdeveloped countries.
The likes of Microsoft (NASDAQ:MSFT), Apple (NASDAQ:A`L), Netflix (NASDAQ:NFLX), and NIKE (NKE) have already sounded the alarm among investors that the currency issue could hurt their earnings. Now that America’s focus on onshoring is increasing and higher interest rates are likely to keep the dollar high for the foreseeable future, even Europe and Japan could find it difficult to import from the US, which is becoming too expensive for the rest of the US becomes world.
This is a boon not only for Chinese manufacturers but also for other sectors of the economy such as consumer discretionary and banks. As shown in the chart below, the upward trend in China’s GDP over the past five years has been closely accompanied by annual revenue growth for FXI’s six largest holdings.
Comparing China’s GDP and annual earnings of FXI’s top six holdings (ycharts.com)
Realistically, it can be argued that Chinese companies could suffer from the possible loss of US market share due to “deglobalization” and the consequent loss of dollar earnings. However, as evidenced by rising sales since 2019, when the US Commerce Department began imposing higher tariffs on Chinese goods, trade restrictions have done little to dampen sales growth at key Chinese companies.
On the contrary, they seem to have found alternative markets that should gain more traction in the future in the developed markets of Europe, which I will discuss in more detail later, in addition to many developing countries where they are already strong.
However, despite their strength, Chinese stocks remain a risky bet.
High volatility risks
The reason is that China, like the US, has ambitious goals of producing sophisticated semiconductor technology to compete with those in Taiwan and South Korea. However, Chinese efforts dating back more than 20 years have largely failed as the country mainly makes low-end chips, not the sophisticated ones developed by US companies, for which they outsource manufacturing to foundry companies like Taiwan Semiconductor (TSM) or outsource Samsung Electronics (OTCPK:SSNLF).
As a result, both the U.S. and China depend on semiconductor and electronics manufacturers in Taiwan, creating geopolitical tensions between the two countries, the impact of which is spilling over into the Hong Kong stock market. Tensions increased further after House Speaker Pelosi’s visit to Taiwan, with both Chinese and Taiwanese stocks now subject to additional risk premiums.
Another reason for the volatility, especially for companies in the technology sector, is Chinese regulators imposing tough regulations and heavy fines on companies without having a clear regulatory action plan. Additionally, issues affecting the real estate sector have dragged down the performance of financial companies. Whether it is 1 month or 1 year performance, these are all negative as shown in the table below.
Comparing key metrics for FXI’s top six holdings (www.seekingalpha.com)
However, there are some positives when looking at three-year returns.
Looking at the bigger picture, according to the International Monetary Fund, China accounts for around 18.8% of global GDP based on PPP or Purchasing Power Parity.
Consequently, the country’s share of global production should rise on top of a rising dollar as it benefits from a slump in the German economy, with companies paying more for Russian energy while their Chinese counterparts are paying less. With Europe’s economic power in trouble, industrialists are more likely to shift their manufacturing activities to China.
Returns outweigh the risks
With geopolitical risks mounting and war affecting Europe’s key economies, the United States is keen to bring supply chains for key components back to its territory, and China will capitalize on the opportunities that arise. However, the country has its own problems such as the highly restrictive Covid-zero policy, which has negatively impacted the supply of electronic components to the world’s leading network manufacturers such as Cisco (NASDAQ:CSCO) or finished products to Apple (NASDAQ:A`L).
These are large multinationals that have the means to redesign their supply chains to include countries like Vietnam, India and Mexico. But that’s not the case for thousands of smaller companies in the US or Europe, for whom moving away from cheaper Chinese supply chains could mean losing a competitive advantage. For others in developing countries, reducing the flow of goods from China can become an existential threat.
Therefore, China’s role in global supply chains should experience new dynamics after the Covid episode, which would benefit its manufacturing base. This, in turn, should lead to more financial transactions for its banks and sales for the eCommerce ecosystem.
Now, if you don’t have access to individual company research data from some China-based firms, FXI offers access to fifty of China’s largest stocks in a single fund with management fees of 0.74%. To do this, it tracks an index composed of large-cap Chinese stocks traded on the Hong Kong Stock Exchange.
This differs from buying shares of listed stocks in mainland China that trade on the Shanghai or Shenzhen stock exchanges. These more domestic stocks are part of the iShares MSCI China A ETF (CNYA). Coming back to the volatility rhetoric, investors will note that CNYA has underperformed FXI as illustrated in the chart below.
Comparing the performances of FXI and CNYA (www.seekingalpha.com)
This is mainly because these two ETFs don’t hold the same stocks, but the fact that they both hold Chinese companies shows that Hong Kong-listed securities carry additional geopolitical risks that should remain at least until the Chinese Communist Party meets in October, when normally important decisions are made.
In the long term, however, the rewards outweigh the risks.
Conclusion
In the longer term, China should continue to expand its economic influence beyond Africa, taking advantage of the fact that the rising dollar is choking the economies of many countries around the world. With the US primarily focused on controlling domestic inflation, resulting in a stronger currency, more supply chains are likely to find their sources in China, which in turn benefits the country’s larger companies that are part of the FXI. Now there are risks related to Covid, but with food and energy prices already higher, more political leaders around the world are likely to partner with China to protect their people from the rising inflation hurting their economies.
In these circumstances, for those who bought the S&P 500 decline too late and have some cash to spare, it makes sense to partially diversify into the FXI. The ETF is paying dividend yields of 1.97% while waiting for an upside move. In that case, based on its current share price of $30.24, FXI could be flirting again with the $33-34 range after a 26% year-on-year decline after a 10% surge. Another benefit is that it gives a single country’s perspective on the second largest economy in the world.
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