Trade war fears are now near the top of almost every investor’s list of fears. That’s at least partly because the possibility of a trade war appears to be unprecedented. Investors have become comfortable with the idea of globalization even knowing there are costs associated with free trade.
The costs of free trade are often easy to overlook. One of the greatest costs of free trade, at least according to many pundits right now is lost jobs. But, job losses have always been an issue that is less concerning to those with jobs.
Ronald Reagan recognized this in the 1980 Presidential election when he famously said, “A recession is when your neighbor loses his job. A depression is when you lose yours.”
In 2018, the job losses are becoming harder to ignore because, some argue, the losses were in good paying jobs and the remaining jobs might offer low wages and no benefits. This has led some voters to consider populist policies and tariffs have been a part of populism for more than a century.
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Historians notice that today’s rhetoric seems to be repeating the themes of the 1896 election when candidate William McKinley argued that tariffs enabled American men to earn a family wage and protect their families.
Once again tariffs are in the news and this time, China is a target of great concern.
Trade War Woes Grow
The trade war between the U. S. and China has been building for months. In March, the U. S. imposed tariffs on about $50 billion worth of Chinese imports following a seven month investigation into the intellectual property theft, a longstanding point of contention in US-China trade relations.
In addition to the tariffs, the US also imposed new investment restrictions, took action against China at the World Trade Organization and followed up with more threats of tariffs.
The threats have had an impact on the Chinese stock market as the chart of the iShares FTSE China Index Fund (NYSE: FXI) shows.
This ETF has been trading in a down trend as the trade war escalated. That price move is a continuation of a bear market that began more than three years ago as the next chart shows. This is a longer term view of the Shanghai Composite index that shows the bubble in 2015 and collapse that began that summer.
That speculative bubble in 2015 demonstrated the volatility of Chinese stocks and was explained at the time by the Guardian as an example of a market where fundamentals were disregarded:
“The fact that Chinese stocks were climbing ever higher while the Chinese economy was cooling should have been an unmistakable warning of a bubble, but it caused surprisingly little concern.
Another reason to worry might have been the disparity in prices between so-called “A-shares”, which can only be purchased by investors inside China to keep the domestic market shielded from outside foreign manipulation, and stakes in the same companies available to foreign investors through the Hong Kong exchange, known as “H-Shares”.
This disparity suggested Chinese investors were bidding up prices well beyond any reasonable approximation of their value.
In fact, drawn by the casino-like profits to be made in the boom, more and more small investors flocked to the thousands of brokerage houses that are now proliferating in every Chinese city in order to buy and sell while staring up at flickering electronic data boards charting the rise and fall of equity prices.
With markets rising in straight lines on graphs plotting their progress – the Shanghai exchange had shot up some 135%, and the Shenzhen exchange had gone even higher at 150% in less than a year – stocks had begun to seem like a sure bet for Chinese investors with fevered dreams of quick wealth.
They promised a much higher rate of return than traditional low-interest bank savings accounts, which have paltry annual yields of barely 2%.
At the time of the crash, 9% of Chinese households – some report the figure as high as 200 million people – had bought into the booming market”
Now, those investors could still be sitting with losses and they are unlikely buyers since they suffered such large losses.
China Could Be a Value Trap
At this point, some value investors might find China attractive, especially when comparing the fundamentals of FXI to the SPDR S&P 500 ETF (NYSE: SPY). FXI is on the left in the next table with SPY on the right.
Some believe this is bullish. Barron’s recently noted that, “Chinese stocks are often cheaper than the rest of the world in terms of forward valuations, and with recent declines they now stand at “excessively low P/Es” against other global indexes.
That has drawn the interest of strategists at Bespoke Investment Group who think China could be setting up for a rebound and that in turn could help broader emerging markets.
Bespoke’s macro strategist George Pearkes notes that the Shanghai Shenzhen CSI 300 Index (large-cap stocks), the Shanghai Composite, and the Hang Seng Index (Hong Kong) trade at 10.4 forward earnings or less and are among the cheapest markets globally.
On a technical basis, Pearkes says the iShares China Large-Cap ETF (FXI) is getting close to breaking out after starting to create a base. A turnaround in Chinese stocks would help revive broader emerging markets.
Since Jan. 26, the companies based in China and included in the iShares Emerging Markets index ETF (EEM) are responsible for almost half of the ETF’s decline, Pearkes notes. So far this year, the Chinese ETF is down 4.8% while the broader emerging markets ETF is down 6%.
A quick look at net flows in August suggests China is drawing more investor interest. According to Credit Suisse’s Victor Lin, international equity exchange-traded products attracted inflows of $570 million in August, and China was the biggest country to see cash coming in.”
But, the analysts noted caution is needed, “Though the market could be shaping up for a near-term rebound, it is hard to dismiss the longer-term problems China still faces as it pushes through major economic reforms while contending with a trade spat with the U.S.”
Traders could consider buying put options to benefit from potential weakness in FXI or they could add FXI to their watch list and wait for a rebound before entering the trade. An uptrend would mean both value and momentum edict in the market.
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