ECNS: Chinese Economic And Market Conditions Unfavorable To Small Caps

seekingalpha02-12

The iShares MSCI China Small-Cap ETF provides exposure to small caps in China's equity market.Weak investor sentiment, unfavorable macro conditions, and the ongoing turmoil in the Chinese real estate ...

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The fund has an expense ratio of 0.59% which is a bit higher than other comprehensive Chinese indexes like Franklin FTSE China ETF (FLCH) at 0.19% and KraneShares MSCI All China Index ETF (KALL) and comparable to other popular China ETFs like the SPDR S&P China ETF (GXC) and the iShares MSCI China ETF (MCHI). However, it does seem to be the cheapest option for specific exposure to Chinese small caps. Holdings   iShares ECNS’ portfolio is spread across 251 different holdings which in total are only worth about $46.8 million. Those assets are very well diversified with no holdings accounting for more than 2% of the total portfolio. In terms of sectors, the fund is much less diversified. Health Care (21.2%), Industrials (14.9%), Consumer Discretionary (12.2%), and Materials (11.4%) account for just under 60% of the total portfolio. Two other things to notice are the sector weightings. The Real Estate sector is number five on the list, accounting for just under 10% of the portfolio, which is a bit concerning considering the persistent weakness of that sector over the last three years. The second thing to consider is that Information Technology is just 6.3% of the entire portfolio (less than Real Estate in fact). This is a rare sighting these days in a technology-driven market and might be a dealbreaker for many investors who think this sector will continue to drive equity gains over the next few years (or more). For some context, iShares' Russell 2000 ETF and MSCI Europe Small-Cap ETF have larger tech exposures of 14.0% and 8.8%, respectively. I am bearish on ECNS and here is why. Bearish Investor Sentiment The Chinese equity market has been weak to start 2024 with the main Shanghai Composite index falling -3.6% on a YTD basis after the market made back some gains in the last week. This includes a day when the index reached a three-year low before short-term sentiment flipped and a rebound occurred last week. ECNS’s performance has been much worse, down -14.1%, and the ETF set a new record low at $21.01. The last three months have seen capital outflows of over 1.72 million shares as the price has dropped to these new lows. For some contrarians, weak performance like this could take the shape of a reversal opportunity. However, there are some troubling signs to consider. Data by YCharts Chinese authorities announced further measures to try and address poor sentiment including restrictions on short-selling and another reserve requirement ratio cut. Both of these helped to spur the short-term rally in the second-to-last week of January. Those gains were evaporated as investor sentiment was unshaken by these attempts to promote more bullish attitudes. To add to the pain, the news of the Chinese court ruling that Evergrande will be fully liquidated reignited concerns that the real estate sector is worse than previously thought. Just last week, there were some sharp positive reactions to more news that Chinese regulators would do more to support the Chinese equity market. Gains in the Shanghai Composite and small-cap CSI 1000 index were supported by strong volume, but both are still below January highs. In reality, we don’t know if investor sentiment has truly reverted or if investors are just taking advantage of oversold conditions. Needless to say, Chinese small-caps are unlikely to see gains in a bearish market environment which market regulators are scrambling to stabilize. Unfavorable Macro Conditions Another reason to be bearish on small caps in China is that the macro data does not point to an environment where small businesses typically thrive. Three data points stick out in the release of December activity data and the January PMIs: Fixed asset investment data shows that capital flows are favoring state-owned businesses while privately owned businesses are being neglected. Although growth in investment was up 3.0% in 2023, for state-owned firms investment flows increased 6.4% while private firms’ investment fell -0.4%. The preference for state-owned businesses makes it more difficult for smaller businesses to expand. As of mid-2023, the PIIE suggests that 61.0% of China’s 100 largest companies were either state-owned or mix-owned, up from 57.2% at the end of 2022. China National Bureau of Statistics  Some of the worst data out of China has been in the CPI and PPI reports where deflation has shown evidence of weak domestic demand. In January, consumer prices were down -0.8% YoY which is the lowest annual rate since 2009. Goods prices specifically are down -1.7% YoY while services prices are only slightly healthier at 0.5% YoY. The pricing trend for producers is significantly worse with PPI growth at -3.4% YoY which is actually an improvement from the worst of 2023. However, the near-term trend is pointing to the return of tough conditions for firms. Over the last three months (Nov-Jan), the monthly increase of PPI averaged -0.23%, a reversal from the 0.33% average in the three months before (Aug-Oct). The bottom line is that smaller businesses can be especially sensitive to weak profit margins, so in a deflationary environment, large caps would be preferred. The CFLP PMIs out of China actually saw some slight improvement in January, and the Composite PMI reached 50.9 which is the highest since September 2023 when it was 52.0. The advancements were largely a result of slightly better production and some gains in other subsegments, but in general, measures of demand remained in contraction. The Manufacturing New Orders index moved up to 49.0 but was the second weakest since July 2023, and the Manufacturing Export Orders index, at 47.2, has been in decline since March 2023. The trend is similar in the services sector. The Non-Manufacturing New Orders index was 47.6, just off the lows of late 2023, and the Non-Manufacturing New Export Orders index crashed -5.7 pts to 45.2, signaling the weakest foreign demand for Chinese services since December 2022. All of these subcomponents are consistent with weak foreign and domestic demand for both goods and services.  Risks Remain in Real Estate The ongoing turmoil in the Chinese real estate sector, highlighted by the Evergrande crisis, is continuing a three-year-long liquidity crunch that is impacting the broader economy, particularly small-cap firms. Evergrande's ordered liquidation, aimed at addressing its $300 billion liabilities that have been hanging in the balance since its initial default in 2021, casts a shadow of uncertainty over the real economy, especially the construction sector which accounts for roughly 25% of China's GDP. The IMF emphasized the potential repercussions of Evergrande's woes in the January 2024 update of its World Economic Outlook (WEO), warning that “absent a comprehensive restructuring policy package for the troubled property sector, real estate investment could drop more than expected, and for longer, with negative implications for domestic growth and trading partners.” The liquidity crunch created by the Evergrande crisis is shown in BIS data which reveals the substantial decline in bank credit extended to China's non-financial sector since 2021, with global banks scaling back their exposure. As of the end of September 2023, global banks' credit to China stood at $826 billion, marking a -12% drop from mid-2021 levels. This tightening credit environment exacerbates the liquidity constraints faced by small-cap firms, hindering their ability to outperform their larger counterparts in the Chinese market. Consequently, the Chinese small-caps of ECNS are likely to be more sensitive to the headwinds created by the real estate sector weakness and broader uncertainties.   ECNS vs MCHI: Small Cap Underperformance Data by YCharts  Even if the Chinese market is set to rebound, the combination of weak investor sentiment, unfavorable macro conditions, and fragile financial conditions points to small-cap Chinese firms underperforming their large-cap peers. ECNS trended somewhat favorably against MCHI from 2021 to the beginning of 2023 with a price ratio of about 0.75, but that trend has changed as the expectations of a strong post-COVID recovery in China gave way to the realization that an external demand shock and a liquidity crunch is going to slow Chinese growth significantly. The ECNS-MCHI ratio is now below 0.60, and I expect it to stay that way whether or not the market bounces.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2411824465"}