iShares China Large-Cap ETF: The Balloon Pops (NYSEARCA:FXI)

China is an economic powerhouse, but its relations with the United States, Europe, Japan, and their allies have suffered over the past year. Chinese business with the world’s wealthiest countries has suffered.

Moreover, China’s COVID-19 lockdowns significantly impacted economic progress. While the rest of the world moved past pandemic protocols, China only recently eased restrictions. For years, Chinese stocks trading on U.S. and foreign exchanges have lagged behind the leading U.S. stock market indices. In 2022, the DJIA fell 8.78%, the S&P 500 was down 19.44%, and the tech-heavy Nasdaq lost 33.1% of its value. The iShares China Large-Cap ETF (NYSEARCA:FXI) product, which holds its most significant percentage exposure to Alibaba (BABA), fell 22.6% in 2022, outperforming the Nasdaq, but underperforming the S&P 500, the most diversified U.S. stock market index.

Meanwhile, all the U.S. leading indices reached record highs in late 2021 and early 2022. The FXI’s high was in 2007, and it has made lower lows since 2011.

After a bullish start to 2023, a geopolitical event in early February could cause investors to shun Chinese stocks, even though they offer value compared to U.S. stocks.

A bullish start to 2023

I follow developments in China like a hawk because it’s the demand side of the fundamental equation for raw material markets. China is the most populous country worldwide, with the second-leading economy. Over past decades, Chinese economic growth has been nothing short of spectacular. China is the 800-pound gorilla in the commodity asset class, determining the path of least resistance of prices.

Chinese stocks that trade on U.S. and European exchanges have attracted lots of attention because of the country’s growth. The two assets I track are the diversified iShares China Large-Cap ETF product and Alibaba Group Holding Limited shares, the Chinese e-commerce giant. FXI’s latest top holdings include:

As the chart shows, BABA is FXI’s top holding, with over 9.5% of its market cap invested in the e-commerce company.

FXI closed 2022 at $28.30 per share and rose to a $33.38 high on Jan. 27. At just over $31 per share on Feb. 9, FXI was 9.6% higher than the Dec. 30, 2022, closing level.

BABA shares have done even better, rising from $88.09 on Dec. 30, 2022, to $121.30 on Jan. 26. At $108.52 on Feb. 9, BABA was 23.2% higher in 2023. While FXI and BABA have outperformed the S&P 500, which was 6.5% higher in 2023, they have both turned lower from the late January 2023 high.

As of Feb. 9, the blended price-to-earnings ratio of the SPR ETF, which tracks the diversified S&P 500 index, is around the 17.36 level. The metric for the tech-heavy QQQ is 21.05. FXI’s P/E ratio is 8.19, and BABA’s is 16.11, making them compelling opportunities for some value investors. According to Daily Journal Corporation’s Q4 2022 13-F filing, Warren Buffett’s partner, Charlie Munger, owns 300,000 BABA shares, his third-largest holding, representing 15% of his portfolio. However, risk-reward dynamics caused Mr. Munger to trim his long position by half in Q1 2022.

Geopolitics pops the bullish balloon

From Jan. 28 through Feb. 4, 2023, a Chinese-operated, giant white high-altitude balloon traveled across North American airspace, including Alaska, western Canada, and the contiguous United States. The balloon was roughly 200-feet tall and the size of four buses.

While Chinese officials said it was a privately-operated weather balloon that had blown off course, U.S. officials believe it was a government spy mission to hone the ability to gather data about American military bases. The balloon’s route took it over Malmstrom Air Force Base in Montana, where the U.S. stores some of its land-based nuclear weapons. On Feb 4, a U.S. F-22 Raptor fighter from the 1st Fighter Wing at Langley Air Force Base, Virginia, fired one AIM-9X Sidewinder missile at the balloon, causing it to crash. U.S. Secretary of Defense Lloyd J. Austin III said, “The balloon, which was being used by the PRC in an attempt to surveil strategic sites in the continental United States, was brought down above U.S. territorial waters.” U.S. President Biden gave the order to shoot down the balloon.

Since the downing, China has insisted it was only a weather balloon. After apologizing for its “mistaken transgression,” China criticized the U.S. for its military action, characterizing it as an “over-reaction” that could lead to “serious repercussions.” Meanwhile, the administration determined the balloon was operating with electronic surveillance technology capable of monitoring U.S. communications.

Spy missions are nothing new, and while China and other countries conduct surveillance against the U.S. and its allies, the U.S. does the same. However, the high-profile downing of the balloon has only added to frictions between Washington and Beijing after China’s 2022 “no-limits” alliance with Russia.

As the balloon traveled across the U.S., FXI, and BABA shares turned lower.

An unfair playing field

China has made increasing investments worldwide, and the U.S. has not been immune to the expanding Chinese sphere of influence and financial interests. In 2013, a Chinese company purchased Smithfield Foods, the world’s leading pork producer, for nearly $5 billion. The U.S. government did not stand in front of China’s ownership of the Virginia-based company. In 2012, a Chinese entity bought the world’s leading nonferrous metals trading platform, the London Metals Exchange, for 1.4 billion pounds.

Chinese financial interests have acquired more than $120 billion of assets in the U.S. economy from 2002 through 2016. In 2021, Chinese companies invested $38.25 billion in U.S. companies.

The chart highlights China had invested between $30 and $40 billion in U.S. assets from 2016 through 2021. China’s centrally planned political system means the government is the ultimate owner of these investments.

An early 2023 article in the Quad-City Times warned that China is buying U.S. farmland at an “alarming rate,” noting that Chinese ownership of U.S. farmland rose from $81 million in 2010 to $1.8 billion in 2020.

While U.S. companies have investments in China, a report from the Brookings Institution stated, “The small amount of U.S. investment in China can be traced to two primary factors: First, poor protection of property rights, including intellectual property rights, which limits the potential benefits that U.S. firms can receive from their technology and brands; and China’s restrictions on direct investment in many sectors important to U.S. firms. Among G-20 countries, China is the most restrictive in terms of openness to direct investment.“

The bottom line is the political systems, China’s communism, and the U.S.’s capitalism precludes a level playing field. By extension, the landscape deters U.S. investors from aggressive ownership of Chinese shares, like FI and BABA, that trade on U.S. exchanges because of financial reporting, regulations, and the potential for U.S. or Chinese trade and ownership restrictions.

“No limits” cooperation and Taiwan will add to Chinese stock volatility

One year ago, in February 2022, Chinese President Xi and Russian President Vladimir Putin shook hands on a “no-limits” alliance and trade agreement. Russian troops invaded Ukraine in under one month, launching a war that continues to rage.

Russia long considered Ukraine a part of its sovereign territory, justifying its aggression. Meanwhile, China believes Taiwan is a breakaway republic and has stated its reunification plans. The U.S. and its allies support Ukrainian and Taiwanese sovereignty.

Markets reflect the economic and geopolitical landscapes. The bifurcation of nuclear powers has significant ramifications for trade and increases the potential for continued and new hostilities.

The latest balloon incident is a reminder of the geopolitical divide between Moscow/Beijing and the U.S. and its allies, intensifying risk aversion by U.S. investors.

China is a growing economic, political, and military force, but…

Countries would find common ground in a perfect world, respecting political systems and promoting mutually beneficial trade. The U.S. is the world’s leading economy, but China is hot on its heels to become the leader in the coming years.

The U.S. consumer is critical for China’s economy and trade, and China is crucial for the U.S., which has become dependent on its many products. The widening geopolitical landscape appears likely to cause both countries to look inward and become self-sufficient. As tensions rise, the U.S. could prohibit Chinese investment, and China may look to other global partners to replace the U.S. Moreover, China, Russia, North Korea, and Iran are nuclear powers. The U.S., Japan, and NATO allies in Europe stand opposed to territorial objectives that could lead to new conflicts with nuclear ramifications.

The U.S. and China are the world’s leading economies, but tensions between Washington and Beijing have only increased after the latest Balloon incident. FXI, BABA, and other Chinese stocks got off to a great start in 2023 because they offer value compared to U.S. stocks, but their paths of the least resistance over the coming weeks and months depend on Beijing’s actions and the U.S. response. On Feb. 9, 2023, the potential rewards for Chinese stocks remain compelling, but the risk is equally significant. The short-term trends for Chinese stocks have turned bearish, as geopolitics is more compelling than valuation in the current environment.