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The Growth Story Behind the Phase One Deal

The Chinese Central Bank is flooding China with liquidity … which, history shows, could mean big gains in stocks

Next Wednesday, January 15 …

That’s the scheduled signing date of the U.S./China Phase-One Deal.

Yesterday, The Wall Street Journal reported that Vice Premier Liu will travel to Washington early next week to sign the deal.

Now, if/when this happens, most investors will see this as good news for U.S. companies that have been hit by tariffs. They’ll also see it supportive of a bullish U.S. stock market.

And it is.

But there’s another story behind all this … one that could make you a lot of money in 2020 without being invested in any U.S. company.

In fact, while the Phase-One agreement is a big deal which we don’t mean to diminish, it’s actually a bit of a distraction from this other opportunity.

So, what’s going on?

For the answer, we need to look beyond the trade war, and focus on the People’s Bank of China (PBOC).


***The tidal wave of money flowing into the Chinese economy

 

The PBOC is similar to our Federal Reserve. In both cases, these central banks do their best to steer their respective economies.

As you’re likely aware, the primary way that the Federal Reserve does this is by lowering or raising short-term interest rates. This makes it either less or more expensive for companies to borrow money, which has a significant impact on economic growth.

For example, lower borrowing rates makes it cheaper/easier to borrow, which (hopefully) stimulates economic activity, and grows the economy.

In China, the PBOC attempts to steer its economy not as much through interest rates, but rather, by bank reserve requirements. When the Chinese central bank wants to encourage economic expansion, it reduces these reserve requirements, freeing banks to lend more.

Despite the different tools, the intended outcome is the same — make access to money widely available in hopes it will rev up the economy.

Now, while most U.S. investors have been focusing on the Fed over recent months, they’ve missed what’s been happening in China.

Last week, the PBOC cut banks’ reserve requirement ratio by 50 basis points, bringing the level for big banks down to 12.5%. This was the eighth cut since early 2018. It also signaled it will likely continue to reduce borrowing costs for companies in 2020.

But the PBOC didn’t stop there …

It also pumped $115bn into the Chinese financial system.

Beyond this, last year, Chinese local governments carried out additional measures to pump money into the economy through tax cuts on companies and individuals valued at $298 billion.

In essence, we’re seeing Chinese policymakers dead-set on growing their economy.

Now, turning toward the investment implications of all this …

Is there any recent precedent for what can happen to a stock market when a government floods an economy with liquidity?

You probably know this answer.

We saw what happened under similar circumstances here in the U.S. in the wake of the global financial crisis.

Below, you can see how gains in the S&P mirrored the Fed’s quantitative easing programs. Though the Fed was buying government securities back then, the goal was the same as it is today in China — increase the money supply.

The chart below reveals a clear correlation: “more liquidity” equals “more stock market gains.”

 


Source: Clark Planning

 

The question is how will the Chinese stock market be affected by the flood of capital the PBOC is directing into the Chinese economy?

If it follows the trajectory of the U.S. stock market, bet on big gains to come.

With this in mind, let’s turn our attention to the Chinese market now.

Specifically, if an investor was interested in putting some chips alongside the PBOC, what’s the state of Chinese stocks? Are they expensive today or trading at a bargain?


***The huge discount in Chinese stocks

 

Steve Sjuggerud is an analyst at our sister publication, Stansberry Research. Steve is a China bull, and recently noted the buying opportunity in Chinese stocks, highlighting their valuation amongst other reasons to be excited.

From Steve:

Chinese stocks are dirt-cheap compared with their U.S. counterparts. We can see this by first looking at the price-to-earnings (P/E) ratio for the FTSE China 50 Index …

The P/E ratio is one of the simplest and most commonly used valuation measures. The lower the ratio, the cheaper the investment.

Right now, Chinese stocks are trading for a P/E of 9.1. That’s dirt-cheap compared with the S&P 500’s P/E of 21.5.

Said another way, Chinese stocks trade for a 58% discount based on this measure. That’s massive!

Bottom line — the combination of a central bank hell-bent on growth, as well as low stock market valuations, makes China a very attractive investment opportunity that many are overlooking.


***So, how can investors play China?

 

One of the easiest ways is FXI, the iShares China Large-Cap ETF.

If you’re looking for one-click convenience, FXI offers investors a way to own some of the biggest companies in the Chinese stock market, including Tencent, China Mobile, and the Bank of China.

Similar to the FTSE China 50 Index which Steve referenced above, FXI trades at a low PE, just 10.9. Meanwhile, as you’re waiting for gains, its current yield is 2.55%. Pretty great compared to the S&P 500’s current dividend yield of 1.75%.

Below you can see FXI climbing 8% since the Phase One trade deal was announced back in December. The S&P is up 4.4% over that period.

 

 

But while FXI is a great way to get broad exposure to the Chinese growth story, if you’re looking for potentially far-bigger gains, you should look to specific stocks.

For example, our own Matt McCall is wildly bullish on the Chinese biotech sector.

One of Matt’s picks we’ve profiled here in the Digest is Zai Labs (ZLAB). It’s an innovative, early stage biotech that focuses on transformative medicines for cancer, autoimmune disorders, and infectious diseases. It boasts one of the strongest portfolios of late-stage oncology treatments in China.

It’s up 42% since Matt’s recommendation. As I write, it’s trading at nearly $41. Matt’s buy-up-to price is $38, so watch for a pullback before initiating a new position.

But Matt isn’t the only InvestorPlace analyst watching China. This fall, Louis Navellier recommended New Oriental Education and Technology Group (EDU).

Always the numbers guy, Louis zeroed in on EDU’s financial situation back in his October update:

The Chinese education company reported that first-quarter student enrollments soared 50.4% year-over-year to 2.61 million.

For the first quarter, EDU reported earnings of $1.44 per ADS and revenue of $1.07 billion in revenue. That represented 24.6% annual revenue growth and 24.6% annual earnings growth. The consensus estimate called for earnings of $1.37 per ADS on $1.07 billion in revenue, so EDU posted a 5.1% earnings surprise and in-line revenue.

EDU is up more than 15% since Louis’ recommendation.


***How to separate the good Chinese companies from the not-so-good

 

FXI is going to give you exposure to lots of Chinese companies, some of which you may not actually want in your portfolio. But if you try to pick specific Chinese stocks, how do you separate the good from the bad?

To help you with this, remember, Louis offers a free grading tool that’s rooted in his proprietary numbers-based market approach.

To illustrate, I just ran Matt’s ZLAB bitotech pick through Louis’ Portfolio Grader. Here’s the snapshot takeaway:

 

 

And what about Louis’ pick, EDU?

It’s below, this time I’m showing you the Portfolio Grader’s detailed report, which is free as well:

 

 

The Portfolio Grader is a great way to check the inherent earnings and income strength of a prospective investment.

But the tool isn’t just about picking the right stocks, it’s also about avoiding the wrong ones.

Take a look at China Mobile (CHL). It’s actually one of the biggest holdings in the China ETF, FXI which we just profiled.

Here’s how China Mobile looks through Louis’ Portfolio Grader:

 

 

With this “F” rating in mind, let’s see how China Mobile has performed over the last year …

As you’ll see below, over the past 12 months, though FXI is up 13%, CHL is down almost 15%.

 

 

There are two ways to look at this: 1) you could argue this is a big drag on the overall return of FXI, which is a reason not to invest in such an ETF. 2) you could argue this is a reason not to gamble on specific Chinese stocks, since any one can do poorly even while most others are rising.

Of course, there’s a third interpretation …

Use a tool like Louis’ Portfolio Grader to help you find the best Chinese stocks that outperform, while avoiding those that drag down returns.

You can access Louis’ tool by clicking here.

Wrapping up, the Phase One deal getting signed is good news, but don’t miss the other big story behind it …

China stocks are headed higher thanks to the PBOC.

We’ll continue to keep you up to speed here in the Digest.

Have a good evening,

Jeff Remsburg


Article printed from InvestorPlace Media, https://investorplace.com/2020/01/the-growth-story-behind-the-phase-one-deal/.

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