EWH: Hong Kong’s Deteriorating Ex-Consumption Outlook Justifies Caution (NYSEARCA:EWH)

I have been bullish because the begin of the 12 months on Hong Kong, primarily attributable to its leverage to China’s border reopening. To date, cross-border journey momentum has been encouraging, with Chinese language outbound tourism persevering with to select up in current months, in flip boosting retail sales to +19.6% YoY in June (accelerating from +18.5% YoY beforehand).

The problem is that this retail energy hasn’t fairly translated elsewhere within the financial system. As a substitute, Hong Kong large-caps’ sturdy ties to a slowing China (ex-consumer) have labored in opposition to them this 12 months. Not solely did the Q2 GDP report underwhelm, however the slowing progress numbers have additionally translated into negative earnings revisions for Hong Kong large-caps. Because of this, the iShares MSCI Hong Kong ETF (NYSEARCA:EWH) is now pacing to low-teens % YoY earnings progress in 2023/2024 vs an expensive ~17x P/E valuation. Web, EWH appears pretty priced relative to a lowered earnings progress outlook; I might transfer to the sidelines right here.

Fund Overview – A Concentrated Portfolio of Hong Kong Champions

The iShares MSCI Hong Kong ETF, which tracks a portfolio of large-cap Hong Kong equities per the MSCI Hong Kong 25/50 Index, has seen its internet asset base additional decline to $634m (vs. $727m prior) amid one other quarter of underperformance and investor outflows. The expense ratio stays aggressive relative to the remainder of the Asian ETF universe at 0.5% however pales compared to its closest different, the Franklin FTSE Hong Kong ETF (FLHK), at 0.1%. There is not a lot distinction between the funds in any other case – each have roughly related weightage caps and compositions, however EWH’s benefit is its longer monitor document (inception in 1996 vs. 2017 for FLHK).

The sector breakdown stays targeted on financials, with the current allocation shift from actual property (down additional to 19.3%) to insurance coverage (22.0%) gaining additional momentum. Extra broadly, the EWH portfolio mirrors the Hong Kong financial system in its financials-heavy composition – together, the insurance coverage, diversified monetary companies, and banking sectors now contribute a bigger ~42%. Actual property (together with administration & improvement) can also be a significant allocation at a cumulative ~23%.

There hasn’t been a lot change to the 33-stock portfolio’s single-stock allocation, both. Multinational insurer AIA Group (OTCPK:AAGIY) stays the most important holding at 22.0%, whereas change and clearing home operator Hong Kong Exchanges and Clearing Restricted (OTCPK:HKXCY) has gained barely at 12.8% of the portfolio. The largest change to the highest 5 is Hyperlink Actual Property Funding Belief’s (OTC:LKREF) decline, with resort and on line casino operator Galaxy Leisure (OTCPK:GXYEF) now the third-largest holding at 4.3%. Of notice, the portfolio composition is essentially in keeping with FLHK, although the latter’s stricter weightage of caps and extra intensive 80-stock portfolio means EWH buyers bear larger focus threat.

Fund Efficiency – Observe Report Marred by One other Yr of NAV Declines

Following a promising Q2, the ETF has declined on the again of deteriorating China information and a subpar GDP report. Because of this, the fund has now declined -9.0% YTD, pacing towards the worst calendar 12 months return within the final 5 years. Zooming out, the fund’s sturdy pre-COVID efficiency has stored the general compounding fee at a good +4.5% (in market value and NAV phrases) since its inception in 1996. Over one, three, and five-year timeframes, nonetheless, EWH buyers have realized -9.9%, -0.7%, and -1.9% of annualized declines.

But, the portfolio remains to be priced at a relatively wealthy 16.7x P/E (in keeping with FLHK), reflecting intact investor optimism on Hong Kong equities regardless of the deteriorating earnings progress. So, whereas I nonetheless just like the portfolio’s relative defensiveness (fairness beta of 0.48 vs. the S&P 500 (SPY)) and well-covered ~3% yield (3.3% 30-day SEC yield), the positives listed below are greater than offset by the rising negatives, for my part.

Slowing GDP Progress Regardless of Consumption Energy

Hong Kong’s hopes for a mid-single-digit % GDP progress 12 months had been dealt a blow in Q2, with total progress faltering to +1.5% YoY (down 1.3% QoQ). The excellent news is that following a robust Q1 rebound, private consumption expenditure progress continued to be the important thing progress driver at +8.5% YoY in Q2. Retail gross sales information got here in at a equally sturdy +19.6% YoY, not solely attributable to tourism-related demand (proxied by “jewellery, watches and clocks” gross sales) but in addition client sturdy items (+4.0% MoM). All in all, home personal spending progress seems to be monitoring effectively, reflecting the continued restoration of outbound China tourism, in addition to a seasonal summer time vacation increase. Wanting forward, the consumption aspect of the financial system might sluggish as soon as the summer time tailwind fades, however with inbound tourism nonetheless on the rise and an added increase from consumption vouchers within the pipeline, the Hong Kong client ought to stay in nice form.

Any consumption-related constructive was greater than offset, nonetheless, by weak spot within the different GDP parts. Authorities spending progress stood out for its steep -9.6% YoY decline in Q2, although unfavorable base results performed an element (authorities spending was at its highest in Q2 2022 in response to a brand new COVID wave). Extra regarding was the declining personal funding contribution (down 1.0% YoY) amid tightening monetary situations globally, in addition to the mid-teens % YoY decline in exports (regardless of +23% YoY companies export progress). Imports (ex-services) had been additionally down, so on stability, the headline constructive internet export contribution is not an excellent signal. All in all, Hong Kong’s financial system seems to be pacing for a slower H2 this 12 months, and thus, extra downward earnings revisions are doubtless on the playing cards.

Hong Kong’s Deteriorating Ex-Consumption Outlook Justifies Warning

Having began the 12 months on a constructive notice, Hong Kong’s fundamentals have since deteriorated alongside China’s. Whereas my prior bullishness on a tourism rebound, pushed by China’s border reopening, has materialized, as proven by the accelerating retail gross sales progress (+19.6% YoY in June), the consumption energy hasn’t fairly broadened out. Because of this, GDP progress has been revised decrease in Q2, together with the EWH portfolio’s earnings outlook (consensus EPS presently at +11% YoY in 2023 and +12% YoY in 2024). Relative to the lowered earnings base, EWH’s P/E additionally screens richly at ~17x – even after the de-rating in current months. Given the EWH portfolio’s restricted client weightage (vs. financials and actual property) and ties to an more and more troubled Chinese language financial system as effectively, I now not see a compelling purpose to personal the fund right here.