China's Growth Downgraded: What Will Happen to Chinese ETFs?

Weaker-than-expected economic activity in China during January and February is making big financial institutions lower their Chinese GDP growth forecasts for the first quarter and full-year 2014. In fact, Bank of America Merrill Lynch, Barclays, and Nomura recently announced downgrades in their growth projections. B of A Merrill Lynch cut its first-quarter GDP growth forecast to 7.3% from 8% and its annual growth forecast to 7.2% from 7.6%, making one of the strongest downgrades. Nomura also forecasts 7.3% growth for the quarter and notes that its full-year forecast of 7.4% holds downside risks. But what data is making these banks downgrade their forecasts?

Weak trade data
Recently, Chinese foreign-trade data showed that overseas shipments fell 18.1% in the country last month compared to the prior year -- the biggest drop since 2009. On the other hand, imports into the world's second-largest economy rose 10.1%, generating the biggest trade deficit in two years: $23 billion.

First onshore bond default
One last element raising risk in China is the fact that the country's onshore bond market had its first default two weeks ago when Shanghai Chaori Solar Energy Science & Technology failed to pay all of a $14.7 million interest payment due on its March 2017 bonds.

Funds tracking China
Depending on what level of exposure you would like to have, there are quite a few funds that specialize in Chinese assets. For example, there's iShares MSCI China ETF (NYSEMKT: MCHI  ) , which provides broad exposure to Chinese equities by matching the MSCI China index. This fund is popular among investors and has good trading volumes, with nearly $850 million in total assets. However, it is heavily skewed toward large caps, and given the circumstances, its composition presents a risk factor. Why? A hefty 36% of this fund is invested in the financial sector. Given the rising uncertainty surrounding China and the fact that the financial sector is often the first one to make corrections, this ETF could be vulnerable. In fact, it's down 10% year to date, and this underperformance owes partly to the financials.

There's also Guggenheim China Small Cap ETF (NYSEMKT: HAO  ) , which tracks the AlphaShares China small cap index and holds about 280 Chinese small-cap firms.

This fund provides better exposure to sectors that will benefit from growth in domestic consumption relative to a broad-market China ETF like iShares MSCI China. In fact, about 22% of its portfolio is in consumer stocks. Another 15.5% is in IT, predominantly consisting of domestic Internet companies..

A similar alternative
There is another fund similar to Guggenheim China Small Cap but with slight differences: iShares MSCI China Small Cap ETF (NYSEMKT: ECNS  ) . Both focus on small-cap equity with a significant consumer weighting, but the latter doesn't hold any U.S-listed Chinese stocks, while Guggenheim has about 10% of its portfolio invested in these assets.

The main difference, though, is that the average market capitalization of iShares MSCI China Small Cap's stocks is around $900 million, whereas the Guggenheim China Small Cap ETF's stocks have an average market cap of $2 billion.

This lower market-cap tilt makes iShares MSCI China Small Cap slightly more volatile overall. However, this has helped the fund outperform the other two so far this year. The fund is up 1.9% year to date, whereas Guggenheim China Small Cap is down 3.3%.

Final Foolish thoughts
We still need to see more data, but there's a possibility China could in fact be slowing down. Still, no one's questioning that the country's economy will grow; what analysts are discussing is the speed of that growth.

Many analysts argue that the Chinese government has shifted away from targeting a specific growth rate and will start establishing flexible objectives aiming to create incentives for employment and nationwide income gains. Others say GDP growth is a dominant economic objective that the country will continue to pursue aggressively. In fact, they expect authorities to implement targeted stimulus measures to support growth.

iShares MSCI China is not heavily correlated to the U.S. equity market, so it could work as a diversification mechanism. However, its high exposure to the country's highly state-regulated financial sector is risky at the moment, as the industry could bear the brunt could of the forecast economic slowdown.

iShares MSCI China Small Cap and Guggenheim China Small Cap provide exposure to China's domestic growth trends and focus on small caps, which could be a good investment approach if your bet is that the Chinese authorities will shift policies toward a consumer-oriented economy. The iShares MSCI China Small Cap ETF has been performing a lot better year to date thanks to its higher exposure to smaller companies. Nonetheless, numbers on the Chinese consumer sector are winding down lately. In January, Chinese retail sales grew 11.8% year over year but missed forecasts of 13.5%. So if this slower consumer activity continues over time, these two ETFs will also be affected.

So here's a suggestion: Wait until upcoming data releases either confirm or invalidate this incipient pessimism. To start with, keep an eye on trade data and the evolution of retail figures.

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