The market’s obsession with trade wars may finally be exhausted and priced in. Move on to the next market mover: massive Chinese tax cuts, which should aid the WisdomTree ICBCCS S&P China 500 Fund (WCHN) and the WisdomTree China ex-State-Owned Enterprises Fund (CXSE), our passive ETFs for the country.
Sure, China exported $457 billion worth of goods and services to the U.S. in the year through June,1 and some fraction of those exports is at risk from a deterioration in Sino-U.S. relations. But engage a drastic scenario: Lop off $200 billion or $300 billion from that figure. Even if that happened, most of that sum wouldn’t even disappear; it would be sold elsewhere, maybe inside China, at concessionary prices. But even suspending logic and having it all vanish, is it really doomsday for China’s $14.1 trillion economy ($25.2 trillion at purchasing power parity)?2 We don’t want to minimize the importance of trade conflicts, but the airtime given this topic is hysteric.
When President Obama was in office, many conservatives and free-market acolytes convinced themselves he would destroy the economy, so they ignored massive fiscal and monetary stimulus—the data—and missed the equity bull market. Emotions ruled; logic lost.
Now it’s happening with President Trump. Among some investors, emotions are defeating data. The recent BofA/Merrill Lynch Fund Manager Survey pointed to a trade war as the market’s biggest risk. That may be because some investors so badly wish Trump to fail that, like conservatives during the Obama years, positive news is simply ignored. Forget Japan’s major trade deal with the EU, ink still wet. Forget Trump’s meeting with European Commission President Jean-Claude Juncker, where they agreed to work toward zero tariffs. The end is near!
Astute investors need a sober, facts-based thesis.
A Thesis without Emotion
A more realistic take on matters is that China finds itself isolated, unable to pair with Moscow in a two-country geostrategic counterbalance to the West. This forces Beijing to backtrack on intellectual property theft, inordinately high tariff levels, state subsidies and dumping, due to its weak bargaining hand.
The pain must be offset, so Beijing gives the market that which it aches for: trillions of dollars in tax cuts at the business, product and personal income tax levels. Yes, Trump’s ability to stir the pot is important, but mathematics matters more.
Chinese equities are the play here.
We calculate that many Chinese will see their personal income tax liability fall by half or more, effective January 1, 2019. Add to this our estimate of nearly $500 billion in value-added tax (VAT) cuts over the next decade, with still-in-the-works business tax relief on top, which would be another $132 billion to $138 billion if activity grows at a 6% to 7% pace. For perspective, Beijing’s Lehman-era $586 billion spending package, hypothesized by some to be the reason the global financial crisis ended, is smaller than 2018’s total announced tax cuts, if we calculate them over several years. This is this year’s big story.
Income Tax Scenarios: Implications for Everyday Chinese
The proposed personal income tax code changes are staggering (figure 1). Exemptions and the minimum bounds for the 10%, 20% and 25% brackets are set to gap higher, while tuition, medical and mortgage deductions add to the savings.
Figure 1: China Personal Income Tax Code
If these become law in October and are implemented in January, someone making CNY15,000 per month ($2,242), a wage that is common in a city like Shanghai, where 2017 median monthly income is $1,569, would see his or her monthly taxes cut by CNY1,080 ($161).3 The person making half that amount, CNY7,500 per month, which is short of the metropolitan median, would save about $400 per year on an income of $13,450. This is serious.
Chinese Equity Valuations
With many Chinese equity markets hammered this year, the S&P China 500 Index’s forward P/E multiple has fallen to 12.3, a sharp discount to the U.S. S&P 500 (P/E of 17.7).4 It trades for such a low multiple even though it has 16.6% of its weight in Tencent and Alibaba5, part of the FAANGs + BATs octet of market darlings.6
The WisdomTree China ex-State-Owned Enterprises Index, a “future of China” growth index that gets rid of big monolithic arms of the Chinese Communist Party, trades for 16.8x forward earnings, also a multiple that is lower than the U.S. broad market, even though our Index is tech-heavy.
For an emotional assessment of trade war doom, consult your Facebook “friends.” For a sober take, internalize trillions in Reagan-style tax cuts.
1Source: Customs General Administration PRC.
2Source: IMF Report for China 2018 est., as of 4/18.
3Source: “China Wage Levels Equal to or Surpass Parts of Europe,” Forbes, 8/16/17.
4Source: Bloomberg, as of 7/27/18.
5Please click the tickers for the holding of Tencent and Alibaba holdings in CXSE and WCHN.
6Source: WisdomTree, as of 7/13/18. FAANGs = Facebook, Apple, Amazon, Netflix and Google parent Alphabet, which have been market leaders in recent years. BATs = the Chinese equivalent, comprising Baidu, Alibaba and Tencent.
Important Risks Related to this Article
Neither WisdomTree Investments, Inc., nor its affiliates, nor Foreside Fund Services, LLC, or its affiliates provide tax advice. All references to tax matters or information provided on this site are for illustrative purposes only and should not be considered tax advice and cannot be used for the purpose of avoiding tax penalties. Investors seeking tax advice should consult an independent tax advisor.
There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. The Funds focus their investments in China, including A-shares, which include risk of the RQFII regime and Stock Connect program, thereby increasing the impact of events and developments associated with the region, which can adversely affect performance. Investments in emerging or offshore markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. The Funds’ exposure to certain sectors may make them more vulnerable to any single economic or regulatory development related to such sectors. As these Funds can have a high concentration in some issuers, the Funds can be adversely impacted by changes affecting those issuers. These Funds will be required to include cash as part of their redemption proceeds, which introduces additional risks, particularly due to the potential volatility in the Chinese market and market closures. These Funds invest in the securities included in, or representative of, their Indexes regardless of their investment merit, and these Funds do not attempt to outperform their Indexes or take defensive positions in declining markets. Due to the investment strategy of each of these Funds, they may make higher capital gain distributions than other ETFs. Please read each Fund’s prospectus for specific details regarding the Fund’s risk profile.