Apr 29, 2014
China’s slowing investment bubble will hurt Apple’s sales growth
Part 12345678910Part 11(1)China ETFs (53)
Why Apple may face slowing sales growth in China
By Marc Wiersum, MBA - Disclosure •
Investment in China hits a peak and could slow
The below graph reflects the relative performance of key technology shares for Google (GOOGL), Apple (AAPL), China’s Baidu (BIDU), and Russia’s Yandex (YNDX). As we noted in a prior article, China saw spectacular wage growth in 2012 of around 30%. Wage growth is now closer to 12%. Growing wages and an exceptionally high level of investment in China have supported technology sales for companies like Apple. However, as post–2008 crisis stimulus measures fade, it might appear that spectacular growth rates in wages and investment may decline to merely very high levels of growth. This series examines the changes in China’s overall investment portion of its economy and considers the impact for consumer-oriented technology firms like Apple and Baidu, as well as Google and Russia’s Yandex.
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For more detailed comparative analysis on Google (GOOG) versus Yandex (YNDX) and Baidu (BIDU), please see Market Realist Smita Nair’s series Evaluating Yandex versus other key search engines.
Apple’s earnings versus prior quarter
Apple earned $8.44 billion in China sales in the quarter ended in December 2013—up 29% year-over-year. U.S. revenues were $20.09 billion and the European revenues were $13.07 billion. Revenues rose 29% for China, 11% for Japan, and 5% for Europe, though they fell 1% for the U.S. In the most recent quarter announced in April, Apple had nearly $10 billion in revenues from China. In comparison, in 2011—for the entire year—Apple saw $12.5 billion in revenues from China and a mere $2.8 billion in 2010. Given these growth rates, it’s easy to see why China is so important for Apple, and why China’s Baidu also has a vested interest in the continuation of robust sales of technology and telecom in China. Apple just began breaking out Chinese sales data formally in the quarter ending December 39, 2013. As U.S. revenue growth rates slow, it might seem that pointing to growth rates in China is prudent. Given the explosive growth Apple has seen in China, it’s easy to see how China’s revenues could become a more important focal point for U.S. investors than the slow growth markets of the USA or Europe. At current growth rates, China could become a bigger market than the U.S. within ten years.
Apple in China: Is Apple saturated in Tier I and Tier II cities?
The Wall Street Journal’s Juro Osawa points out that smartphone shipments in mainland China enjoyed robust growth post–2008 crisis as government stimulus rolled out and wage growth in China exploded. 2012 was definitely the year of the Dragon in China and the year of the iPhone for Apple. However, it would appear the wealthier urban cities have been well penetrated at this point and that future success for Apple in China could become more dependent upon Apple’s partnership with China Mobile to grow sales in the more remote areas. With 40% of China’s mobile users using smartphones, it’s easy to get optimistic about more smartphone sales in China. However, as Osawa points out, it might seem that those who could afford the higher monthly fees of smartphone connectivity have purchased smartphones, and that China’s more rural population is still not ready for the cost of smartphones. Wage growth in manufacturing is encouraging, though as the below graph suggests, the average worker in China isn’t anticipated to be a sudden source of ongoing 30% revenue growth for Apple’s smartphones or computers in China.
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Google in China: Baidu owns keyword search, Google in contextual advertising
As the below chart suggests, Google remains strong as a contextual advertising provider, though it seems to be out of China’s much larger keyword advertising, dominated by Baidu. However, search engine revenue growth in China is around 40% for 2013 at 40 billion yuan, and iResearch estimates revenue to double to nearly 100 billion yuan in 2017 ($17 billion). Google ended 2013 with $16.86 billion in consolidated revenue and 17% growth. So far, Google seems to have 16% of China’s $6.6 billion market, or $1 billion. Perhaps revenue for Google in China also will also double to $2 billion by 2017. While this is also a strong growth rate (similar to iPhone growth in China), relative to iPhone sales, search engine revenue growth in China won’t be as critical to Google’s revenue growth as iPhone sales will be for Apple. Apple’s overall revenue growth over the next few years will be more China-dependent than Google’s. Apple is the fifth largest smartphone company in China, with 7% of the market. The market leaders are currently Samsung, Lenovo, Coolpad, and Huawei. Though Apple current sits in sixth place in terms of market share, many expect that Apple’s new partnership with China Mobile will grow their market share significantly.
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Key word advertising is key for Baidu and contextual advertising is key for Google China
As the below graph reflects, Baidu dominates China’s keyword advertising landscape, while Google seems to occupy a significant niche of its own.
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Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
AAPL $592.64 $1.16 0.20%
BIDU $159.91 $1.22 0.77%
FXI $34.99 0.00 0.00%
GOOG $528.00 -$3.35 -0.63%
YNDX $26.52 -$0.02 -0.07%
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PART 2
Are China’s consumers supporting Baidu and Apple sales growth?
By Marc Wiersum, MBA - Disclosure • 3:27 pm EDT Tweet Share Email Print
Investment may slow: Will consumption fill the void?
The below graph reflects the rapid growth, as well as extremely high level, of investment as a percentage of gross domestic product, GDP, in China’s economy. Investment spiked with the creation and growth of “special economic zones” post-1992. The second wave of accelerating growth occurred as the world emerged from the Dot Com crisis post-2000. The third wave of accelerating growth occurred as China’s government’s $586 billion stimulus package entered the economy post-2008. The question arises: in light of weak global economic data post-2008, is China’s high level of investment appropriate, given altered global economic circumstances? This series examines trends in China’s investment data and considers the future implication for China’s equity markets. More specifically, will the recent trend of domestic consumption growth be sustained, supporting the China-based revenues of Apple and Google as well as China’s Baidu?
Enlarge Graph
For more detailed comparative analysis on Google (GOOG) versus Yandex (YNDX) and Baidu (BIDU), please see Market Realist Smita Nair’s series Evaluating Yandex versus other key search engines.
China’s investment boom: Prudent economic planning or political desperation?
The above graph suggests that the level of investment as a percentage of GDP relative to consumption as a percentage of GDP may have become excessive. In particular, the resurgence in China’s investment post-2008 crisis, bringing investment to post-1982 highs as a percentage of GDP, is a cause for concern. You’d wonder if pushing investment to peak levels during a period of slowing global economic growth is prudent economic planning or simply a political act of desperation. With U.S. fixed investment at approximately 13% of GDP and Japan at around 22% of GDP post-2008, can China sustain 40%-plus levels of investment?
Is this level of investment sustainable?
Plus, fixed investment continues to grow as a percentage of GDP while consumption as a percentage of GDP remains low. While growth in fixed investment has been responsible for the rapid growth in China’s economy, rising from around $1 trillion in 2000 to over $8 trillion today, the continuation of such high levels of investment relative to consumption are disconcerting. While it’s prudent financial planning to grow investment and curtail consumption when additional investments yield great returns, it’s also prudent financial planning to restrain additional investment when the returns on investment decline and become unattractive. (Note that the above consumption data for 2013 is an estimate.)
Debt returns decline
Gordon Chang notes in Forbes that the days of credit-fueled growth may be facing a dramatic slowdown, as every dollar in credit growth in 2007 was associated with 87 cents of growth, whereas currently, every dollar of credit growth is associated with a mere 17 cents of growth. Given this dramatic deceleration of the multiplier effect associated with debt growth, it would appear that a significant near-term deceleration of economic growth is underway in China. Unless China can pick up the pace of its own consumption, cheap Chinese goods will continue to pile up on the shelves in Walmart in the USA, where inventory growth rates have outpaced sales growth rates in 10 of the last 12 quarters.
China’s 20-year gamble
As the Wall Street Journal pointed out, China’s shift toward modernization and urbanization is a tremendous work in progress, based on a long-term economic view. While China’s central planning has performed fairly well so far, as we noted in a related article, there are many reasons to suggest that China is potentially taking a great leap of faith in pushing forward with aggressive expansionary policies. The media reports of the creation of “ghost cities” that have been built in anticipation of continued growth in urbanization. Unless consumption growth rates pick up in China and abroad, these ghost cities could see occupancy rates remain lower than expected for some time—an additional source of dead capital in tough economic times.
Should economic data remain soft in the USA and Europe, it may be increasingly challenging for China’s central planners to achieve their growth goals. With an economy that’s 30% exports, China may need to rethink the trend described in the above graph: the modest decline in investment growth may need to decelerate further and faster, and the modest increase in consumption in China may have to accelerate faster than anticipated. Too much investment and exportation and not enough private consumption render China a very vulnerable economy, just as Japan was in the 1980s. China’s economy is highly leveraged to economic growth rates in the USA and Europe. The current improvement in consumption growth in China is encouraging. However, it would be more comforting to see further gains in consumption as potentially excessive investment levels decline. In the near term, it’s important that China not create an excessive production capacity overhang, and capacity utilization levels need to improve before more production capacity develops. The supply chain in China is still looking a little top-heavy.
Apple sales
As the above graph suggests, Apple—not to mention Google and Baidu—enjoyed a welcome reprieve from the 2008 crisis when the Chinese government rolled out the large-scale stimulus package. Investment levels soared, wage growth also hit record levels in 2012, and sales were brisk. However, even though we’re now seeing a modest pick-up in domestic consumption, this improvement in consumption may rest heavily on China’s post-2008 investment campaign. While wage growth in China is still in the lower double digits, an investment-related overhang could limit average wage growth in the future, and the large market of China’s consumers outside of the already well-penetrated major cities may not be interested in acquiring smartphones over standard cell phones anytime soon. The results from Apple’s recent tie-up with China Mobile will reflect the extent to which China’s non-urban consumers can add to higher-end items such as Apple’s iPhone or PCs. Early indications from the China Mobile partnership are encouraging, though the next three quarters will tell a more complete story of Apple’s China-related growth rate will pan out.
To see how the “investment-related overhang” reflects in China’s weak purchasing price index, please see the next article in this series.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
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PART 3
China’s producer price index is better for Apple than Chinese banks
By Marc Wiersum, MBA - Disclosure • Apr 30, 2014 9:00 am EDT Tweet Share Email Print
Consumer goods: Pricing remains solid
The below graph reflects the producer price index for various sectors of the Chinese economy. The producer price index, or PPI, measures the average change in the price of goods and services sold by the manufacturers. The below graph tells us that the Chinese government’s post-2008 stimulus initiative was quite successful in staving off deflation and, in fact, returned the PPI to its pre-crisis levels quite quickly. However, post-2012, the PPI data has been bouncing off of the -5% level. Yet the consumer goods producers (those who make Apple products) report fairly constant pricing power (the green line). This article considers the prospects for companies like Apple, Google, and Baidu in light of China’s headline PPI data, which don’t look so great.
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For more detailed comparative analysis on Google (GOOG) versus Yandex (YNDX) and Baidu (BIDU), please see Market Realist Smita Nair’s series Evaluating Yandex versus other key search engines.
Tech versus raw materials: A tale of two related economies
As the above graph reflects, consumer goods such as technology gadgets are maintaining their pricing power while heavy manufacturing and processing of raw materials (copper, iron ore) are seeing the worst pricing power performance. So far, this has been great new for Apple sales in China, and even Google is seeing its China-related revenues grow in the 30% range. However, as we mentioned earlier, wage growth hit astronomical growth rates in 2012, which could go down as the year of the iPhone Dragon in China. Looking forward, wage growth will likely moderate, and it will be some time before the more rural population will pile onto the iPhone or smartphone bandwagon. In other words, the smartphone growth rate is still great but will probably not match historical growth rates. In the case of Apple, the tie-up with China Mobile should mitigate the potential slowdown in sales, and the 2014 data will be extremely important with regard to Apple’s future growth prospects. The early indications from the China Mobile partnership are promising, and if growth rates in China remain around 20%, this should mean the continuation of success in China for Apple, and related technology companies like Baidu and even Google China.
Heavy metal
As for China’s Baoshan Iron and Steel Co., it would appear that China’s aggressive investment environment post-2008 has contributed to the weak PPI data and declining stock price. Since April 2012, China’s Large Cap ETF, iShares’ FXI, has declined about 6%, while Baoshan Iron and Steel is down closer to 22%. Meanwhile, Baidu is up closer to 12%. Apple is still down near 6% and Google is up over 70%. These relative equity returns reflect that technology companies that aren’t highly encumbered in debt have outperformed more leveraged manufacturing companies and that China’s soft PPI and capacity issues have had a much more severe impact on Chinese domestic manufacturers in heavy industry relative to consumer goods and technology. Though Bidu is still quite tied to the Chinese overall economy, as Russia’s Yandex remains linked to Russia, the low debt capital structure and leveraged business models of Baidu and Google have kept them somewhat removed from the broader economy’s softening growth data.
Outlook: Tech versus metal
Looking forward, the current trend in China’s PPI data, in conjunction with strong wage growth, could suggest that companies like Baidu and Google should continue to see excellent growth rates in China—over 20%. Apple’s ability to top its prior quarter growth rate of 29% will likely depend on the success of the China Mobile venture, but it’s hard to hold one’s breath for 30%-plus growth. As for Baoshan Steel, the fact that China’s overcapacity runs as high as 300 million tons (nearly twice total Europe steel output in 2013) remains a problem that companies like Apple, Google, or Baidu don’t have. However, China is well on its way to replacing inefficient steel production with new technology, with the add rate running at twice the remove rate. Yet, as the PPI raw materials line in the above graph reflect, it wouldn’t appear that raw materials companies will see the growth that tech companies will see over the next few years.
To see how the rapid growth in China’s wages should continue to support Baidu over Google and Yandex, please see How wage inflation in China supports Baidu over Google and Yandex.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
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YNDX $26.52 -$0.02 -0.07%
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PART 4
Why China’s buying US debt offsets the Fed taper, helping Google
By Marc Wiersum, MBA - Disclosure • 1:00 pm EDT Tweet Share Email Print
China keeps U.S. rates under control—so far
The below graph reflects China’s pre– and post–2008 crisis purchases of U.S. Treasuries, U.S. agencies, and U.S. corporate debt. Just prior to the 2008 crisis, China was purchasing $6 billion per month of agency debt (the red line), $5 billion per month of Treasuries, and $4 billion per month of corporate debt—about $15 billion per month, which is right around China’s trade surplus and perfectly normal. Investors have watched the U.S. Fed taper its monthly bond purchases from $85 billion per month this year to closer to $65 billion currently. Great interest surrounds the prospects of fewer Fed purchases, though as the below graph reflects, China still recycles its trade surplus via purchasing U.S. debt securities. Should global growth improve over the next year and China’s trade surplus expand from the current low level of 2% of GDP (roughly $160 billion) to a mere 3% of GDP in 2014 (an additional $80 billion dollars), such a modest change in the current account surplus could support China’s ability to absorb some of the Fed’s declining purchases over the course of the year. This article considers the role of China’s purchases of U.S. government securities and the effects on equities such as Apple, Google, and Baidu.
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To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
China’s consistent trade surplus means consistent Treasury purchases
As the 2008 crisis hit, China engaged in a flight to quality, dumping agency bonds and buying more Treasuries, as the U.S. Government’s protection of the government-sponsored agencies became somewhat questioned. As the panic has passed, China is once again snapping up strong levels of U.S. agency debt at a greater rate than Treasury debt, at roughly $6 and $5 billion, respectively, while U.S. corporate debt acquisition remains low, at closer to $1 billion per month. Apparently, China finds the credit spreads on corporate bonds unattractive.
Low rates in the U.S. support global blue chip stocks and large cap growth stocks like Google, Apple, and Baidu
For investors in large cap growth stocks in the U.S., the post-2008 low rates have been a great source of rising equity prices. As the above graph reflects, China’s continued appetite for U.S. debt over other sovereign debt should keep any taper-related interest rate spike under control. China doesn’t want higher rates in the USA to cool its soggy manufacturing data any further. This economic reality should persist, and companies like Apple and Google in the USA and even Baidu in China should continue to benefit from the modest growth in Chinese exports as the continued strong appetite for recycling global trade surpluses into U.S. debt securities continues.
To see how the rapid growth in China’s wages should continue to support Baidu over Google and Yandex, please see How wage inflation in China supports Baidu over Google and Yandex.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
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PART 5
Will China’s cooling real estate and investment bubble help Baidu?
By Marc Wiersum, MBA - Disclosure • 5:00 pm EDT Tweet Share Email Print
Construction slows and housing prices rise
The below graph reflects the significant decline in fixed asset investment as a percentage of GDP (the black line) as well as the significant decline in the growth rate of real estate–related construction and investment (the red line). As the government stimulus package of $586 billion led to a recovery across a wide variety of economic indicators post-2008, the stimulus-led recovery has certainly cooled, and investment data is just starting to cool. Many critics point to the bursting of a real estate bubble in China as a major risk to investing in any aspect of the Chinese equity market. With many Chinese banks currently trading below book value, this is clearly a major concern. However, as we pointed out below, it’s possible that China will be successful in managing a soft landing as it cautiously cools investment and manufacturing oversupply while nurturing domestic consumption.
This article considers the slowdown in China’s investment data in conjunction with the modest recovery in consumption data and consumer sentiment. Slowing construction seems to have firmed up housing prices again. Either the real estate bubble is back, or China’s economy is simply showing signs of firming up. In either case, these development could be a positive for domestic demand-sensitive companies like Baidu, Apple, and Google.
Enlarge Graph
To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
A housing bubble?
The housing component of investments makes up approximately 12% of China’s gross domestic product, or GDP. In 2006, at the peak of the U.S. housing bubble, housing made up roughly 6% of U.S. GDP, while China stood at about 7% of GDP. In comparison, both Spain and Ireland saw housing reach just over 12% of GDP during the 2006 peak—much like China today. In retrospect, it’s easy to say that both Spain and Ireland overbuilt and have since been saddled by excess capacity and debt problems.
Housing prices vary widely in China, with housing cost to wage ratios reaching 22 times in the political center of Beijing, closer to 16 times in the export and financial market center of Shanghai, and six times in the manufacturing center of Chongqing. Given the growth differential between China and Spain or Ireland, it’s not clear that China’s real estate sector is necessarily growing too quickly or that housing prices are that inconsistent with actual wages and wage growth levels. The worry is that a further slowdown in overall investment and GDP growth could lead to an unexpected decline in current real estate price levels and place even more pressure on China’s banks.
Half empty or half full?
China skeptics see the glass as half empty. Their concern is that the slowing of fixed and residential investment will put increased pressure on banks, as current price levels on invested capital may be unsustainable in the face of weak growth. on the other hand, China optimists can see the glass as half full: the stimulus package may be wearing off in China, though it’s possible that the pullback in the most inflated assets (real estate in urban areas) could contain the bubble and ease the pressures on banks. The slowdown in construction should help ease supply and firm prices, though readers should note that Beijing real estate is on a tear the past year, so housing prices may not be cooling enough in the context of China’s current economic environment.
To see how the rapid growth in China’s wages should continue to support Baidu over Google and Yandex, please see How wage inflation in China supports Baidu over Google and Yandex.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
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PART 6
Why China’s cooling construction supports banks and Baidu
By Marc Wiersum, MBA - Disclosure • May 1, 2014 9:00 am EDT Tweet Share Email Print
Reining in excess investment
The below graph reflects the recent decline in construction in China, as well as the prior investment cycles in China’s past. While construction growth rates remained strong from 2000 to 2007 and had rebounded post–2008 crisis on stimulus measures, construction growth rates have once again bottomed out at a sub-zero percent growth rate over the prior year. This article considers the trends in construction growth within the contact of overall investment in China’s economy and considers the implications for China’s equity markets. Overall, the below graph would support the thesis that China is engineering a soft landing and controlling oversupply of investment capital in new construction. If this is the case, it’s possible to see some pressure taken off the beleaguered Chinese banks, and we could see better support for Chinese equities as the year progresses. While companies like Baidu, Google, and Apple have remained removed from many of the issues that plague China’s manufacturing companies in areas such as raw materials, a collapse in real estate values and severe bank problems could be enough to significantly temper historically high growth rates in consumer-oriented technology.
Enlarge Graph
To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
A slowdown in investment
As we noted in the second article in this series, China has seen investment as a percentage of its economy continue to rise dramatically post-2008. As China has maintained investment levels of over 45% of GDP since 2010, you could argue that investment levels are still far in excess of what the Chinese and global economy can support under current economic growth conditions. As China’s consumption rates as a percentage of the total economy have shown some signs of improvement in the past two years, it’s important to note that these trends in strong investment and weak consumption have been showing signs of easing during the past two years. This is a positive development for improving China’s domestic consumption levels and the broader economy as a whole. Increased demand from the Chinese domestic economy is a welcome development for the global economy, as well as for Apple, Baidu, and Google China. The risk is that excessive investment could topple the current levels of consumption in China.
Construction slows
As the above graph suggests, the more dramatic decline in construction over the past year in China is a contributing factor in China’s overall declining rate of investment. This economic data reflects much of the economic data seen across the globe: economic conditions softened post–2008 crisis, though they improved from 2009 until 2012, as large government stimulus spending compensated for a decline in private-sector consumption and investment. However, over the past two years, the government stimulus is beginning to wear off, and the private sector is just starting to pick up the slack in the overall economy, as we noted in the second article in this series. Time will tell if China can maintain overall economic growth rates of over 7.0% without additional large-scale stimulus measures.
Emerging market ripple effect
While the decline in construction in China might be encouraging in terms of managing oversupply in soft global economic conditions, raw material exporters, such as Brazil, will remain affected by China’s slowing imports of construction materials, such as iron ore. Iron ore and minerals producer Companhia Vale Rio Doce (VALE) has seen its stock price fall from $35 per share to closer to $14 per share since January 2009. With slowing demand in the USA and EU, China will likely be importing fewer raw materials from other emerging market countries. Purchasing manufacturing indices in emerging markets, such as Brazil, had moved from expansionary to contractionary levels since the beginning of 2012, though they’re now just above the contractionary levels—just over 50. Going forward, investors will need to be mindful of declining investment, including construction-related investment, on China’s overall economic growth rates. Plus, should China’s slowing growth rates post-2008 continue, other emerging market economies and their equity markets will also experience additional pressures. As we mentioned earlier, Apple, Baidu, and Google China have seen excellent growth rates in China, though if construction cools too quickly and GDP growth slows dramatically, slower growth rates could develop.
To see how the rapid growth in China’s wages should continue to support Baidu over Google and Yandex, please see How wage inflation in China supports Baidu over Google and Yandex.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
BIDU $159.91 $1.22 0.77%
DXJ $46.31 -$0.12 -0.26%
EWJ $11.21 -$0.01 -0.09%
FXI $34.99 0.00 0.00%
SPY $187.96 -$0.36 -0.19%
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PART 7
Is China’s real estate bubble getting out of control again?
By Marc Wiersum, MBA - Disclosure • May 1, 2014 1:00 pm EDT Tweet Share Email Print
The bubble is back
As the below graph reflects, housing prices in Beijing have risen dramatically as China’s construction and investment have cooled. As real estate growth has declined from an approximate historical average of around 25% per year to closer to 15% the past few years, the prices in Beijing have continued to a climb once again. Wages have been growing while construction growth has been slowing. It shouldn’t be a surprise that housing prices in urban areas are therefore rising. Perhaps the improvement in the housing-related wealth effect could trickle through to domestic demand–related stocks like Baidu, Apple, and Google China later in the year. on the other hand, future credit growth to a bubbly real estate sector could eventually spell danger for China’s already troubled banks.
Enlarge Graph
To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Will the bubble burst?
With new properties developing slower, the current price levels in China could in fact be supported. The risk for the future of housing prices is more likely to be associated with China’s GDP growth rate slipping significantly below the current level of 7.5% per annum. Yet, with wage growth running in excess of 15% per annum, there would seem to be the case for well-supported housing prices and robust construction data. At the moment, it would appear that the real estate development-price relationship has already adjusted to a more balanced equilibrium, consistent with slowing overall growth data. This scenario would support a soft landing for China and continue to support the strong growth prospects for domestic economy–sensitive shares such as Baidu, Apple, or Google China.
With the momentum in wage growth in China, investment may cool a bit, but consumption gains are showing signs of improvement, and real estate seems to be getting a little tight. on a relative value basis, an investment in Baidu may begin to look more attractive than urban real estate if real estate continues to rise in value so quickly. In this environment, it might appear that sales of new Apple products in urban areas could surprise to the upside in 2014 as urban consumers see their real estate values appreciate. The urban wealth affect due to appreciating property values should support Apple, Baidu, and Google in the near term, though the longer term risk is that China’s banks could rein in all lending if their industrial loans face further declines in credit quality.
To see how the rapid growth in China’s wages should continue to support Baidu over Google and Yandex, please see How wage inflation in China supports Baidu over Google and Yandex.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
BIDU $159.91 $1.22 0.77%
DXJ $46.31 -$0.12 -0.26%
EWJ $11.21 -$0.01 -0.09%
FXI $34.99 0.00 0.00%
SPY $187.96 -$0.36 -0.19%
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PART 8
Will declining inflation end China’s investment boom?
By Marc Wiersum, MBA - Disclosure • 5:00 pm EDT Tweet Share Email Print
More investment on less inflation pressures banks
The below graph reflects the historical dynamics of capital formation—the percentage amount of gross domestic product (or GDP) at which capital is invested—in the USA, Japan, and China. As the graph reflects, China exhibits a tremendous level of investment as a percentage of GDP relative to the more mature economies of Japan and the USA: three times the level of the USA and just over twice the level of Japan. While the USA has been experiencing a decline in capital formation post-2008, Japan has been in a long-term decline in this area, with a drastic decline since its bubble economy burst in 1990. While all three countries have seen capital formation essentially flatline since 2009, the question arises: will China also see, at long last, an ongoing decline in investment? This article examines the possible cause of a potential long-term change in China’s investment dynamics and considers the implication for China’s economy and equity markets, to include Baidu, Apple, and Google.
Enlarge Graph
To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Avoiding a hard landing is key
As we noted in prior articles, the key to engineering a soft landing in China will be to maintain credit quality at banks while investment levels decline and consumption begins to grow. Should inflation fall too low in this process and deflation arrive, this could be very bad for Chinese banks and pressure the broader Chinese equity market. While companies like Apple, Baidu, and Google are somewhat removed from some of these macroeconomic issues, they could get swept up in growing systemic risk in China and encounter selling pressure if the soft landing becomes harder.
China’s deflationary threat
As the below graph reflects, the consumer price level in China has declined to 2.5% per annum. While we can consider this rate of consumer price inflation a fairly normal and healthy level (the central banks of the EU and Japan would welcome a 2.0% inflation rate), the risk is that China begins to slip back toward much lower inflation levels, or even deflation, as economic growth rates decline.
Enlarge Graph
Investment: Too much of a good thing?
It’s possible that the rate at which new investment growth has outpaced consumption growth has become problematic. Despite the recent declines in fixed investment and construction in general, as we noted in parts 5 and 6 in this series, producer prices continue to decline (as we noted in Part 3). Though consumer electronics haven’t seen the PPI declines that raw materials manufacturers have seen, further declines in overall PPI could begin to trickle through to even the consumer electronics sector as wage and overall economic growth rates decline. In other words, if PPI declines far enough long enough, even the strong growth rates for Baidu, Apple, and Google China could see some negative impact.
To see how the rapid growth in China’s wages should continue to support Baidu over Google and Yandex, please see How wage inflation in China supports Baidu over Google and Yandex.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
AAPL $592.64 $1.16 0.20%
BIDU $159.91 $1.22 0.77%
FXI $34.99 0.00 0.00%
GOOG $528.00 -$3.35 -0.63%
SPY $187.96 -$0.36 -0.19%
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There are no shortcuts to investing.
But if I knew how to manage my portfolio safer and smarter than most hedge fund managers, I could realistically grow my wealth.
I Agree
PART 9
Why a strong yuan may be better for Baidu than China’s exporters
By Marc Wiersum, MBA - Disclosure • May 2, 2014 9:00 am EDT Tweet Share Email Print
From hard peg to soft peg
The Chinese yuan has appreciated approximately 3% per year since the launch of exchange rate reform in 2005, appreciating from 8.25 to 6.22 versus the U.S. dollar. The Chinese Central Bank “pegs” its exchange rate to the U.S. dollar, though it has allowed its currency to appreciate against the U.S. dollar more aggressively since 2005, as the below graph reflects. From a U.S. investor’s perspective, this will raise the value of Baidu’s, Apple’s, and Google’s, yuan-based revenues versus the dollar as well. For Chinese banks, their exporting borrowers are seeing capacity utilization levels decline as the yuan rises. This trend could continue for some time and may suggest that companies like Baidu, Apple, and Google with yuan-based revenues may be on firmer earnings ground than many Chinese manufacturing firms and banks.
Enlarge Graph
For more detailed comparative analysis on Google (GOOG) versus Yandex (YNDX) and Baidu (BIDU), please see Market Realist Smita Nair’s series Evaluating Yandex versus other key search engines.
What is the yuan really worth?
Economists differ on the extent to which the Chinese yuan might appreciate should this currency “peg” be terminated and the currency be allowed to “float” and trade without restriction in the international money market. Some economists estimate that the yuan should be 30% stronger than its current level. However, the Chinese yuan appreciated a mere 1.5% in 2012 and remained unchanged since 2013, as current global macroeconomic issues introduce greater uncertainty into Chinese economic growth rates and thereby into the historical rates of yuan appreciation. The Chinese trade surplus puts upward pressure on the yuan, as Chinese exporters must ultimately sell dollars to buy yuan, which they use to run their factories in China. Any dollars not repatriated to cover costs in China can stay in the USA, typically in the form of U.S. Treasuries. While the Chinese central bank has “pegged” the yuan-dollar exchange rate to mitigate yuan appreciation and nurture Chinese exporters in the past, the Chinese central bank has also allowed the yuan to appreciate more aggressively since 2005, as we noted above—the black line on the graph.
The Japan yen and Korean won weaken dramatically against the Chinese yuan post-2008
While the above graph reflects the relatively smooth appreciation of the Chinese yuan versus the U.S. dollar, it also reflects, by virtue of its “peg” to the U.S. dollar, the volatility of the dollar and yuan against other currencies. Most notable is the post-2012 yen weakness against the U.S. dollar, which, by virtue of the yuan-dollar peg, reflects in weakness against the Chinese yuan. The yuan has thereby appreciated rapidly against the Japanese yen, as well as the Korean won, in sync with the U.S. dollar. If this trend continues, China will face intensifying competition from the highly productive Japanese export machine, while Korean exports continue to surprise to the upside. Japan simply needs a weaker currency associated with its high productivity to recover its export strength and return to a more positive level of economic growth. While a strong yuan will pressure Chinese manufacturers and financial sector, Baidu and Google China should remain less vulnerable to this exchange-related pressure, though advertising sales could soften. Apple should continue to see strong yuan-based revenue growth, though if the yuan remains too strong for too long, the higher-end products may not be adopted as quickly as hoped—especially in non-urban areas.
Foreign exchange and earnings
By pegging the yuan to the U.S. dollar, and perhaps by preventing the yuan from appreciating too rapidly against global currencies, the Chinese economy has benefited from a fairly weak and stable currency. This managed and stable currency has been a great asset in attracting foreign direct investment, building a significant base of domestic capital formation, and thereby building the modern Chinese manufacturing machine. However, as we look to the future, we must also note the downside of maintaining a currency peg with the U.S. dollar.
While a stable or appreciating currency can attract foreign investment, as it has for China in the past, a strengthening currency may not attract as much investment as it used to when investment opportunities provide lower returns, due to a higher cost base. Should the dollar continue to strengthen as a result of the expectation of future higher interest rates, this could also put further appreciation pressure on the Chinese yuan. However, as the Chinese yuan won’t likely weaken significantly anytime soon (like the Japanese yen could weaken), Baidu’s dollar equivalent earnings should remain fairly solid.
In the case of Yandex (YNDX), troubles in Ukraine have led to a 10% drop in the Russian Micex equity index, as well as the Russian ruble. It might appear that Yandex’s 43% decline this year reflect both political and economic concerns in Russia. However, given Yandex’s strong margins and growth, the recent selloff could be overdone. Putin’s intentions on Internet control remain a cloud over Yandex’s operational environment in Russia.
To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
AAPL $592.64 $1.16 0.20%
BIDU $159.91 $1.22 0.77%
FXI $34.99 0.00 0.00%
GOOG $528.00 -$3.35 -0.63%
SPY $187.96 -$0.36 -0.19%
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PART 10
Will economic growth raise Chinese equities like FXI in 2014?
By Marc Wiersum, MBA - Disclosure • 1:00 pm EDT Tweet Share Email Print
China’s large-cap rally: Five years of flat returns
The below graph reflects the long-term outperformance of Chinese and Korean equities over U.S. equity markets, while Japan, the red line, has made a strong comeback post-2012. As global economies engineered monetary and fiscal stimulus to mitigate the impact of the 2008 financial crisis, equity markets recovered handsomely. China and Korea returned to high levels, though Chinese equities have remained mostly flat since 2009. The U.S. equity market continually grinds higher while Japan experiences fits of growth on monetary policy activism.
This article considers China’s prospects to see its equity market rally once again after a few years of soft landing–induced tightening. It might appear that China has avoided the hard landing so far and that the caution baked into Chinese equity valuations could subside as 2014 progresses. The outlook for Chinese equities based on low valuations is looking more positive, though China’s capacity utilization and producer price levels need to see some improvement before the bull market returns in Chinese equities in general. Baidu, Apple, and Google China have remained somewhat removed from manufacturing declines and credit contagion, though with a fairly high price-to-earnings multiple, even these technology companies could become vulnerable to near-term selling if panic spreads through the overall Chinese equity market. Hopefully, strong wage growth and low unemployment will continue to support Baidu and other Chinese equities in 2014 while excess capacity declines and PPI improves. However, if excess capacity and PPI deteriorate as 2014 progresses, investors may have to temper growth expectations for even technology-related companies.
Enlarge Graph
For more detailed comparative analysis on Google (GOOG) versus Yandex (YNDX) and Baidu (BIDU), please see Market Realist Smita Nair’s series Evaluating Yandex versus other key search engines.
Equity outlook: Will multiple expansion spread to China in 2014?
Asian markets have remained flat since 2013, and China is no exception. More recently, tensions in Ukraine had led to a nearly 20% sudden drop in the Russian stock market, though it has recovered half of its losses since. China’s Shanghai Composite Index is also down 15% from its 12-month peak. The VIX volatility index in the USA had risen to 17.0% during the height of the Ukraine situation, though it’s back to a very low 14.0% (April 28). This is still a fairly low level of volatility in the U.S. markets, as VIX volatility is normally within the 12%-to-20% annual volatility range. However, it should be clear that the volatility in global markets is being driven, to some degree, by the tensions in Ukraine and evidence of some deterioration and oversupply in China. Given this cloudy international outlook, it might appear that investors are finding comfort in the U.S. dollar and US equities, while international markets, such as Japan, China, and Korea, are receiving less attention. With the U.S. at record highs, it might take an interest rate spike and equity market drop to refocus attention on China’s lower price-to-book equities. Plus, as consumer sentiment and consumption are starting to pick up in China, it’s possible that the apparent manufacturing overhang will look less menacing as the year progresses.
China credit issues: A few bumps, or getting worse?
In China, recent announcements of the bankruptcies of Chaori Solar and a trust investment portfolio loan of $500 million to Shanxi Energy raised concerns that China’s shadow banking system is coming under increased pressure. With China’s ICBC bank letting trust product investors take the losses on this $500 million coal company loan, it might appear that the speculatively inclined Chinese investor on the mainland is getting a lesson in credit risk. This should keep the speculative investment climate a bit cooler in China, and Asian markets in general will likely not see significant real money asset allocations increase any time soon. The engineering of potential slowdown in China has investors a bit skittish, though as clouds clear, China’s relatively low equity valuations should become attractive as the year progresses. However, as we mentioned earlier, both excess manufacturing capacity and producer price indices will need to show signs of recovery if strong growth expectations are to be realized.
China, Japan, and Korea
Though post-2008 issues have cooled interest in Asian equities in general while the U.S. market has been on a bull run, readers should remember that Japan is in a very different situation than China and Korea. The effects of Japan’s massive monetary and fiscal stimulus that applied over the course of 2013—and that’s still reinforced with equal vigor in 2014—has probably not been fully felt in the broad economy in Japan. Japan’s trade deficit with China could shrink. While China has various growth-related issues to mitigate as the year progresses, at least China has managed a soft landing so far. If the U.S. and EU can get back to trend growth of 2.5% or so in the next year or two, that should be enough to support China’s excess capacity and producer price weakness near-term. Meanwhile, the Chinese consumer appears to be picking up some of the demand slack in the West. This scenario would support Chinese equity valuations and the earnings for Baidu, Apple, and Google China.
To see how Chinese ETFs are performing in comparison to Japanese and Korean ETFs, please see the next article in this series.
To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
AAPL $592.64 $1.16 0.20%
BIDU $159.91 $1.22 0.77%
FXI $34.99 0.00 0.00%
GOOG $528.00 -$3.35 -0.63%
SPY $187.96 -$0.36 -0.19%
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PART 11
Will China’s large-cap ETF, iShares’ FXI, stop underperforming?
By Marc Wiersum, MBA - Disclosure • 5:00 pm EDT Tweet Share Email Print
China’s bank-ridden FXI: The best of the worst since 2012?
The below graph reflects the performance of Asian equity ETFs since the election of Japan’s new prime minister in November 2012. The Japanese ETFs—DXJ and EWJ– performed very well as the currency weakened under new policy initiatives. Meanwhile, both Korean and Chinese ETFs—EWY and FXI—have been flat, with China still in slightly negative territory, remaining the worst performer to date. The Blackrock iShares China Large Cap ETF (FXI) holds China’s construction bank as its top holding, at 9.03% of holdings, Industrial and Commercial Bank of China as its fourth holding, at 7.01%, Bank of China as its fifth holding, at 6.17%, and the Agriculture Bank of China as its ninth holding, at 4.03%.
This article considers the prospects for these main Asian ETFs to break out of the doldrums in 2014. With FXI holding 26% in large-cap Chinese banks, we would really need to see some better capacity utilization and producer price index improvement before these shares lead the market higher. The loan portfolios of Chinese banks are in dire need of improved credit quality. For Baidu, Apple, and Google China, the improvement in the domestic consumption area has been encouraging, though construction and manufacturing still aren’t firing on all eight cylinders. Perhaps we’ve seen enough investment and banking activity in China in the near term and technology companies like Baidu, Apple, and Google China can outperform the broader market in this environment.
Enlarge Graph
China’s investment drives the economy
Capital formation in China—investment—is the main driver of China’s economic engine. Investment is financed by banks, and the FXI ETF is heavily invested in banks. As the International Monetary Fund pointed out in its “World Economic Outlook,” in January 2014, “In China, the recent rebound highlights that investment remains the key driver in growth dynamics. More progress is required on rebalancing domestic demand from investment to consumption to effectively contain the risks to growth and financial stability from overinvestment.”
Investment is key in China
Japan’s consumption as a percent of GDP is around 61%. The U.S. is around 68%. China’s final private consumption comes in around 33%—half of the average U.S. and Japan rates of consumption as a percentage of GDP. Notably, as a percent of GDP, China’s trade surplus of 10% of GDP in 2008 has declined to 2.0% of GDP currently. At least the capital and current account balance seems well in hand. The investment growth into the 2008 crisis raises eyebrows at the IMF. on the other hand, China is still a rapidly growing economy.
The recent, though modest, pickup in China’s domestic consumption growth and consumer sentiment are welcome developments. Should this trend accelerate as the year progresses, this could take some of the pressure off of China’s export reliance and ease banking pressures at home. This would be a positive scenario for the iShares FXI, as bank shares could become perceived as less risky in the future. However, investors will need to look for ongoing improvement in China’s producer price indices and industrial capacity utilization rates.
Though consumer goods-related PPI indices haven’t dipped into negative territory yet, further declines in non-consumer PPI indices could drag even consumer prices into negative territory as the Chinese domestic economy weakens. Investors will need to be mindful of these key economic indicators as the year progresses. Further declines in PPI indices could lead to increased price and profit margin pressures for even consumer-oriented companies such as Baidu, Apple, and Google China. Perhaps the soft landing will continue and China’s domestic consumption growth surprise to the upside.
To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.
To learn more about investing in global equities like FXI or DXJ, check out Market Realists’s Global Equity ETFs page.
AAPL $592.64 $1.16 0.20%
BIDU $159.91 $1.22 0.77%
DXJ $46.31 -$0.12 -0.26%
EWY $62.67 -$0.19 -0.30%
FXI $34.99 0.00 0.00%
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