The China Conundrum — July 2015
July 28, 2015
Dow Jones Average: 17,441
S&P 500 Index: 2,068
The China Conundrum
China has become a major force in the global economy, and its influence seems destined to grow even larger over time. With an increasingly prosperous population of 1.3 billion people, even a small share of business in China can dramatically increase a company’s revenue. About one quarter of Apple’s iPhone sales come from China, and the company expects that China will be its biggest market fairly soon. While the U.S. is still the most profitable market for high priced pharmaceuticals and medical devices, China is the dominant consumer of many other products.
Doing business in China is complicated, because it is a hybrid economic system, combining elements of capitalism and communism. It is highly bureaucratic, with rules and policy flowing from an all-powerful central authority. The central bank of China makes the U.S. Federal Reserve look weak. Whereas the Fed may encourage banks to increase lending, the Chinese central bank mandates such action. Success in China requires predicting the next move of the central authorities, which is quite difficult.
The financial crisis of 2008, which devastated the relatively free-market, deregulated economies of the United States and Western Europe, had minimal impact on the more centrally planned economies of Russia and China. The Chinese leaders prevented economic contraction and unemployment by ramping up large scale building projects. With one party rule their massive stimulus program was launched without any legislative delay. China built gleaming, new cities designed to house millions. They poured money into industrial expansion, quickly becoming the largest provider of solar equipment, steel, and many other products.
While centrally planned economies can at times appear more efficient and less messy than free markets, there can be unhappy consequences to plans that are overdone. There was overbuilding in both the housing and industrial sectors. Many of the newly built cities in China are unoccupied. Previously profitable industries have become money losers due to over-capacity. The end of the building boom in China has been devastating for global commodity producers and for manufacturers of finished goods, such as steel, that are used in building.
It had been apparent for some time that the Chinese economy was in a troubled state. There was a property price bubble in the face of an overbuilt housing sector, a bad loan crisis brewing, and one industry after another crippled by the fierce competition that comes from over-capacity. The stock market for Mainland Chinese companies was stagnant for a fifth straight year, reflecting widespread concerns and skepticism.
With few options left for further economic stimulation the Chinese leaders decided to pull one more rabbit out of their hat. The central authorities decided that a rising stock market would make people feel wealthier and boost consumption, while allowing cash strapped companies to raise funds by selling shares at high prices. So in mid-2014 the Chinese government declared that the domestic Chinese stock market was undervalued and was going to go higher. When the government in China says something is going to happen the people have learned to take it seriously. The public started to buy stocks, in many cases using borrowed funds. A huge rally ensued, pushing prices up by about 150% between June 2014 and June 2015. And then the bubble burst. Panic selling pushed prices down by 35% in a matter of weeks, wiping out about half of the advance. Fearing a complete meltdown and financial ruin for those using margin debt, the government instituted rules designed to save the market. They forbade selling by larger investors for at least six months, stopped all new share offerings (initial public offerings), and halted trading in a large number of companies. These draconian moves have arrested the decline for now, but confidence has been shaken.
The problem for U.S. based and other global companies is that while business in China is central to a growth strategy, it comes with uncertainty that makes forecasting next to impossible. Exposure to China could propel a company’s results and make its shareholders very happy, or it could torpedo those results. More of the latter has been reported recently, with all kinds of companies, from car makers to elevator manufacturers, saying that weakness in Chinese sales had hurt their results. While most companies feel it is imperative to stay in China for their long-term growth prospects, it seems to us that investors should apply a discount to results earned in this unstable, highly manipulated economy.
The major market indices in the U.S., such as the S&P 500 Index and Dow Jones 30, have been largely flat throughout 2015. While the market appears to have stalled, there has been significant rotation of money among different industry sectors. The slowdown in China coupled with a strong U.S. Dollar has hurt results and stock prices in the commodity sector, industrial equipment, auto and auto suppliers, and a growing number of tech companies. A twelve percent year-to-date decline in the Dow Jones Transportation Index is the clearest sign that business conditions have deteriorated for many industry sectors. Relative stability in the S&P and Dow Jones 30 Index has been due to continued strength in financial stocks, the medical complex, and a small number of very highly valued, glamour stocks. It is not surprising that markets have become less rewarding for investors, as years of market manipulation by central banks in the U.S. and Europe has become entwined with even more extreme manipulation of markets in China.
We are holding onto a base of large, financially strong, dividend paying companies in the medical, financial, and technology sectors. These core holdings have been supplemented by a few new buys in potential growth areas. With interest rates still at zero percent, we are reluctant to part with the bigger dividend paying stocks, even though some of the share prices are extended. Bond holdings and substantial cash reserves in most of our client accounts should provide enough ballast in the event of a meaningful market decline.
The fixed income markets have experienced little change in recent months. The expectations for the first Fed interest rate hike in seven years have been tempered by turmoil in China and a collapse in commodity prices. The Fed may raise rates to . of one percent sometime this fall, which will be inconsequential, unless it is followed by further increases. For now the ten-year U.S. Treasury rate remains stuck at the 2.25 percent level, which is historically low. Longer dated municipal bonds, yielding 3.5 to 4 percent tax-free, are closer to historic norms, and are therefore more reasonable bond buys in our opinion.
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