Thursday, November 15, 2012

How Will Slower Growth in China Affect Your Investments

t’s time to look at China again. In a sense considerations over the country’s growth prospects are a bit like an itch that will not go away. You can try and ignore it for a while but deep down you know you need to do something about it. It’s all very well feeling good by listening to your favorite CEO eulogizing over his company’s Asian growth numbers and prospects in China but if growth is weaker than expected, those estimates will have to be taken down.  I thought it would be interesting to look at what sectors could be threatened by this and which might have an opportunity.

Is China Slowing?

It takes two to make a market and you will not get a definitive argument either way on this subject. My view is that it is and I’m skeptical over the argument that stimulus packages will save the day. Forgive me but I am an unreconstructed free marketer and I’m not willing to conveniently forget everything I’ve learnt in my lifetime. Communist Governments (or any other kind for that matter) aren’t very good at stimulating economies and the real story of China is about the increase in productivity created by foreign investment and allowing the free market greater leeway.

However, free markets can create economic bubbles. They do so especially when they are being fuelled by Governments issuing capital in order to weaken their own currency because they want to keep their exports cheap and keep social cohesion high with full employment. This game tends to end up in a local asset class bubble and Jim Chanos and others are arguing that that is what is happening in China.  A plausible argument but is there evidence for it?

I think there is.

First, let’s look at how automotive sales are weakening this year.

And other evidence is pointing to a slowdown in things like electricity demand, export growth, property prices and fixed asset investment. These sorts of things usually manifest themselves in consumer expectations.

It’s not just consumers who are getting less optimistic. Here are the new orders indices from China’s official PMI data.

Let’s recall that the official PMI data is not widely accepted as being as accurate as other private surveys which are showing worse conditions. Furthermore, the manufacturing numbers (unlike the US) are more important in China.

Stimulus Efforts?

I don’t want to dwell to long on this issue because I have outlined some thoughts on the issue in an article linked here.  Simply put, I think it will be a lot harder for the Government to do this than many people think it is. If you share my views than the next step will be to try and incorporate this into your investing by looking at which companies are heavily relying on China and which companies might actually benefit.

Early Warnings

There are early signs of a slowdown everywhere. For example FedEx (NYSE: FDX) recently gave notice that global trade is slowing faster than global GDP growth. It particularly mentioned issues with China’s export trade for a couple of reasons. First, protectionism is rearing its ugly head and Governments are implementing policies which are slowing trade. Second, consumer demand in Europe is causing Chinese export growth to slow disproportionately. Putting these factors together led to FedEx lowering its own earnings guidance as well as its estimates for GDP growth.

Similarly, we have seen Asian focused luxury goods maker Burberry warn that conditions were weakening. I think the luxury goods sector could be at risk and Coach (NYSE: COH) might be a stock worth being cautious with. It relies on China and Japan for much of its growth and with more intensive domestic competition coming from Michael Kors and others it is going to be even more reliant on the Asian consumer.

Other signs of a slowdown have been seen in the commodity sector where China has been the driver of marginal demand for the last decade. We can see this in how earnings estimates are falling for a diversified mining company like Rio Tinto (NYSE: RIO)

Another area that might get affected is technology and telecommunications. For example China’s ZTE gave a grim warning this year over domestic spending. I’ve discussed this in an article linked here and I think Cisco (NASDAQ: CSCO) could be affected in a couple of ways. First, its own sales to China are likely to be directly affected and second if Huawei and ZTE are facing difficult conditions at home they are more likely to get price aggressive in other markets and that means challenging Cisco in its core routers and switching market in the West.

Who Might Benefit?

If commodities have been driven up by China’s demand then a slowing should see prices falling even more and this is good news for the input costs of many manufacturers. It is also good news for Western consumers who have been forced to pay higher costs for soft commodities and food stocks. Indeed, if we focus on recent statement from the food producers like General Mills and others, the good news is that cost inflation is set to slow significantly.

I also think that the big box retailers could benefit too. Not only will input cost prices slow for the likes of Wal-Mart but lower energy prices will see gasoline costs reduce. This is good news for US consumers discretionary spending and mass market retail should see a boost as a consequence.

In conclusion, there are winners and losers from a potential slowdown in China. Whether it is inevitably going to happen is debatable and investors should watch stimulus plans and see if they have the desired effect. For now I think it makes more sense to take a cautious approach because the data is trending in a weak fashion.