No longer do we live in an isolated world. If you weren’t convinced of this before the Global Financial Crisis, the credit crunch of late last decade should have changed that. Just as the interconnectedness of global financial markets is undeniable, we think the significance of the health of the Chinese economy is as critically important to the trajectory of equity prices across the globe. That’s why we’re not taking the recent collapse in the Chinese stock market lightly.
Here’s what we’re hearing.
China’s major restaurant bellwether, Yum! Brands (YUM), owner of KFC, addressed whether a decline in the country’s equity market has impacted sales. Though the company noted that “a very small percentage of customers have been impacted,” we’re not reading much into this statement. For one, Yum! Brands continues to recover from a number of missteps in the country, and we doubt it can truly differentiate whether there has been an impact to sales, as they recover from negative consumer sentiment related to the well-publicized sourcing scandal and ongoing bird flu scares. McDonald’s (MCD) is in the same boat (i.e. still recovering from last year’s supplier issue), but we give greater weight to its view that weaker macroeconomic conditions in the country have hurt spending in “lower-tier cities.”
Though the luxury goods and gaming markets are separate and distinct, both heavily rely on either tourism dollars or high-end rollers in or from China for incremental upside delta. On aspirational handbag maker Coach’s (COH) fiscal fourth-quarter conference call, CEO Victor Luis actually noted “strong growth in China” that “was driven entirely by the Mainland, as Hong Kong and Macau continued to experience traffic declines from a decrease in PRC tourists.” Interestingly, Coach’s performance may bode well for other aspirational players, but the statement was consistent with what we’re seeing in the Macau gaming market.
Gaming revenue in Macau, the world’s largest gaming market by revenue, dropped nearly 35% during the month of July from the same month last year. The pace of the fall was roughly in-line with the 36% drop in June (and in-line with estimates), but the sheer magnitude is simply eye-opening. Many continue to point to the government’s anti-corruption crackdown and business pressures for the sustained weakness in the take rates. Las Vegas Sands (LVS), Wynn Resorts (WYNN) and MGM Resorts (MGM) are key operators in Macau, and all three continue to expand capacity in the market (Persian resort, Wynn Palace, and MGM Cotai, respectively), despite the declining revenue.
Government intervention appears to have temporarily derailed the Macau gaming market, and there could be growing risks that the August 4 announcement that China “plans to set up ‘network security offices’ staffed by police inside major Internet companies,” may have some impact to the torrid pace of e-commerce growth in the country. The Chinese government appears to be taking its control of web content to the next level, and we don’t think heightened oversight and regulation can possibly be viewed as an incremental positive for the growth rates of Alibaba (BABA), Tencent (TCEHY), and Baidu (BIDU), the three largest Internet companies in the country, at least in the near term. One would think that limiting criminal activity would have a negligible dynamic on Internet commerce, but the same could have been said about the government’s anti-corruption crackdown on gaming revenues in Macau. Baidu’s shares have fallen nearly 30% since we removed them from the Best Ideas Newsletter portfolio in July 2014, after a near-doubling of shares. Alibaba’s second-quarter earnings call is scheduled for August 12, and we’re a bit nervous that no matter how great the quarter may turn out to be, a bout of selling may ensue.
General Motors (GM) threw cold water on excitement surrounding the pace of auto sales in China. GM CFO Chuck Stevens noted on the conference call that “it has been clear to us for some time that the (industry) moderation is stronger and the pricing environment is more challenging that we anticipated.” Stevens went on to say: “the potential recovery from the current reaction to the volatilities in the stock market…clearly, June and thus far in July, there has been pretty significant headwinds on a year-over-year basis.” Volkswagen (VLKAY) stated on its call that “sales performance…in China has become increasingly difficult,” pointing to a “notable slowdown in the Chinese market in June.” Ford’s (F) CEO Mark Fields reiterated that “it’s clear we’ve seen a market slowdown in the (China) market.” It’s clear to us that the collapsing equity market in China has impacted auto sales, and the weakness may have extended to other consumer durable items as well.
Concerns about the impact on consumer spending from Chinese stock market weakness have also crept into Apple’s (AAPL) share price, with the iPhone giant facing some selling pressure the past few trading sessions. Unlike more discretionary purchases from “eating out” and gaming to e-commerce spending and consumer durable sales, however, we think in this age of connectivity, the impact of the sell-off in Chinese equities on sales of Apple’s products in China may only hit the “upgrade cycle” and only at the margin. From our perspective, the market is not giving Apple credit for significant expansion in the country (anyway), and therefore, we still believe China represents a key source of upside for shares. Shares of Apple trade at a below-market earnings multiple (~12 times September 2016 numbers), and its cash hoard is tremendous.
One thing is clear. Companies across a variety of sectors and industries are experiencing a fall-out from the recent collapse in Chinese equities, and our opinion is that the full impact has yet to be realized. We’re monitoring developments closely.