A global financial contagion like that of the Financial Crisis just six short years ago cannot be ruled out.
The magnitude of wealth lost in China’s (FXI) equity market is simply staggering, and we’re already witnessing bad loans soar across China’s Big 4 banks. We’re hearing that property, used as collateral for stock margin trading in China, is often being sold for 90 cents on the dollar as speculators look to cover losses. We expect the fallout from the collapse in Chinese equity markets to eventually reverberate through their property markets, impacting loan-to-values in the commercial and residential arenas, sparking significant loss rates and asset write-downs across the Chinese financial system.
We continue to assess the tangible evidence of an economy in China that is in tremendous turmoil. We received word that, while Apple’s (AAPL) market share continues to increase in the country, total smartphone sales in the country fell for the first time during the second quarter. Auto sales in China are under pressure as GM (GM) and Ford (F) have noted, and the gaming markets have been shattered by incessant government intervention in its “war” against corruption. What really keeps us up at night, however, in addition to the tangible, real slowing of the Chinese economy, is how writers are largely saying China’s impact to the US is immaterial.
But if you recall, the country was once the solution to all of the US’ growth problems. Prior to the collapse in Chinese shares, almost every multinational corporation from Yum! Brands (YUM) to Starbucks (SBUX) to Nike (NKE) to Boeing (BA) and beyond championed their tremendous opportunity in the Communist country. Now that China’s strength has become a grave question, new “research” has surfaced implying that less than 2% of sales from S&P 500 companies originate directly from the country. The stark reality, however, is that China is much more important than perhaps we’re even giving it credit for. That the bulls haven’t yet turned cautious is perhaps the biggest red flag that we have much more tough sledding to come.
We outlined that the British banks, HSBC (HSBC) and Standard Chartered, are on the hook for billions in outstanding loans to China, and that several investment banks in the US have meaningful direct exposure to the country, with Citigroup (C) having the largest. We learned during the Financial Crisis that the financial sector operates mostly on confidence, and in China, any semblance of confidence has been eradicated, particularly as the government instills fear. To measure exposure to China in sales, for example, with respect to the financial sector (XLF) is simply misleading to the American investing public, in our view. We live in a global, inter-connected world, and when a country as large as China sneezes, the US (SPY) gets sick.
Apple, the largest company in the S&P 500, generates nearly two thirds of its revenue from non-US markets, with the Greater China region as its second-largest market after the US. At $13.2 billion of quarterly revenues from the region alone in the latest period, that’s more than 25% of sales for the iPhone maker. SkyWorks (SWKS), Wynn Resorts (WYNN), Qualcomm (QCOM), Broadcom (BRCM), Micron (MU), and Nvidia (NVDA) also have significant direct exposure to China, but the bigger concern is how the “China fallout” will impact broader Asia. The Financial Times reported today that exports in South Korea fell nearly 15% in August, the largest decline since 2009. China accounts for about 25% of South Korea’s exports, with the “value of shipments to the country falling 8.8 percent in the period.” The contagion has already spread, in our view, and weakness in Asia is a much more serious issue than isolated troubles in China alone.
Not only are the financial sector and technology sector (XLK) more exposed to China and Asia than the general consensus believes, but even the domestic oil and gas plays (XLE) are not immune to the “Asian contagion.” Unconfirmed reports have indicated that member nations of OPEC may be looking to schedule an emergency meeting, but nothing has been set in stone to our knowledge. Monday did bring news from the EIA that US oil production (USO) during the first five months of 2015 was slightly lower than previously estimated (9.4 million, 9.5 million), but the supply glut of oil inventories, the greatest in 80 years for this time of year, may take a back seat to a greater concern: if China and all of Asia are slowing down, there are now tangible demand concerns with respect to crude oil, and that means prices have yet to hit bottom. The strength in the US dollar won’t help matters either.
From our perspective, falling energy resource prices will simply wreak havoc on the over-extended US-based oil and gas sector, which remains buried under a mountain of debt as it struggles to survive. Bloomberg recently reported that about $500 billion in bonds “are due for repayment over the next five years.” OPEC has no duty to keep US domestics afloat, and under a situation where default rates in the upstream arena soar in coming years, we would also expect the dividends of the largest bellwethers, Chevron (CVX) and ConocoPhillips (COP), to be tested. Energy service entities are not immune either, and even the midstream segment could experience repercussions related to customer bankruptcies and disruptions in supply. We think the dividends of midstream operators are in peril, mostly due to their overleveraged balance sheets and extreme dependence on capital-market infusions as a result of their risky MLP structures.
The broad declines in the price of iron ore, the key ingredient to making steel, also suggests China’s economic health is far worse than reported numbers, in our view. But even reported numbers are bad. Just today, China’s purchasing managers index fell to 49.7 (from 50 in July), marking the lowest level in 3 years and implying a level of contraction. Other country-specific indices that measure manufacturing activity have fallen to 6+ year lows. The construction, mining, and manufacturing industries seem to be reeling in the country and have reportedly been large contributors to the bad loans at China-based banks. Even US-based basic materials entities won’t be spared from the impact from sliding commodity prices, as BHP (BHP), Rio Tinto (RIO) and others continue to add to the supply glut in iron ore. There are no signs of their slowing down.
The consumer staples (XLP) and the healthcare (XLV) sectors may be the most resilient in this environment, but many constituents have already caught the favor of a wide variety of investors, and the multiples across these sectors are far from attractive. The consumer staples sector and healthcare sector, according to FactSet’s latest Earnings Insight, are trading at 18.5 times forward earnings and 16.2 times forward earnings, hardly bargains, and about two multiple turns greater than their 5-year and 10-year averages. That means we could see another 10%-15% price drop in the “safest” sectors of this market, and we wouldn’t even blink. We’d only be back to “normal,” if earnings estimates are not revised lower–and clearly the situation we’re in today is far from normal. Dividend growth investors that have been lured to sleep from steadily-increasing income streams may be most at risk from complacency resulting from this 6+ year upward sloping bull market.
Add the threat of a rising interest rate environment, which could trample the broader investment case for REITs, coupled with the possibility of international currency wars (and the likelihood of yet another currency crisis), we have all the makings of another US market crash (DIA). Our best ideas for this market continue to be in the Valuentum newsletter portfolios.