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The chance that China's economy will grow more slowly than expected in 2012 adds unexpected risk to global consumer stocks
12/02/2011 8:30 am EST
This may be the biggest immediate legacy of the euro debt crisis. With the EuroZone projected to grow by just 0.7%--or less-- next year and the U.S. economy projected to chug along at 2% growth or less, China will be the make or break story for a huge number of companies in 2012.
Investors are used to this by now for the shares of companies like Freeport McMoRan Copper & Gold (FCX) or Vale (VALE) or Peabody Energy (BTU). Worries that growth in China might be slowing drives down shares of the companies that supply the commodities that feed China’s manufacturing machine slump. Growth looks stronger than expected, on the other hand, and these shares climb.
But China’s influence has been growing and it now extends well outside the commodity and materials sectors to stocks that don’t immediately seem to have a China connection. The China risk in many of these stocks isn’t well recognized by investors. And I’d argue that’s likely to be especially dangerous over the next six months or so because of the way that many of these stocks are increasingly dependent on China for growth.
I call this the Tiffany & Co. (TIF) problem. On November 29, before the New York market opened, the high-end luxury retailer announced third quarter earnings for the fiscal year that ends on January 31 that beat Wall Street estimates by 10 cents a share. But the stock plunged 11.2% from the November 28 close to the November 29 open when the company announced disappointing guidance for the fourth quarter and for the full fiscal year.
Global net sales would climb by a percentage in the high teens for the full year, Tiffany told investors and analysts, but would increase by just a low-teens percentage in the fourth quarter. That’s disappointing after a 20% increase in worldwide sales in the first half of the year. Which, of course, explains the sell off.
But what interests me is the regional composition of the company’s sales guidance. In the fourth quarter Tiffany’s expects sales to slow in the U.S. Northeast and in Europe. For the full year that doesn’t have a big effect on projections for sales growth in Europe and the United States. In its full year guidance Tiffany kept sales growth projections unchanged at 20% for Europe and in the high teens for the United States.
The only region where Tiffany is projecting an increase in sales from its last guidance is the Asia- Pacific. In that region, dominated by China’s economy (especially since Tiffany breaks out Japan as a separate region), the company has raised its projections for growth to 35% for the year from earlier guidance of 30%.
Think about that for a minute or two. Here’s a company saying that it expects sales growth to accelerate from the region dominated by China at a time when China’s growth, which has already dropped to an annual 9.1% in the third quarter from 9.5% in the second quarter and 9.7% in the first quarter, is expected to slow further. And here’s a company that delivered disappointing guidance on growth for the fourth quarter ratcheting up its projections for that quarter’s growth from the region where growth is slowing in order to reach those growth targets.
I’m not saying that Tiffany won’t make or beat those projections for the fourth quarter and the fiscal year. But I am saying that uncertainties about growth in China increase the risk in this stock and similar stocks such as Coach (COH), a member of my Jubak’s Picks portfolio http://jubakpicks.com/ , that are counting on growth from China to make up for slowing growth in Europe and the United States.
I’d break down that China risk for Tiffany and similar consumer copanies depending on growth in China into two parts.
First, there’s the risk that these companies share with commodity and materials companies—China’s efforts to slow its economy in order to fight inflation might just have worked too well.
Last week the HSBC flash purchasing managers index (PMI) showed a drop to 48 in November from 51 in October. (Anything below 50 signals a contraction.) The drop took the index down to the lows of April 2009 when China’s economy was still struggling to throw off the effects of the global financial crisis. That PMI reading suggests that industrial output is likely to fall to 11% to 12% growth in the last quarter of the year. That would be the slowest since 2009. Export growth hit an eight month low in October. Housing prices moved lower in October for the first time in 2011.
Yep, China’s economy is slowing. The World Bank projects that growth in China will slow to 8.4% in 2012. (If that doesn’t seem so bad from the perspective of a U.S. economy that would love to see 4% growth, economists calculate that 8.4% growth in China is below the economy’s potential. When economists talk about a hard landing in China, some mean that growth would dip below 8%.)
And, of course, there’s the chance that China’s growth will slow below that forecast. The biggest danger here is from the unequal effect of the lending slowdown that the People’s Bank engineered. This slowdown was an inconvenience to China’s big state owned companies, which by and large continued to be able to borrow. But it has turned into a credit crunch for China’s small and middle-sized companies. A campaign to require at least half of a commercial bank’s clients to be small and middle-sized companies seems to have headed off a full scale credit crunch for now but the worry is that in the first quarter of 2012, when many companies have payments to suppliers and workers due just before the Chinese New Year (that falls in January in 2012), these companies won’t have the cash to pay their bills.
Even if they can borrow, these companies are paying more for their funds. Only 13% of small and medium-sized business have access to bank loans—the rest are borrowing in the shadow banking system where interest rates range from 14% to 70%. Add those higher borrowing costs to higher prices for labor and raw materials and you’ve got a profit crisis in this part of China’s economy. A survey by e-commerce provider Alibaba Group and Peking University found that so far in 2011 the average profit margin for China’s small and medium-sized business is down 40%. A recent survey by the Federation of Hong Kong Industries reported that up to one-third of factories in China owned by Hong Kong companies could downsize or shut by the end of 2011.
There’s certainly the potential here for a hard landing.
Which is why, on November 30, the People’s Bank cut bank reserve requirements to 21% from 21.5%, a record high, effective on December 5. The move will allow banks to lend out more capital—an additional $61 billion--but it’s more important as a signal that the central bank has decided to move to a looser monetary policy and more quickly than expected too. This is the first reduction in the reserve ratio since 2008 and the first reduction after six increases in 2011 alone. I’d expect another cut in January to free up funds for the New Year’s crunch.
And why the latest five-year plan calls for the construction of 36 million units of low-cost rental housing by 2015 with 10 million units to start this year. That’s an effort to make up for the effects of efforts to slow China’s private sector real estate boom. The real estate sector accounts for 15% of China’s GDP. Without a pick up in government sponsored housing construction, a slowdown in the private real estate market would crimp companies from concrete to steel.
The second risk to Tiffany and similar consumer companies counting on growth from China is a result of the peculiar structure of the Chinese economy. In the United States consumer spending accounts for about 70% of GDP; in China the ratio is closer to 35%, according to World Bank data. In fact, consumer spending as a proportion to GDP has been falling for most of the last decade, according to Yasheng Huang, the founder of MIT’s China Lab.
That means that getting China’s GDP growth stabilized and then gently accelerating again may not translate into a proportionate increase in consumer spending. If the increase in bank lending, for example, goes to state-owned enterprises rather than to private-sector businesses, it will produce GDP growth all right, but less job growth—and thus less income--than you might expect. The state sector accounts for 80% of bank borrowing but just 20% of jobs, MIT’s Huang calculates. The private sector gets just 205 of bank loans but accounts for 80% of jobs.
China’s top-down, government-mandated approach to growth is extremely effective at generating GDP, but it’s much less effective at growing incomes and consumption, the data for the last two decades show, says Huang. And frequently the commands from the center have perverse effects. For example, the 15% annual increase in the minimum wage mandated in the latest five-year plan as an attempt to increase incomes and reorient China’s economy toward consumer spending will boost consumer spending less than projected, Huang notes, because most of the increase in the minimum wage will go to migrant workers who don’t spend. Since they don’t have resident status in the cities where they work, migrant workers save and save for the services that they aren’t entitled to as non-resident workers. So they put aside money for health care, for education of their children, and for retirement rather than spending it.
That doesn’t mean that increasing the minimum wage is a bad idea or that it won’t put pump some growth in consumption into China’s economy.
But it does mean that companies depending on China’s consumers to bail out their growth projections, in a year when Europe won’t grow at all and when the U.S. economy will continue to struggle, stand a good chance of missing estimates.
You don’t have to dump your shares of Tiffany or Coach or Yum! Brands (YUM) or General Motors (GM).
But you should certainly include these two kinds of risk in your decision to buy, sell or hold over the next six to eight months. Why six to eight months? Because by June investors will know how slow China’s slow growth will be in 2012.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares in Coach and Freeport McMoRan Copper & Gold as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/