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Since 2012, I've been a frequent visitor to the People's Republic of
China. With 52 red stamps on my passport to prove it, I'm still
mystified by the incongruities that jump out at me as a Westerner.
I’ve come to accept that plenty of contradictions about China will
never make sense to the Western mindset. Yet China, whose Communist
Party government turns 70 today, marches on, contradictions and all.
The same China that’s famous for its human rights violations is the
China that lifted more than 800 million people out of poverty as per
capita GDP rose from $89 in 1960 to roughly $10,000 today. The China
where rural kids burn trash to keep warm is the same China that minted
two billionaires per week in 2017, and where life expectancy rose from
43.7 years in 1960 to nearly 80 years today.
However you see China, these days, you must see China. It cannot be ignored, especially by investors.
Let’s see how China’s economy as we know it happened, from its rocky
early decades through to present, and on to where it’s going.
1949: Inflation Fighter Mao
Ideology tends to birth major leaders, but so, too, does inflation.
Chiang Kai-Shek’s Nationalist government had turned to the printing
press to finance the 1937 war with Japan and the 1946 civil war against
Mao Zedong’s communists. According to data from the libertarian
think-tank Foundation for Economic Education, in 1937, 3.6 billion yuan
were in circulation. By 1948, 5.1 quadrillion (the next number after a
trillion) were -- and that’s after a 3,000,000-to-1 reverse split. This, plus Nationalist corruption, helped turned popular support Mao’s way.
1958-1962: Great Leap Forward
Mao wasn’t an economist. Nor was he an
agriculturalist. During the Great Leap Forward, as many as 45 million
people died from Mao’s failed attempt to convert small family farms to
communes while simultaneously getting them into steel
production. Chinese living standards, as measured by purchasing power parity, fell 20% from 1958-1962, according to data from Angus Maddison cited by the Congressional Research Service.
1966-1976: Cultural Revolution
He buried 460 scholars alive. We have buried 46,000 scholars
alive. You [intellectuals] revile us for being Qin Shi Huangs. You are
wrong. We have surpassed Qin Shi Huang a hundredfold. -Mao Zedong, 1958
Mao wasn’t much for intellectuals, which both he and Qin Shi Huang,
who became China’s first emperor 2,000 year ago by standardizing
currency, script, and units of measure, saw as threats to power. Mao’s
campaign to eradicate both cultural relics (and the traditionalism they
beget) and academic intellectualism caused industrial production to drop
by 14% in 1967.
1979: Deng Opens the Door
Black cat.. White cat... color doesn’t matter as long as it
catches mice. A contradiction between socialism and the market economy
does not exist.
-Deng Xiaoping, 1962, 1985
Deng began China’s real economic miracle with his 1979 Open Door
Policy. Critics point out the irony of communist China’s “miracle”
coming from its taste of capitalism. But China fans will say that
China’s results stem from effective hybridization of two systems.
For example, a hallmark of hybridization has been state-owned enterprises
(SOEs), which initially dominated China’s economy, then were reduced,
only to be strengthened again under Xi Jinping. Democratic nations say
sovereign help in the form of reduced competition, preferential
financing, or subsidies gives China’s firms an unfair boost. China says
that’s the point.
Thanks in part to these boosts, the Middle Kingdom is becoming middle
class. Consulting firm McKinsey notes that 76% of China’s urban
population will be considered middle class by 2022 (defined as earning
between $9,000 and $34,000 per year, which affords a decent life in
China). In 2000, just 4% made this cut.
However we see it, from 1978-2018, China’s real (i.e.,
adjusted for inflation) GDP increased by 9.5% annually--enough to double
every 8 years. And while real GDP is slowing, from 14.2% growth in 2007
to an IMF-estimated 5.5% growth in by 2024, even slow numbers by
China’s standards are breakneck by the rest of the world’s. Source: TradingView.com.
2013-Present: Xi Jinping era
President-for-life Xi Jinping has maintained China’s hallowed
above-6% GDP growth (generally assumed to be stretched by analysts), but
at the cost of debt:
Building of ghost cities and roads to nowhere has eased, select
companies are now being allowed to default, and Western economists are
finally coming to understand that a state-controlled economy can absorb
bad debt in ways that a market economy can’t – though some still suspect
China’s banks of having up to 10 times more bad loans than they report.
Trade War
Originally prompted by President Trump’s dissatisfaction with the
U.S.' $540 billion annual exports to China in 2018, relative to China’s
$120 billion in exports to the U.S., the trade war has expanded to
address a range of issues from IP theft to state subsidies. Xi likely
doesn’t mind buying more soybeans or whether canoe paddles are taxed at
12.5% or 25%; China’s soul searching is around whether U.S. demands
around state subsidies and IP transfers are at fundamental odds with how
its socialist model works.
The Future: Does China Own it?
Try sending a Chinese person an email. Try using your credit card in
China anywhere other than a hotel. Try paying with cash at a big-city
restaurant. Not impossible. But hard.
Email has been replaced by WeChat. So have credit cards and cash, for
that matter. “China speed” partly arises because a country building
from scratch can leapfrog legacy technologies (taken an Amtrak lately?),
partly because China’s populace is pragmatic and fast-adopting
(already, 83% of China’s payments are mobile), and partly because the
government sees betting heavily on technology as a way to get ahead
while demonstrating the superiority of the Chinese model.
5G
China’s authoritarian system and ownership of the country’s three
main telecom companies have allowed it greatly to expand 5G wireless
coverage which is at least 20 times faster than 4G, enabling better
connectivity among all sorts of devices from driverless cars to smart
appliances. Whereas the U.S., where 5G is developed privately and
beholden to both federal and state regulators, has been left to play
catch-up.
Artificial Intelligence (A.I.)
The Chinese government recently outspent the U.S. government 200-to-1
in artificial intelligence, in keeping with China’s plan to become the
world leader in AI by 2030 (the U.S., meanwhile, has reduced science
funding). Americans shudder to think of China’s Big Brother-style
network scoring people via surveillance cameras, social media, and
financial records. But values aside, China, with abundant data and few
restrictions on how that data is used, at least has the petri dish for
refining certain AI faster than the democratic world.
Technological Self-Sufficiency
McKinsey notes that despite being second in the world for research
and development spending, China still imports six times more
intellectual property than it exports. China still relies heavily on
foreign technology in semiconductors and healthcare, for example, and
technology transfer writ large, whether by theft (estimates of China’s
annual IP theft from the U.S. run as high as $600 billion), policy
(China traditionally forced foreign firms into technology-sharing
partnerships as a condition of market access – a requirement that the
U.S. and others claim violates the World Trade Organization rules China
agreed to in 2001), or purchase, has been a pillar of the post-Deng
Chinese model.
Made in China 2025 is China’s attempt to climb the manufacturing
ladder to self-sufficiency in key technologies. The debate around the
program is a microcosm of the debate around the overall Chinese model:
China says it’s simply trying to modernize. The U.S. gripes that the
tools of that modernization include heavy state subsidies and aggressive
technology transfer, adding that China’s blurred lines between company
and state make use of acquired technology to advance powers and values
not aligned with the U.S. likely. Made in China 2025 Industries
Information technology
Machine tools and robots
Aerospace
Ocean engineering and high-tech ships
High-tech rail
Electric cars
Electric power equipment
Farming machines
Advanced materials
Medicine and medical devices
Conclusion
A strange thing about China’s birthday is that I’ve seen
anti-communist Chinese celebrating it. Westerners separate people,
governments, and histories, but the Chinese mindset tends to identify
“China” as a fusion of the current government, thousands of years of
history, and the Chinese people today.
As their China turns 70, the people’s biggest concern for the moment
is not the trade war, Hong Kong, or their country’s role on the
geopolitical stage. It’s pork prices, which have spiked from the African
swine flu. Pork is oddly integral to Chinese society, and the creation
of China’s strategic pork reserves in 2007 was the government’s effort
to ensure that its people – who can go without freedom but not without
pork – feel their priorities are cared for in ways that don’t
necessarily make sense to the Western mindset. Leadership’s
acknowledgement that “China” is a fusion of people and traditions
together that, as much if not more so than the government, have made
China what it is today. Popular opinion may be that as long as the
government itself doesn’t lose this sight, China may celebrate its 140th
birthday.
The third quarter of 2019 comes to a close on Monday (where did the year go?).
Earnings season will kick off in a couple of weeks, except for a few companies that report off-cycle, such as Pepsi (PEP), Constellation Brands (STZ), and Bed Bath and Beyond (BBY),
which all report next week. They all have their fingers on the pulse of
the global consumer, so their forecasts will be important to listen to.
The theme of the second quarter earnings was the impact of the trade
war and global uncertainty balanced by the strength of the U.S.
consumer. We'll see if that narrative holds up, and more importantly, if
companies are taking down forecasts going into the final quarter of the
year.
Late Sunday, a reading of private manufacturing in China came in
better than expected. The Caixin/Markit Purchasing Managers Index posted
its best reading in 19 months. This Tuesday is the Republic of China's
70th anniversary and the stage will be set for President Xi to proclaim
China's rise since he became president, and present his future vision.
Note that the U.S. and Chinese trade representatives are planning to
meet on Oct. 10.
We'll get U.S. manufacturing reports for September on Tuesday. That
has also been trending lower until last month, when a rise in new orders
and output growth boosted the U.S. Purchasing Managers Index off of
10-year lows. Export growth, however continued to weaken, which has been
the pervasive theme since late 2017.
U.K. GDP and Brexit
We'll get the final second quarter GDP results for the United Kingdom
on Monday and the forecast is for a 0.5% drop. That would be the first
negative quarter of growth for the U.K. since 2009. But, let's be
honest... all anyone cares about is if, how, and when Brexit will be
resolved. Now that Parliament is back in session after a high court
judge ruled that PM Boris Johnson's attempt to prorogue it was unlawful,
the clock is ticking towards the Oct. 31 Brexit deadline.
The potential outcomes are:
The UK asks for and is granted a delay by the EU, pushing the Oct. 31 deadline out and delaying Brexit
The U.K. asks for and is refused a delay, or doesn't ask for a delay, and the U.K. has to Hard Brexit out of the EU on Oct. 31
Members
of the U.K. Parliament and PM Johnson miraculously agree on a plan that
the EU blesses, and the U.K. exits the EU with a deal on Oct. 31
None of the above, and Parliament holds a "no confidence" vote on PM Johnson, and everything is thrown up in the air
Greenland buys the U.K. (I kid... it's Friday)
U.S. Jobs Report (Friday)
Friday brings the September nonfarm payrolls report.
The U.S. jobs market is tight. Unemployment is low and we've seen some
real wage increases that have helped boost consumer confidence. There
are signs, however, that both are starting to show weakness.
As mentioned earlier, consumer confidence in the U.S. weakened in
the past month—the second in a row. It's still relatively strong, but
the trade war and other political uncertainties are starting to wear
down the consumer.
Social media company Snap Inc. (SNAP) was a red-hot IPO, but its shares peaked on its second day of trading, March 3, 2017. From there to an intraday trading
bottom on Dec. 21, 2018, Snap plummeted 83.6%. Since then, the stock
has vaulted upward by a spectacular 255% through the close on Sept. 25,
2019.
Michael Morris, an analyst with Guggenheim Securities, calls Snap "well positioned to outperform
our Internet and Media coverage universe through year end and provide
an investor return of nearly 30% through the next 12 months," as he
wrote in a report released on Sept. 24 and quoted in Barron's. His price target is $22, or 28.6% above the Sept. 25 close.
The Road Down
In 2018, owners of Apple iOS devices disliked a redesign of the app, curtailing usage, as reported by Barron's. Daily user growth had stagnated or declined during the final three quarters of 2018, The Wall Street Journal reports. Adding to the negatives surrounding the company, several top executives left in 2018.
Snap has turned in earnings reports that have beaten consensus estimates in each of the last four quarters, but by posting smaller than expected losses rather than larger than expected profits.
Key Takeaways
Snap's share price plummeted from its March 2017 IPO to Dec. 2018.
Active users stagnated or fell through most of 2018.
A redesign for Apple devices was poorly received.
Now usage and advertising are on an upswing.
A redesign for Android devices has gotten good reviews.
Gaming and e-commerce applications are growing.
'Unique Value Proposition'
Snap offers a "unique value proposition for advertisers [that] should
drive momentum through 2020 and beyond," argues Michael Morris of
Guggenheim. Usage already has been boosted by a new design for Android
devices. In particular, he notes that Snap users in the 18 to 34 age
bracket are spending increased amount of time on the app, including with
functions other than messaging.
Morris sees "long-term revenue potential at Snap as the most
under-appreciated in our universe which should support a sustained
premium valuation
multiple." He believes that continued improvements to Snap's platform
will increase advertising, producing revenue growth beyond current
expectations. He also sees Snap becoming a major player in gaming as
well as e-commerce, with an increasingly global footprint.
Growing Usage
Snap's monthly active user base is over 500 million, compared to 335 million for Twitter Inc. (TWTR) and 2.4 billion for Facebook Inc. (FB),
per Barron's. Snap's daily active user base expanded by 4 million in 1Q
2019 and 13 million in 2Q 2019, raising the daily figure to 203
million, according to another Barron's report.
Meanwhile, the intense regulatory and political scrutiny focused on
Facebook may be encouraging some advertisers to choose Snap instead,
Barron's observes. Shyam Patil, an analyst with Susquehanna Financial
Group, indicates that better self-service technology, a reorganization
that has helped advertisers understand how to use Snap, and “lower-cost
inventory” are the positives for Snap, per yet another Barron's article. However, he has a neutral rating on the stock.
Challenges Ahead
A cautionary view is voiced by Youssef Squali, an analyst with
SunTrust Robinson Humphrey. He acknowledges positives for Snap such as
growth in active users and user engagement, driven by desirable updates
and increased content. However, spending on product development,
marketing and hiring “could further pressure margins," he warned, as quoted by Barron's. He rates Snap a hold.
Meanwhile, Snap is not expected to turn a profit before 2023, and the
next economic downturn, which many observers think is long overdue, is
bound to send its ad revenue tumbling, pushing that key date yet farther
into the future. “We would be cautious regarding cash-flow-negative companies” as a result, warns Mark Kelley, an analyst with Nomura Instinet, per Barron's.
Earnings Outlook
The 3Q 2019 earnings report from Snap is expected to be released late in October, per Yahoo Finance. The consensus estimate calls for EPS
that is a loss of 5 cents, versus per share losses of 12 cents in the
same period of 2018, 10 cents in 1Q 2019, and 6 cents in 2Q 2019.
With respect to revenues, the 3Q 2019 consensus forecast is $434 million, a year-over-year (YOY) jump of 45.9%, and an increase of 11.9% from 2Q 2019.
Among the 36 analysts covering Snap, just 6, or 17%, rate it a buy or
a strong buy. Their average price target is $16.57, or 3.2% below the
close on Sept. 25.
Even as the S&P 500 Index (SPX)
hovers near its all-time high, a recent report from Goldman Sachs finds
that stocks in three areas still have significant potential for
additional gains: services-providing companies, dividend-paying stocks,
and domestic-focused firms. Among the 50 stocks in Goldman's basket of
stocks with a high percentage of sales derived within the U.S. are:
Anthem Inc. (ANTM), AllState Corp. (ALL), Charter Communications Inc. (CHTR), Norfolk Southern Corp. (NSC), Republic Services Inc. (RSG), and Arista Networks Inc. (ANET).
Additionally, Goldman also recommends that investors focus on
aerospace and defense stocks with the lowest exposure to China. They
note that these have the lowest reported sales to the Asia Pacific
region, the closest proxy they can find across most company reports for
sales to China: Northrop Grumman Corp. (NOC), TransDigm Group Inc. (TDG), and Huntington Ingalls Industries (HII).
Significance for Investors
"Our economists expect that a U.S. recession
is unlikely during the next two years," Goldman says in a recent
edition of their U.S. Weekly Kickstart report. "They highlight the lack
of economic imbalances and believe that elevated consumer spending and a
smaller drag from inventory accumulation should boost economic growth
through the end of 2019 and 2020," the report adds.
"During the past 10 years, Aerospace & Defense has been least
sensitive to U.S. and global economic growth across Industrials
subsectors," the report observes. "High defense spending should continue
to boost the top-line of Aerospace & Defense companies," it adds.
Moreover, Goldman's recommendation of these stocks is bolstered by this
finding: "Outside of recessions, Aerospace & Defense has outpaced
the S&P 500 by a median of 250 bp during the 6-month period when the ISM [Manufacturing Index] fell from 50 to its trough." The ISM recently dipped below 50.
Analyst Rajeev Lalwani at Morgan Stanley has an overweight, or buy, rating on Northrop Grumman, per Barron's. His price target
is $418, or 12.5% above the close on Sept. 16. Shares of Grumman have
risen about 9% since Lalwani's report was released. He projects
accelerating growth in the company's profit margins
and sales, leading to positive earning surprises. “Northrop is the best
way to play the long-term strategic priorities of the U.S. government,”
he wrote in a report, as quoted by Barron's.
Meanwhile, investing in stocks with high sales exposure to the U.S.
market is a way to hedge against a continued worsening of the U.S.-China
trade conflict. Goldman indicates that the median stock in the S&P
500 derives 71% of sales in the U.S., while the median stock in its
domestic sales basket gets 100%. Of the six stocks from this basket
highlighted Arista has 72% U.S. sales and all the others are at 100%.
Looking Ahead
An ISM Manufacturing Index reading below 50 normally indicates that
the U.S. manufacturing sector is contracting. However, Goldman believes
that manufacturing is stabilizing, and expects that continued U.S.
economic expansion will support the sector, thus they remain overweight in industrials.
Moreover, Goldman finds that the ISM index has been a poor predictor
of upcoming recessions, given that, since the 1990s, recessions have
followed an ISM reading below 50 only 30% of the time. Much of the
reason for the diminished value of the ISM index as an economic leading indicator comes from the fact that manufacturing is now only 10% of U.S. GDP, down from 20% in the 1970s and 1980s.
