China keeps U.S. rates under control—so far
The below graph reflects China’s pre– and post–2008 crisis purchases of U.S. Treasuries, U.S. agencies, and U.S. corporate debt. Just prior to the 2008 crisis, China was purchasing $6 billion per month of agency debt (the red line), $5 billion per month of Treasuries, and $4 billion per month of corporate debt—about $15 billion per month, which is right around China’s trade surplus and perfectly normal. Investors have watched the U.S. Fed taper its monthly bond purchases from $85 billion per month this year to closer to $65 billion currently. Great interest surrounds the prospects of fewer Fed purchases, though as the below graph reflects, China still recycles its trade surplus via purchasing U.S. debt securities. Should global growth improve over the next year and China’s trade surplus expand from the current low level of 2% of GDP (roughly $160 billion) to a mere 3% of GDP in 2014 (an additional $80 billion dollars), such a modest change in the current account surplus could support China’s ability to absorb some of the Fed’s declining purchases over the course of the year. This article considers the role of China’s purchases of U.S. government securities and the effects on equities such as Apple, Google, and Baidu.
To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
China’s consistent trade surplus means consistent Treasury purchases
As the 2008 crisis hit, China engaged in a flight to quality, dumping agency bonds and buying more Treasuries, as the U.S. Government’s protection of the government-sponsored agencies became somewhat questioned. As the panic has passed, China is once again snapping up strong levels of U.S. agency debt at a greater rate than Treasury debt, at roughly $6 and $5 billion, respectively, while U.S. corporate debt acquisition remains low, at closer to $1 billion per month. Apparently, China finds the credit spreads on corporate bonds unattractive.
Low rates in the U.S. support global blue chip stocks and large cap growth stocks like Google, Apple, and Baidu
For investors in large cap growth stocks in the U.S., the post-2008 low rates have been a great source of rising equity prices. As the above graph reflects, China’s continued appetite for U.S. debt over other sovereign debt should keep any taper-related interest rate spike under control. China doesn’t want higher rates in the USA to cool its soggy manufacturing data any further. This economic reality should persist, and companies like Apple and Google in the USA and even Baidu in China should continue to benefit from the modest growth in Chinese exports as the continued strong appetite for recycling global trade surpluses into U.S. debt securities continues.
To see how the rapid growth in China’s wages should continue to support Baidu over Google and Yandex, please see How wage inflation in China supports Baidu over Google and Yandex.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.