Consumer goods: Pricing remains solid
The below graph reflects the producer price index for various sectors of the Chinese economy. The producer price index, or PPI, measures the average change in the price of goods and services sold by the manufacturers. The below graph tells us that the Chinese government’s post-2008 stimulus initiative was quite successful in staving off deflation and, in fact, returned the PPI to its pre-crisis levels quite quickly. However, post-2012, the PPI data has been bouncing off of the -5% level. Yet the consumer goods producers (those who make Apple products) report fairly constant pricing power (the green line). This article considers the prospects for companies like Apple, Google, and Baidu in light of China’s headline PPI data, which don’t look so great.
Receive e-mail alerts for new research on AAPL:
Interested in AAPL?
Don’t miss the next report.
Tech versus raw materials: A tale of two related economies
As the above graph reflects, consumer goods such as technology gadgets are maintaining their pricing power while heavy manufacturing and processing of raw materials (copper, iron ore) are seeing the worst pricing power performance. So far, this has been great new for Apple sales in China, and even Google is seeing its China-related revenues grow in the 30% range. However, as we mentioned earlier, wage growth hit astronomical growth rates in 2012, which could go down as the year of the iPhone Dragon in China. Looking forward, wage growth will likely moderate, and it will be some time before the more rural population will pile onto the iPhone or smartphone bandwagon. In other words, the smartphone growth rate is still great but will probably not match historical growth rates. In the case of Apple, the tie-up with China Mobile should mitigate the potential slowdown in sales, and the 2014 data will be extremely important with regard to Apple’s future growth prospects. The early indications from the China Mobile partnership are promising, and if growth rates in China remain around 20%, this should mean the continuation of success in China for Apple, and related technology companies like Baidu and even Google China.
As for China’s Baoshan Iron and Steel Co., it would appear that China’s aggressive investment environment post-2008 has contributed to the weak PPI data and declining stock price. Since April 2012, China’s Large Cap ETF, iShares’ FXI, has declined about 6%, while Baoshan Iron and Steel is down closer to 22%. Meanwhile, Baidu is up closer to 12%. Apple is still down near 6% and Google is up over 70%. These relative equity returns reflect that technology companies that aren’t highly encumbered in debt have outperformed more leveraged manufacturing companies and that China’s soft PPI and capacity issues have had a much more severe impact on Chinese domestic manufacturers in heavy industry relative to consumer goods and technology. Though Bidu is still quite tied to the Chinese overall economy, as Russia’s Yandex remains linked to Russia, the low debt capital structure and leveraged business models of Baidu and Google have kept them somewhat removed from the broader economy’s softening growth data.
Outlook: Tech versus metal
Looking forward, the current trend in China’s PPI data, in conjunction with strong wage growth, could suggest that companies like Baidu and Google should continue to see excellent growth rates in China—over 20%. Apple’s ability to top its prior quarter growth rate of 29% will likely depend on the success of the China Mobile venture, but it’s hard to hold one’s breath for 30%-plus growth. As for Baoshan Steel, the fact that China’s overcapacity runs as high as 300 million tons (nearly twice total Europe steel output in 2013) remains a problem that companies like Apple, Google, or Baidu don’t have. However, China is well on its way to replacing inefficient steel production with new technology, with the add rate running at twice the remove rate. Yet, as the PPI raw materials line in the above graph reflect, it wouldn’t appear that raw materials companies will see the growth that tech companies will see over the next few years.
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.