Weak PPI will eventually drag on wages
The below graph reflects a significant change in China’s economic landscape. The black line reflects China’s real overall wage growth—the actual wage growth minus the rate of inflation (CPI, or Consumer Price Index). As the graph suggests, Chinese wages were accelerating dramatically since 1998, although their growth rates have begun to cool. Despite the post-2012 slow down, real wage gains of around 10% are very strong. Plus, China’s Producer Price Index, or PPI (the red line) also reflects deteriorating data post-2012. This data bodes poorly for overall growth in China, although like Google, Baidu’s strong growth rate, high margins, and low debt levels should provide the firm with some down side protection. However, the rich price earnings ratios of Baidu and Google of around 30 times versus Yandex at closer to 20 times, may suggest that they are vulnerable to shorter-term profit taking and multiple deflation in the case of further soft economic data. As wages grow in China, Baidu (BIDU) should see revenues grow dramatically. Google’s forward looking prospects seem well valued with a nearly 30 times PE, while Yandex (YNDX) has been deflated recently as Russia’s Ukraine issues have developed.
Wage inflation grows domestic consumption, but pressures margins at manufacturers
The high level of wage growth in China supports consumption growth—something sorely lacking in China’s intensely supply-side focused economy. While this pressures corporate profits, and can contribute to a worsening PPI number as shown in the above graph (red line), Baidu stands to benefit strongly from the tremendous upside growth in the Chinese economy and Chinese consumption growth in the future. China has a long way to go in terms of shifting from an investment-driven to a more consumption-driven economic growth model. However, in the meanwhile, double digit growth in real wages is still very supporting of consumption growth in China—to include computers, cell phones, and the associated apps.
Asia’s equity outlook
The weakening yen and a relatively flat wage growth in Japan has supported Japanese markets, as reflected in Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETF’s. An aggressive monetary policy in the U.S. has supported the S&P 500 as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), State Street Global Advisors Dow Jones SPDR (DIA), and 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 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 eventually become increasingly compelling. With FXI’s key holding, banking flagship Bank of China, trading at 0.84 price to book and a 4.95 price to earnings ratio, one has to wonder how much lower Chinese banks and financials can go.
For an overview of the U.S. macroeconomic recovery, which can support China’s export economy, read 2014 US macro outlook: The crack in the debt ceiling.
Read the next part of the series to see how the 30% gain in 2012 manufacturing wages supported Chinese consumption.