China rally long overdue?
China’s first quarter 2014 consumer confidence data, as noted in the following article, is showing signs of improvement. As the Chinese government’s stimulus measures fade, and investment just starts to slow, it would appear that wage growth in China is continuing to support consumer sentiment in China, and that urban area real estate prices have begun rising quickly this year. With an appreciating currency and growing economy, Chinese manufacturers have experienced wage inflation. Private sector wage growth in China was approximately 14% in 2013, while GDP growth has cooled to around 7.5% per annum. This series examines the associated consumption growth trends in China, and considers the implications for Chinese companies like Baidu versus non-Chinese competitors such as Russia’s Yandex (YNDX), and Google (GOOGL), as well as the implications for Asian equities and ETFs.
Tightening profit margins for exporters, but great margins for Baidu
Post-2012 weakness in Chinese equity markets have reflected investors’ concerns that Chinese companies may face shrinking profit margins in the future, and that the banking system in China may also experience increased pressure. As corporate earnings margins have been under pressure, corporations may have less cash flow to service their debt. On the other hand, Baidu is not as directly dependent on bank funding as the manufacturing and construction industry in China. Baidu has a 32% return on equity—right in line with Russia’s Yandex—versus 16% for Google.
China’s growing leverage versus Baidu’s lack of leverage
As China migrates to a single digit growth rate economy with higher wages, attention is now turning to the banking sector’s ability to manage ballooning debt. One study by CLSA analyst Francis Cheung notes that total Chinese debt has doubled in the last four years, and could rise from around 198% of GDP by the end of 2012 to 245% of GDP by 2015. On the other hand, Baidu has a 0.43X debt to equity ratio versus 0.35X for Yandex, and 0.06X for Google. Clearly, these companies have very low debt levels and are unlikely to feel the effects of a credit crunch. Should the Chinese banking sector come under increased pressure in the future, it would seem that Baidu will not have debt service issues.
To know how the rapid growth in China’s wages should continue to support Baidu over Google and Yandex, read Wage inflation improves China’s consumption and Baidu’s sales.
Asia’s equity outlook
The weakening yen and 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. 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 can 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 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 could go.
To see how recovering consumer confidence is supporting Baidu, read the next article.