Baidu rally long overdue
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. Wages are simply growing much faster than the overall economy, which fuels inflation and real estate bubbles when banks are willing lenders. As a result of the growth in the cost base of Chinese production, cost sensitive manufacturers, such a clothing and textile manufacturers, have begun to look to countries such as Vietnam or Thailand to contain production costs. On the other hand, wage inflation can have a positive effect on sales data for domestic technology companies such as Baidu (BIDU). This series examines wage 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 (GOOG), as well as the implications for Asian equities and ETF’s.
Tightening profit margins for exporters, but great margins for Baidu
As wage costs have grown faster than the broader economy, profit margins in China have come under pressure. Recent 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 come under pressure, corporations may have less cash flow to service their debt. Chinese firms must increase productivity to maintain margins through increased technological investment, cutting manufacturing costs such as labor and/or grow sales. These cost pressures are likely to put increased pressure on the profit margins of Chinese exports, and temper historical export growth rates. On the other hand, Baidu is not as directly dependent on near-term capital expenditures as the Chinese manufacturing and construction industry is. Baidu has an 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 may rise from around 198% of GDP by then end of 2012 to 245% of GDP by 2015. The Fitch Ratings agency has signaled a warning on the growth rate of Chinese debt. Gordon Chang notes in Forbes that the days of credit fueled growth may be facing a dramatic slowdown, as every dollar in credit growth in 2007 was associated with 87 cents of growth, whereas currently, every dollar of credit growth is associated with a paltry 17 cents of growth. Given this dramatic deceleration of the multiplier effect associated with debt growth, it would appear that a very significant near-term deceleration of economic growth is underway in China. 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.
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.
To see how China’s currency is more supportive to Baidu than Chinese exporters, read the next part of this series.