by When it comes to global financial markets, China is in the driver’s seat. After it was reported in early January that the world’s second-largest economy grew at its lowest rate in 25 years in 2015, Credit Suisse’s Global Risk Appetite index slipped into panic mode – a rare occurrence that has typically only followed major macro events such as the failure of Bear Stearns or the U.S. sovereign debt downgrade. China is currently in the midst of what might be called a triple bubble — in credit, investment, and real estate. As a result, Credit Suisse Global Markets equity analysts are watching three indicators that they feel would significantly increase the likelihood of a hard landing: property prices dropping more than 15 percent, the financial system’s loan-to-deposit ratio rising above 100 percent, or an acceleration of capital flight. None of these are the bank’s base-case scenario, however. Instead, Credit Suisse analysts expect the government to try to keep those bubbles at least partly inflated by initiating additional stimulus measures, such as cuts in taxes, interest rates, and reserve requirements for banks, So what’s a nervous investor to do? Here’s what they shouldn’t do: invest in the heavy industry that drove China’s growth in recent years.
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When it comes to global financial markets, China is in the driver’s seat. After it was reported in early January that the world’s second-largest economy grew at its lowest rate in 25 years in 2015, Credit Suisse’s Global Risk Appetite index slipped into panic mode – a rare occurrence that has typically only followed major macro events such as the failure of Bear Stearns or the U.S. sovereign debt downgrade.
China is currently in the midst of what might be called a triple bubble — in credit, investment, and real estate. As a result, Credit Suisse Global Markets equity analysts are watching three indicators that they feel would significantly increase the likelihood of a hard landing: property prices dropping more than 15 percent, the financial system’s loan-to-deposit ratio rising above 100 percent, or an acceleration of capital flight. None of these are the bank’s base-case scenario, however. Instead, Credit Suisse analysts expect the government to try to keep those bubbles at least partly inflated by initiating additional stimulus measures, such as cuts in taxes, interest rates, and reserve requirements for banks,
So what’s a nervous investor to do? Here’s what they shouldn’t do: invest in the heavy industry that drove China’s growth in recent years. As the Chinese economy continues its transformation to a consumption-driven model, investment as a share of GDP is expected to drop from 44 percent to 35 percent over the next 10 years. As such, Credit Suisse cautions against investments in capital-intensive industries such as heavy equipment, carbon steel, and bulk chemicals.
Instead, the bank’s analysts suggest that investors focus on the country’s fast-growing, consumer-oriented businesses. Internet giants such as Alibaba, Baidu, Naspers, Tencent, and Vipshop will benefit from a significant expansion of 4G wireless service that has brought faster mobile Internet service to more than 250 million users. While online retail sales currently account for just 10 percent of the Chinese total, Credit Suisse analysts believe that online retailers – as well as companies offering web-based education and banking services – will ultimately achieve greater penetration in China than they have in developed markets, some of which are already seeing 15 percent penetration.
As the past month has shown, what happens in China doesn’t stay in China. But that dependence runs two ways, and savvy investors can also find attractive China-related plays outside the country that are in a position to benefit if the Chinese economy stabilizes. Japanese companies, in particular, are in a prime position to benefit in the event that it does, as they have both high economic exposure to China and the highest operational leverage (fixed costs as a percentage of total costs) in the world, making them particularly sensitive to economic upswings of any sort. Adding to Japan’s allure: Its equities market is the cheapest in the world, with 60 percent of companies trading below replacement value.
European auto parts makers are another way to tap the benefits of Chinese consumer spending without having to buy Chinese companies themselves. There is no sign of a slowdown in demand for cars from China’s growing middle class, and cars will need to have more efficient parts in order to meet China’s ambitious carbon emissions reduction goals. This bodes well for European auto parts makers, which typically earn between 15 and 20 percent of their revenue from China.
Foreign automakers that sell into China aren’t quite as compelling. A new policy under discussion would relax restrictions on auto dealers, allowing them to sell vehicles from multiple car manufacturers, with the likely effect of reducing foreign automakers’ leverage over dealerships. In addition, the quality of China’s cars has improved markedly in the last decade, and the domestic market is increasingly competitive. Beyond automobiles, the growing list of industries in which Western companies face a growing threat from Chinese ones—both in China and elsewhere—includes power transmission and distribution, rail, bearings, automation, solar, steel, and chemicals.
Luxury goods companies with major brand recognition don’t yet have to worry about domestic competition in China, but the slowing economy isn’t doing them any favors either. Leading indicators of luxury spending, such as casino revenue growth in Macau and new orders for Swiss watches, are weak. Make that four bubbles: the Chinese market currently accounts for 30 percent of European luxury goods sales, as its people currently spend twice as much (as a percentage of household wealth) on luxury goods as the Japanese and ten times what Europeans do, a level that is likely unsustainable over the long-term.
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