Apple’s earnings: Why the biggest risk to investors is now China (Part 6 of 10)
China’s U.S. debt holdings
The below graph reflects the dramatic increase in foreign claims on the U.S. dollar. This graph represents foreign holdings of U.S. debt. Total net debt in the USA, excluding the debt held by the Federal Reserve Bank and other governmental agencies, equals about $12 trillion U.S. dollars, versus $16 trillion gross or total debt. China holds approximately 8% of publicly held U.S. debt—about 10% more than U.S. households, with all foreign governments holding around 46%, as the below graph reflects. The growing amount of China’s foreign claims over the past decade has been referred to as a “bubble,” and unless it’s properly managed, it could create significant problems for China’s economic development. However, as the below graph reflects, China has slowed its purchases of U.S. debt since 2011 while export growth rates have declined, as we noted in the prior article of this series.
Plus, countries other than China and Japan have been the large new acquirers of U.S. debt, as the graph reflects below. Overall, this would suggest that China’s “bubble” of U.S. debt is overstated, and that as long as China maintains a fairly stable trade relationship with the USA, China’s U.S. debt holdings shouldn’t not be volatile. This bodes well for the continuation of stable trade and economic growth rates for China, interest rate stability in the USA, and global consumption growth recovery, which should be a positive for Apple’s global sales in the future.
QE3 winds down and Fed holdings stabilize around $4 trillion
Excluded from U.S. net debt stands the U.S. Federal Reserve Bank’s holdings of U.S. Treasury securities, at approximately $4.011 trillion as of April 23, 2014, having stood at a mere $500 billion as of 2009. Subsequent bond purchases during the “quantitative easing” (QE3) program post–2008 crisis have grown the U.S. Central Bank balance sheet significantly, though for now, it seems that around $4 trillion—25% of gross debt and 30% of net debt—should be the ceiling for the Fed.
Total foreign reserves “bubble”
Chinese foreign currency reserves as a percent of nominal GDP stood at 41% in 2012 and at 184% of merchandise imports. These are huge ratios. Some economists consider them an excessive waste of dead capital. At $3.95 trillion as of March 2014, China’s foreign reserve holdings are bigger than the next five holders of foreign reserves combined, including Japan ($1.2 trillion), Saudi Arabia ($656 billion), Switzerland ($476 billion), Russia ($454 billion), and Taiwan ($403 billion).
Roughly 30% of China’s total $3.95 trillion in foreign exchange reserves are in dollars ($1.6 trillion). Of long-term Treasury holdings, Japan holds approximately $1.1 trillion, while China holds $1.2 trillion. Regarding U.S. agency mortgage securities, Japan holds approximately $250 billion, while China holds $202 billion. Japan and China combined hold roughly $450 billion U.S. mortgage-backed securities—just below the U.S. Fed’s $500 billion or so in holdings. Of China’s total holdings of U.S. securities, roughly 72% are in long-term Treasuries, 13% in U.S. agencies, 14% in U.S. equities, and 2% in corporate and short-term debt (Source: Congressional Research Service, August 2013).
Under control so far
China’s foreign reserves bubble seems to be under control—at least as far as the acquisition of U.S. debt is concerned. China’s nearly $4 trillion of reserves can serve to absorb slowing economic growth if slow growth develops. Overall, China maintains significant holdings of foreign securities, as its trade surpluses have been strong though declining in recent years. Should trade slow and China run an import-led trade deficit, foreign holdings would decline and interest rates could rise if China were to engage in panic selling of securities. As long as we don’t see a rapid and severe deterioration of Chinese trade data, it’s unlikely that China will dump foreign holdings any time soon. For now, global interest rates seem to be fairly well subdued, supporting global growth rates, which should continue to support Apple’s global sales.
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), 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 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, the banking flagship Bank of China, trading at 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.
To see why Japan’s ETFs DXJ and EWJ have been outperforming China’s FXI and Korea’s EWY, please see The Bank of Japan Tankan supports a 2014 Japanese equity rally.
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