Apple’s earnings: Why the biggest risk to investors is now China (Part 8 of 10)
A strengthening yuan grows Apple’s U.S. dollar-based revenues
As China’s trade growth has slowed, the Chinese acquisition of foreign reserves has slowed dramatically, and nearly come to a standstill. China’s trade surplus has declined from 10.1% to around 2% of the gross domestic product (or GDP) since 2008. The currency appreciation of the Chinese yuan, driven by large trade surpluses, has also slowed from 3% to 1% per year. In fact, the yuan has depreciated around 3% a year-to-date. Since 2005, the Chinese yuan has appreciated roughly 33% against the U.S. dollar, 20% against the euro, 22% against the yen, and 40% against the Korean won. Without a doubt, China is becoming a relatively less expensive manufacturing base, although it’s also becoming a source of stronger revenues for companies like Apple. If Apple is looking for strong Chinese revenues, the strong yuan post-2008 has been a positive development. However, China’s exporters could feel the pinch of a strong currency as real wages rise at double digit growth rates in China.
This is great for supporting consumer-led growth in China, as long as wage inflation doesn’t have too much of a negative impact on the broader economy and drive China’s GDP growth rates well under 7%. For right now, the current foreign exchange environment remains supportive of Apple’s China-based sales growth and yuan-based revenues. Investors shouldn’t expect major moves up or down in the Chinese yuan; however, should adverse growth burst the real estate bubble, the yuan could weaken, and soften China-based revenues for Apple.
Will the Chinese yuan stay strong?
China’s acquisition of foreign currencies practically stopped in 2011, after growing nearly 29% a year since 2001. The appreciation of the Chinese yuan has slowed dramatically in the past year. As the global economies slow down, countries like Brazil may readjust to a new global economic stability by seeing their currencies undergo a significant devaluation. Plus, China’s trade competitors, like Japan and Korea, have seen very significant declines in the value of their currencies against the Chinese yuan, as reflected in the graph above. In fact, Japan’s current Prime Minister, Shinzo Abe, has specifically targeted 2% inflation since he was elected in November 2012, which has led to a rapid 33% decline against the U.S. dollar and a red hot bull market in Japanese equities in 2013, as corporate profits in Japan continue to increase.
How long can China manage export growth into the U.S. in the European Union (or EU) as long as it remains linked to the U.S. dollar? Over time, China’s regional and global competitors, like Japan and Korea, could finally get a reprieve in their terms of trade. By virtue of China being joined to the strengthening U.S. dollar, China will become increasingly expensive in relation to Japan, Korea, and even Brazil—a long awaited cause for celebration in Brazil (although Brazilians typically don’t let bad economic data interfere with a good celebration). China will have to manage its foreign reserves wisely to grow productivity and maintain its export economy. Japan attempted to do so after the 1990 bubble economy burst, with very poor results. China’s Central Bank Governor Zhou must not repeat the experience of Japan’s Central Bank Governor Mieno in 1990. Engineering a soft landing in the wake of a real estate bubble, driven by a low profit, can get very messy for a market-share chasing export economy.
No currency wars for China—yet
China doesn’t need to result to currency wars with its Asian neighbors just yet. Although, if the strength of the yuan becomes problematic, regional pressures could intensify with Japan and Korea, which have seen their currencies weaken dramatically against the Chinese yuan. With over $3 trillion in reserves, China doesn’t worry about not having enough U.S. dollars or euros to sell to support its currency—that would be the least of China’s worries at this point.
Instead of outright dispositions of U.S. Treasuries, which could roil U.S. and emerging credit markets, China could simply engage in more neutral strategies of foreign currency liquidation by selling U.S. Treasuries and investing in the United States. This would be neutral foreign exchange on the yuan and potentially good for the U.S. economy. Japan began to develop manufacturing facilities for cars in the U.S. after its currency appreciated rapidly in the 1980′s and 1990′s. Given China’s low cost of manufacturing, this hasn’t been an issue.
However, as a study by AlixPartners points out, the cost advantage of general manufacturing off-shoring to China will have lost its edge by 2015. (Apple is the exception to this rule because its China-based operations use more complex design and fabrication processes.) As a result, China’s trade economy and wage growth may slow. In either case, it seems that the current level of earnings in China has improved dramatically despite the strong yuan, supporting growing consumerism post-2012 and two quarters of iPhone sales in China pushing 30% growth rates.
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.
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