China And Commodities: What Are The Markets Missing? by Silvercrest Asset Management

There’s something happening here
What it is ain’t exactly clear
There’s a man with a gun over there
Telling me I got to beware

– Buffalo Springfield, “For What It’s Worth” (1967)

Markets are unsettled. Investors look around and see a number of big changes in the global economy—a slowdown in China, sharp falls in the price of oil and other commodities, the Fed looking to raise interest rates—that appear threatening. They see a number of data points—disappointing earnings, job cuts, cancelled projects—that seem to confirm their fears that the world could be sliding back into recession. Their response is confusion and anxiety—and the worst quarter for stocks in the U.S., Europe, and Asia in four years.

There is something happening here, but there’s a lot that, in our view, is unclear to the typical investor that they are getting wrong. The broad sell-off of recent months has been dominated by several misconceptions, notions that have contributed either to misplaced fears or to a failure to make crucial distinctions between who wins and who loses from the changes that are so evidently taking place.

What Markets Are Missing

When markets misprice risk, they create opportunity. The following are nine misconceptions that we see leading the market astray, creating either opportunities for investors, or pitfalls they need to avoid:

1. Slower China growth means slower global growth.

It seems logical to assume that when the world’s second-largest economy slows, that must be bad for everyone. But when Japan—the world’s second-largest economy at the time—went from boom to stagnation in the 1990s, it—didn’t derail the global economy. That’s because, for most of its trading partners, Japan’s export-led economy was a growth deriver, not a growth driver.

The same has been true for China.

Markets tend to assume that all growth is good growth, no matter where it takes place, or what it consists of. In fact, much of the “growth” China has seen in recent years has been bad growth: a binge of over-investment fueled by excessive credit. While it may have boosted certain industries, this bacchanalia sapped global growth by generating huge overcapacity and contributing to the global glut of supply over demand. China faces a long and painful adjustment, but having produced more than it consumed for years, it can afford to support consumption, even as output falters.

While China’s imports of raw materials like copper and coal have fallen sharply, the amount of food its households import is up +24% so far this year. The volume of imported soybeans, the top U.S. export to China, is up +10%. Caterpillar’s sales of equipment to fuel China’s faltering construction boom may be down this year, but Apple’s iPhone sales in China are up +75% and Nike’s sales have jumped +30%. Both the number of Chinese tourists traveling abroad (116 million in 2014) and the amount they spend ($200 billion this year) are expected to double by 2020. As the Chinese are forced to rein in the wrong kind of growth, redirect their energies in more productive directions, and draw on their collective savings to see their way through, they not only set China on a more sustainable growth path, but become what the global economy, including the U.S., most needs: a source of final demand.

2. Weaker commodity prices reflect a weaker global economy.

Back in the day, “Dr. Copper” was a reliable indicator of the health of the U.S. economy. With copper down -21% so far this year, to a 6 1/2-year low, that would have implied shrinking demand and slowing growth at home. That was then, this is now. Today, the price of copper, iron ore, and other industrial inputs reflects the pace of China’s runaway investment boom, and their sharp drop spells relief for many economies, including the U.S.

China’s investment binge bid up the price of inputs, but pushed down the price of many outputs by creating massive overcapacity. (The most vivid example was the solar sector, where Chinese manufacturers built so much capacity they first drove the Americans out of business, then drove the Europeans out of business, and finally drove themselves out of business). The end of China’s investment binge is having the opposite effect: deflating the price of inputs, and eventually reflating the price of outputs. Rather than signaling broad deflationary pressure, as many fear, the drop in commodity prices signals a sea change in the prevailing terms of trade that certainly hurts some sectors of the global economy, but favors a great many others, and on balance is supportive of U.S. growth.

3. U.S. corporate earnings are falling.

In Q2, operating earnings per share (EPS) for the S&P 500 index was down -11% from the year before. This figure, however, disguises a number of trends. While EPS dropped in 4Q14 and 1Q15, it actually rose +1.3% in 2Q15 as the dollar stabilized and the U.S. economy rebounded, though not enough to make up lost ground. Meanwhile, unadjusted after-tax corporate profits for the economy as a whole rose +6.4% in Q2, up +8.5% from a year ago.

S&P 500 earnings were pulled down mainly by the energy sector (-104.3% from a year ago), along with materials (-15.6%) and industrials feeding into those sectors (-2.2%)—exactly what one would expect from the end of China’s investment binge. Six out of 10 sectors in the S&P 500 actually had higher EPS than a year ago, including utilities (+12.5%), consumer discretionary (+9.5%), and IT (+4.0%). The great disparity in earnings performance among sectors and among firms drives home the fact that while the bottom is not falling out of the U.S. economy, the days of passively riding the major indices are over, and we have entered a market that places a premium on wise selection of stocks.

China

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