Sat, 5 Sep 2015
A slowing China will have a profound impact, but it isn't the be-all and end-all to the health of the global economy, says Morningstar's Bob Johnson.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The U.S. stock market and global stock markets continue to be incredibly volatile as issues in China are under the microscope. I'm here with Bob Johnson--he is our director of economic analysis--for why China matters, why it doesn't, who are some of the winners and losers, and if the market is overreacting.
Bob, thanks for joining today.
Bob Johnson: It's good to be here today.
Glaser: Let's start with why China matters and why it is that the markets are paying attention to the apparent slowdown in growth in China. What are some of the big places where China is a huge factor.
Johnson: Well, China is a big country. Its GDP puts it second in the world, only behind the U.S. by country. The European Union, if you count them all as one block, would be ahead of China. But it's a very big country that's got an influence on a lot of things. One thing to keep in mind, though, with China is that they aren't necessarily the be-all and end-all of the world economy either. They are a somewhat insular country, and so it's not going to necessarily have all the dramatic effects that people seem to be attributing to it.
Glaser: Let's look at commodities--that is one place where they probably will have a big impact.
Johnson: Absolutely. With a lot of the industrial commodities--copper or coal or iron ore--China may absorb as much as 50% of some commodity categories. So, as they go, so go those commodities. So, that's got a very, very big impact on anybody that sells commodities into China. It also has knock-on effects, if you will, on Germany and the U.S. economy. To mine and produce and ship all of those commodities takes a lot of industrial equipment, which the U.S. and Germany happen to be very good at.
So, companies that produce those types of industrial goods will certainly have their share of problems. Also, I might add that China has absorbed a lot of cell phone materials over the last few years--some of it for export back out again. As Apple (AAPL) has grown so have a lot of the imports of raw semiconductors into China. Also, China was one of the fastest-growing users of cell phones and smartphones over the last several years. So, it's been a major source of growth for a lot of tech companies, and I think that is probably slowing up just a little bit or at least market shares are changing pretty drastically there. So certainly, China is having an impact there, and I'd say that those are probably the three big impacts. But a lot of other things aren't as important as you might guess.
Glaser: Looking at the U.S. economy, where is China not having a big impact? Are we seeing any weakness in the U.S. because of what's happening there?
Johnson: I think that one has to really step back here. About 0.9% of the U.S. GDP is dependent on China. That's really a very small number. Canada and Mexico would be far bigger than that. So, it's not terribly important. And a lot of that's not terribly economically sensitive in the short run. It's jetliners that are under 10-year contract deals. We may get different shipments every month, but it's not because of changes in the economy. It's because of changes in Boeing's (BA) production schedule. So, I'm not terribly worried about that.
Even in commodities, where we're probably most exposed in some of the gasoline- and oil-related stuff, those are necessities. And maybe growth won't be as fast as people thought, but it's not like they are going to use less energy than they used before. So, I'm not expecting a big impact on the U.S.
Glaser: But one of the things we learned in the financial crisis was that there can be this interconnectedness; there can be these linkages that could happen if there was, say, a financial crisis. It could bleed over. Is that something that you're at all concerned about.
Johnson: A very good point. That's probably what's got me worried the most. Unfortunately, it's usually something you can't see. Or it's something that you don't think is that big of a deal, and it turns out to surprise everyone. But I think, certainly, my biggest worry that is there's some corporation that's very related to commodities that has a little bit too much debt and brings down a big U.S. bank or a big European bank or brings down some commodities fund or brings down some investment manager who has big lending amounts from a multinational bank. That's probably my biggest worry of what could go wrong here.
But I'm not as worried as maybe some are because China is very much an insular economy. It isn't like every big multinational's got a huge lending operation in China. China controls a lot of the lending market over there, and it's not like there's a lot of exposure to big banks. It probably won't transmit itself around the world. So, I'm a little bit less worried about that. But there are some [other worries]. I mentioned that China's not much of the U.S. economy, but it's more of some other economies. It's 3% of Germany's GDP and 6% of Australia's GDP. Those numbers can be much more affected. So, there are some things that we will see across the economy.
Glaser: So, there could be some contagion, but you think, for the most part, it's not something a U.S.-based investor should be incredibly concerned about.
Johnson: No. I think this situation in China will be relatively contained, especially relative to the U.S. [Solid economic] data just keeps coming out for the U.S. For the first time in probably four or five years, I'm actually attempted to raise my 2% to 2.5% GDP growth rate. The auto sales were tremendous this week--just really great numbers. The housing industry has really picked up strength. The ADP data this week seems to suggest that maybe employment is holding up better than we all thought. So, the U.S. appears to be doing very well.
Glaser: But the U.S. economy and the S&P 500 are two very different things. Could we see a big slowdown in earnings and potential weakness in the stock market because of that?
Johnson: Absolutely. And here is the reason: We talked just a moment ago about China being less than 1% of U.S. GDP. Even if it spreads to Brazil and you include a whole bunch of other countries that this could spread to--like Australia or whatever--exports, in terms of GDP, are about 13% of U.S. GDP. But if you look at the S&P 500--and it's controversial, depending on how you calculate it--but 25% to 40% of revenues are from overseas countries.
So, [the S&P 500 is] roughly twice as dependent on a revenue basis, and on growth probably more than that. And depending on how the accounting goes, it may be more or less of earnings. Nobody can really make a good guess at that. So, it's exceptionally important, and you might ask why there's that big difference. How can it be so much of the S&P 500 and so little of the U.S. economy? Well, a lot of those goods that are made by U.S. multinationals are manufactured in other countries. In fact, some of the stuff that we sell in China might be manufactured in China under a joint venture or something. So, a lot of the situation in the S&P 500 comes because the goods are not manufactured in the U.S. We went through a whole period from 2010-12 where the U.S. economy really grew a lot slower than anybody had hoped, in terms of GDP, but S&P earnings went through the roof. Now, unfortunately, I think we're going through the other end of that, and it could affect S&P earnings.
Glaser: So, we might have an impact on earnings and there is some risk of contagion; but overall, it seems like you have a pretty balanced view of what the impact of China is going to be. Do you think, then, that the market is overreacting with these big swings and this big increase in volatility we've seen? Is this either a misreading of what's happening in China or is there more going on? Are people worried about the Fed?
Johnson: I think there's a lot more going on. I think China happened to be a convenient excuse for people to sell a little bit. I think we've all talked about valuations being a little stretched for some time. Certainly, none of us can really guess exactly when the Fed might be raising rates, but it's highly likely that in the next six months they'll raise rates and then probably raise them even a couple of more times, especially with the strength that we're seeing in the U.S. economy. And higher interest rates are usually not terribly good for stock markets.
And you mentioned earnings, with corporate America being a little bit more dependent on overseas business. Also, we haven't had a sell-off in three or four years of a 10% magnitude. So, it's kind of time. I think all of those things combined made China a convenient scapegoat. And it was interesting that the biggest sell-off this week came on Monday when one of the purchasing manager surveys came out on China, and it dipped below 50.
Well, that's just one measure. There have been other PMI measures that have been below 50 for six months running. So, it's not exactly a surprise to anybody who has been tracking China closely. I think that it seemed odd that the market was selling off on what I viewed as already well-known news on Monday, which leads to why I think those other factors--stretched valuations, the potential for a Fed rise, and earnings--are every bit as important as China for the recent decline.
Glaser: So, there could be more volatility ahead, but it might not just be because of China.
Johnson: Right. The Fed wavering on what they're going to do and the employment report coming out this week will both have an impact, too.
Glaser: Bob, I certainly appreciate your take on this today.
Johnson: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.