Why China Rocked the Boat This Week

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five, Morningstar's take on five stories in the market this week.

Joining me with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Jason.

Stipp: Up first this week, in a big surprise China devalued its currency, with a lot of knock-on effects potentially. What's your take?

Glaser: We thought this would be a quiet week in August. They really made sure that was not going to be the case.

When China devalued the yuan, they took the rate that it trades against the dollar and brought it down. That happened over the course of a couple of days this week. There were a few factors at work in why they decided to do this, and then we'll talk about why the market was so concerned about this.

The official word is basically that they wanted to have the market play a bigger role [in their currency valuation]. This is something the IMF and others have been pushing in order for their currency to get reserve status, something that China has been seeking. They thought that this would give them an opportunity to show that they are willing to let the market have a bigger sway.

Then also it does help to devalue their currency. Given that they are having a slowdown and some issues in their manufacturing sector, having a lower currency versus some of the other big global currencies certainly is a help for them.

But the market in some places really sold off considerably on this news. I think there are a couple of factors behind that. First are concerns that this is really just the start of devaluation, and that it's going to be much larger than the ones we've seen so far this week and could start a currency war--where it would be a race to the bottom in terms of devaluation. There are worries that it could export deflation around the world by bringing prices down at exactly the time that Central Banks are trying to increase inflation in a lot of places. So it's probably the last thing we need.

There is also a sense this could be a problem for commodity prices because it shows that the Chinese economy really is much weaker than people even thought if they are willing to make this type of move, and that could put pressure on commodities, which is not good for other emerging markets that have a lot of commodity sales or big commodity economies.

I think the other thing that's somewhat concerning is that even though they did say, "We're going to let the market have a bigger say," at one point they intervened pretty aggressively at the end of trading on Wednesday to make sure that it didn't fall too much. They were really sending some mixed messages here: OK, we're going to let the market take some off, but oh, not too much.

And you add in some of the things that they've been doing in terms of supporting the stock market, such as halting trading in some stocks and having big stock purchases. It raises questions about whether the central government is up to the economic management. Are they are going to be able to handle an economic slowdown and have a graceful, so-called soft landing. Maybe that becomes a little bit less likely. People are a little bit concerned about the economic management.

I think this is a fascinating story--not one that's going away anytime soon--and it definitely created a lot of issues and a lot of interesting conversations.

Stipp: In another big surprise this week, Google is reorganizing itself, resulting in a new company called Alphabet. What are the details?

<TRANSCRIPT>

Glaser: This was another big surprise, one that people did not see coming. Google is going to reorganize itself, creating this new holding company, and Google will be a subsidiary of that.

I think shareholders need to keep in mind that there is no economic change here. The assets that you owned in Google before this announcement are the exact same assets that you are going to own after this announcement. It's really just another corporate layer that's being added on top of this.

Rick Summer, our Google analyst, thinks that, for the most part, this is going to be a positive move, if not a transformative one for the company. It will give a lot more transparency into what's happening at the real core ad business within Google; you'll be able to see exactly how much you actually need to pay in terms of R&D, in terms of other investments, to keep that cash count running, and you won't be distracted by the investments into things like driverless cars and life sciences and other similar investments that they are making now. Those will be split up. You get better transparency there. And also, it's going to be easier to hold management accountable for some of those other investments because you will see exactly what the potential payoff is from those as well.

So, this deal probably is a positive move for shareholders, but not transformational.

Stipp: Buffett was in the headlines on Monday because Berkshire Hathaway made its biggest deal ever, acquiring Precision Castparts.

Glaser: This is a company that makes some very specialized equipment and industrial parts for things like jet engines and turbines and other markets. This is going to be a more than $30 billion deal that Buffett is going to pay for by using both cash on hand and also borrowing $10 billion, but not issuing any Berkshire shares.

This deal in a lot of ways does seem very classic Buffett. This is maybe not the most exciting business in the world, but it's a very solid business with an economic moat that he is picking up for a fair price--not cheap by any stretch of the imagination--but he's paying a fair price for it and one that he is going to be able to hold for a really long time, and he is going to be able to put more capital to work as he invests in this business.

When this is all said and done, Gregg Warren, our Berkshire analyst, thinks that Berkshire will only have about $10 billion left in excess cash when you take out what he likes to hold to protect the insurance business. So we probably aren't going to see any more huge deals anytime soon out of Berkshire; we could still see some bolt-on deals, some smaller deals. But this is the big target that Buffett has been going after for quite some time.

Stipp: Online giant Alibaba reported this week. It was a disappointing report. The shares sold off. Is the stock looking attractive at this point?

Glaser: The shares sold off both because of earnings and also because of general concerns about what's happening with the Chinese economy. These concerns are not completely unfounded. We see there is true weakness in the economy, and R.J. Hottovy, our Alibaba analyst, did bring down his fair value estimate slightly because of those concerns, because of the heavy investment that they are making now, which is a little bit more than we had initially projected.

But even with a lowered fair value estimate, we still think Alibaba shares do look pretty attractive right now. They are trading in 4-star territory. And if you look at things like user growth and seller growth, and you look at some of the engagement metrics and how well they are doing in monetizing mobile, there still are a lot of positive stories coming out of Alibaba.

Now you do need an iron stomach in order to hold this one. It's not going to be a smooth ride. There is going to be a lot of volatility. It's not going to be a slow, steady type of growth company. But if you have that risk tolerance, it does look like we could be at or near an attractive entry point.

Stipp: In your Week Ahead report last week you mentioned that Macy's was on your radar. They reported this week. What was your take on that?

Glaser: Macy's did not have a great report, and it did not look like a very good quarter for them. Same-store sales were down 1.5%, and they are facing a lot of headwinds now. They continue to have these issues with foreign tourists not spending as much money or having fewer foreign tourists. Because of the strong dollar, it doesn't make sense to shop in New York versus back at home.

The West Coast port issue continues to weigh on results, and it's making their inventory a little bit lumpy. They discontinued one of their discount events that had some issues as well, and they continue to make some of investments to try to get their growth initiatives going.

Management also cut their top-line guidance for the full year, saying that they are not going to be able to meet the targets that they had initially set out. That was disappointing as well.

So after Macy's was able to attain for a long time some impressive operating growth, it looks like they have reached the limits of what they can do right now, and it seems like incremental gains are going to be much more challenging for them. It's a tough spot for them to be in, and we do see the shares as about fairly valued right now.

Stipp: Great recap on the week, Jeremy, as usual. Thanks for joining me.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.