EM Misery and US Large-Cap EuphoriaLearn more about this firm
Dear Fellow Investors:
Many investors are wondering why emerging stock market misery currently equates to weakness in the US stock market as represented by the Dow Jones Industrial Average and the S&P 500 indexes (large-cap). Long time followers of our writing at Smead Capital Management are aware that we have been making the argument this would happen since 2010 and we are happy to review our thesis.
It seems the chickens are coming home to roost in China where dependence on fixed asset investments as a percentage of GDP is still over 50%. To us, building infrastructure as a way to continue an unusually long period of high economic growth has proven to be a failed endeavor from a historical standpoint. How much rent you receive from the things you build determines whether any wealth is being created and China appears to be producing very little rent with their infrastructure. Here is how Michael Pettis from Peking University explained these circumstances back in 2011.
- BRICS and other developing countries have not decoupled in any meaningful sense, and once the current liquidity-driven investment boom subsides the developing world will be hit hard by the global crisis.
- Over the next two years Chinese household consumption will continue declining as a share of GDP.
- Chinese debt levels will continue to rise quickly over the rest of this year and next.
- Chinese growth will begin to slow sharply by 2013-14 and will hit an average of 3% well before the end of the decade.
Much of what he and people like Jim Chanos predicted back then is playing out in front of everyone’s eyes. Growth is decelerating, banks are rolling over loans which the developing world would consider non-performing and consumer spending as a percentage of GDP is low enough on an absolute basis (around 30% of GDP) that it will take years of fast growth to overcome the deceleration in construction/fixed asset investments.
Emerging Markets Tied to China
Providing commodity inputs to China has been the bread and butter for growth in the emerging markets of the world. The first two countries in the term BRIC are Brazil and Russia. Their main export is oil and the bull case for oil has been uninterrupted growth in China. We are astounded that the price of oil is holding up despite the US reducing gasoline use for the last seven years (we don’t have 2013 numbers yet) and China’s economy slowing. The idea that the average Chinese citizen was going to want all the same things that the developed world consumers already have was behind most of the enthusiasm for emerging markets, in our opinion.
Australia and Canada are not emerging, but they have suckled on China’s boom as exporters of natural resources in oil, forest products and minerals. Indonesia and Vietnam are among the next tier of countries which ran huge trade surpluses with China as they exported commodities. Large trade surpluses combined with currency strength attracted massive capital from US investors in wide asset allocation models. Naturally, the sheer size of the commodity use from 2008-2012 in China contributed to booming prices for commodities as shown by the chart below which we have spoken of at length:
Source: Stifel Nicolaus Barry Bannister May 23, 2013
Heavy Industrial Tied to China
Heavy industrial countries like Germany and companies like Caterpillar (CAT) have suckled on China’s boom. When we were in China in late 2011, there was a long line of Chinese Nationals driving BMWs and Mercedes Benz automobiles going through the checkpoint between Hong Kong and Shenzhen. Most of them were brand new and cost well over $60,000 dollars to buy. German producers of heavy industrial goods never had to fly over an ocean to do business in China. Heavy reliance on fixed asset investments and infrastructure caused a boom in heavy machinery and suckered Caterpillar into buying equipment mining company Bucyrus International at what we believe was the 20-year secular peak in commodity prices.
Multi-National US Staple Producers and Tech Companies Tied to China
Reading the earnings reports of US multi-national company’s shows us where their growth came from in the last ten years. For example, globalization and booms in emerging markets were a bonanza for major staple producers like Coke (KO), Proctor and Gamble and others. Countries with low wages relative to the US could afford soda and low-priced staple items. Technology companies sold hardware and software as these newly prosperous countries spent their trade surpluses on productivity improvements. We look at the percentage of revenues in emerging markets for these companies and get very nervous.
Where Will Future Prosperity Come From?
We are on record as saying that the most exciting emerging market in the world is the US and developed world echo-boomers between the ages of 18 and 37. We have 86 million of them in the US and they are centered at the age when people marry (28) and have kids (29). BCA Research argues that we are on the doorstep of a baby boom. They believe it will be caused by a subsiding of the meltdown fears of the last five years and the simultaneous explosion of the largest population group hitting its stride. They also argue that echo-boomers seek financial security before child birth and those who assume they won’t be major baby producers aren’t counting a massive number of kids born to mothers in their 30s.
We believe these echo-boomers will form households soon to include the addition of babies. Babies will likely drive them to purchase cars which fit car-seats and houses with enough space for cribs. It sounds as if everyone believes that Millenials will stay in the inner city, but just wait until their screaming baby keeps everyone awake two nights in a row. Therefore, affordable and stand-alone housing will most likely become a need. The experience of the late 1970s showed us that meeting needs can overpower price and interest rate concerns in the purchase of a house.
US Large-Cap Stock Picking in a Tough EM Environment
We like domestically-oriented companies with addicted customer bases and the majority of revenue inside the US. We believe media companies like Disney (DIS) and Gannett (GCI) advertise autos, houses and consumer goods demanded by those forming households. Big banks like Wells Fargo (WFC), Bank of America (BAC) and JP Morgan (JPM) will provide the auto and housing loans to meet the demand in the US. Companies like Berkshire Hathaway (BRKB), Home Depot (HD) and NVR (NVR) will work to supply us with the new homes. Lastly, we want to own the major pharmaceutical/biotech companies which will provide relief to aging baby boomers in the developed markets who suffer from chronic illnesses. We like Merck (MRK), Amgen (AMGN) and Pfizer (PFE).
We continue to recommend that investors avoid commodity-related common stocks, energy companies and heavy industrial shares which have enjoyed China’s uninterrupted growth. This is our way of avoiding what we contend is the stock market’s primary risk—China-led emerging stock market misery.
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead is CIO and wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
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