There is something going on at the other end of the planet…

 

You know me; I’m not the guy who predicts the next market crash on a quarterly basis. And this time, I’m very worried about China. I don’t know yet how hard it will hit our country, but one thing is for sure; China’s bubble is going to burst and hit the stock market like a rock. Since 2008, the market has gone up every year (besides 2011 in Canada). 2013 was an amazing year for dividend investors where my US stock picks did 37.06%. Since then, I’m looking everywhere for the next bubble. I’m a pretty optimistic guy, but there are now two things that really bug me. The first one being the Canadian housing situation which seems to be falling into the most optimistic scenario for now with a smooth slowdown. The second thing that bugs me is China and how they escaped the 2008 recession. This bubble is about to burst…

 

China is the Second Economy in the World

 chinese real estate

China is not the manufacturer for the world anymore; it has become a very important economic player. Due to its impressive reserve of US dollars, it even had the “guts” to comment on how the US government was handling the 2008 credit crisis. China’s economy has been growing in the double digits since the early 90s. It has slowed down to 7.5%-9% recently but it is still a higher growth than industrialized countries.

 

China was among the few countries which weren’t affected much by the 2008 recession. In fact, the BRIC kind of lifted the whole world out of the recession. The result was impressive, but the solution China found back in 2008 to avoid the recession may very well blow up in our faces today.

 

How China Skipped the 2008 Recession… and How it Will Cause Their Biggest Headache

 

After seeing its “book of orders” melt in 2008, China realized it was impossible for them to maintain their growth level by simply exporting their goods. Their biggest clients (the USA & Europe) were cutting down on their expenses and this was leaving many workers unemployed. Instead of leaving the cold hearted capitalism work its magic by wiping out companies, the Chinese gov’t decided to react: Beijing started the most impressive infrastructure program ever built. They built entire new cities looking like London, Paris and New York. From 2008 to 2013, they built so many skyscrapers that Manhattan looks like a small Lego cities package. The plan worked: China’s growth kept rolling and the economy was saved….until they realized that all these skyscrapers are STILL EMPTY.

 

They blindly thought: “build it and they will come”, but no one has showed up yet. Some cities have been built for 500,000 citizens and yet, only a few thousand have bought one of those rich villas. There are dozens of ghost cities in China and this is becoming a real problem that can’t be hidden.

 

So far, it hasn’t been an issue since the Communist Gov’t had backed any company in financial trouble… until recently. They actually decided to let Real Estate Promoter Zhejiang Xingrun Real Estate Co go down with their debts (567M$). You want my guess? This was their Bear Stearns story. This is the first company to go down, but many others will follow. It is simply impossible to keep huge buildings alive without tenants. A few weeks before this event, Chaori Solar Energy Science & Technology announced their first default on debt payment. Once against, the real estate bubble will burst.

 

The whole financing system is also very hard to explain as it includes complex “shadow banking”. I’m not talking about some sort of evil force of nature with super powers here, I’m talking about a parallel financing system that doesn’t appear on Chinese banks’ balance sheets (doesn’t it sound like subprime mortgage and commercial backed securities to you?). Since nobody can really understand what is happening in the Middle Kingdom, the information is slowly leaking and the problem hasn’t spread around the world yet.

 

I don’t like people screaming their heads off that the world is going to collapse, but I’m pretty sure the Chinese Housing Bubble is not going to help us on the Western side of the world.

 

How China Affects Your Dividend Holdings

 

First things, first, if you hold any Canadian resource companies, I would consider selling them. The price for commodities and metals will most likely continue their drop if the bubble in China would burst. The Chinese Gov’t has the money to back up their companies, pay their dues and keep their system alive. However, they will definitely stop consuming resources at the pace they were. It has already started since 2011 and it will simply continue to get worse.

 

Then, don’t expect companies focusing on their Chinese market to become stellar dividend stocks. Strong companies such as Coca-Cola (KO), Wal-Mart (WMT) or McDonald’s (MCD) will survive this crisis but they won’t publish their strongest results during this period either. Most US consumers will be hurt but they will rely on a very strong base of clients in the US.

 

Try finding companies strong in the US and / or Europe. They will less likely be affected by what is happening in China. Still, I’m not too enthusiastic about this situation, are you?

 

 

 

Disclaimer: I own shares of KO, WMT and MCD

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10 Comments   |  

10 Comments

Norm
April 21, 2014, 9:38 am

The articles on this blog are generally spot on, but I think this one really misses the mark. There’s a lot of misinformation and flawed-assumptions swirling around re. China and unfortunately, this kind of write-up just perpetuates such silliness. I’m a dividend investor (from Canada) who happens to live in Guangdong Province and I work in the manufacturing sector. In a 450km radius of where I work, there are over 100 million people working in factories. You write, “China is not the manufacturer for the world anymore” – really? Take a stroll through Canadian Tire, Walmart, Best Buy or your local mall and notice where product comes from. For every story you hear about a factory that sets up in Vietnam or Bangladesh, there are still millions of people working in factories all through China producing goods for the West. You think China escaped 2008? Nearly 1/3rd of the factories in my town closed between 2008 and 2009. While many of the stories about ghost cities and shadow banking are true, they’re also fringe stories and detract from what is really happening here. There are certainly no shortage of odd practices and downright silly phenomena in China, but take heed not to get tripped up by these news-bytes that get more traction then they deserve. Many of the stocks in your holdings are 5 star brands here. Apple products are on nearly every other billboard. There are convenience stores every 100m or so and every single store has a dedicated Coke fridge. Disney makes almost all of their kitsch here, some of it right near our own factory. Husky has a massive joint venture in the South China Sea. JNJ is one of the most respected names in health care and you can buy their products almost anywhere. MCD is opening a new store every 6 hours somewhere in China and plans to keep up that pace for another 2.5 years. If you really believe what you’re just written about this impending crash, you’d be wise to sell over half your portfolio.

April 21, 2014, 1:49 pm

I think you have some good points here but I’m still not sure if China will see a meltdown or just a slowdown that has minimal impact. That is especially true when you consider what the Chinese government will be willing to do.

Michel
April 22, 2014, 6:16 am

Come on Mike, you know that for a long term dividend investor, this could only be a blip on the way to many years of compound investing. Trying to time this right is almost impossible, and if you happen to be lucky enough to be right, then you need to be lucky enough to get it right on the re-purchase. Instead just buy more when they become on sale!

DivGuy
April 22, 2014, 6:43 am

Hello Norm,

thank you for providing an “insider” view of China. China is still manufacturing a lot for the rest of the world, but their hourly wages had increased and they are “losing” manufactures to smaller countries such as Laos.

In my understanding, Chinese would like to see its consumers take buy more things to become more independent (this is also why they started to build so many empty cities).

Factories were closing in 2008-2009 but their GDP was still showing nearly double digit growth. How can we explain that? Quite simple: while factories were closing, China started to build tons of buildings. Therefore, their workers were simply moved from factories to construction.

As I’ve wrote in my article, big companies will take a hit but it will not be a catastrophe either. However, you know how the stock market is going to react; it will create lots of buying opportunities.

Just my 2 cents :-)

Cheers,

Mike.

DivGuy
April 22, 2014, 6:44 am

Hello Michel,

I’m not saying we should sell our stocks, I’m just saying it will hurt. 2008 hurt and still, most companies are showing better profit than ever only 5 years later. This is the magic of capitalism I guess!

Let’s just say I’m not optimistic in regards to what is happening with their shadow banking system. This looks like too much like commercial paper backed securities.

Plazma
April 22, 2014, 7:39 am

That’s old news. BusinessWeek wrote articles of similar effect a year or two ago. I thought I was re-reading the old BW article :-).

Chris
April 22, 2014, 11:28 am

You’re on the ball with this analysis. Look back to the Asian Crisis to get an idea of what will happen *when* China runs into problems. Right now, shadow banking is manageable, but for how long? When will the world figure out there’s nothing more to build? Once they figure that out, copper and raw material demand will drop. This will hurt the TSX.

DivGuy
April 22, 2014, 12:08 pm

@Plazma,

what is new is the fact that China is letting companies going bankrupt instead of paying for them. This is what is scary; if China doesn’t use its huge cash reserve, what will happen to their ghost cities?

btw, I didn’t read that article at BW ;-)

April 23, 2014, 4:06 am

Interesting analysis :) I’m not sure if it will be this year, but there will probably be a time when China has to deleverage, and when that happens it will hurt many Canadians through our exposure to resource stocks. I hold some other strong companies as well like MCD, SBUX, and DIS, and I’m thinking about being underweight in mining companies for now. The commodity based stocks I do own however are mostly good dividend payers like TCK.B (3.6% yield) so at least I’ll still be paid to wait if a major correction happens :)

May 3, 2014, 12:40 pm

The Asian crisis is unlikely to manifest the same way as it did. What you say is probably true for the likely trend for resources.

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