Creeping deflation in the US, cheap valuations in China

“Two, three, many Apples,” Che Guevara might say if he set out to overthrow the capitalist system today. All the talk about market valuation, recession risk and so forth comes down to the harsh fact that all the equity market leaders of the bubble, er, bull market are aging monopolies with fragile business models.

The market would be fine except for those pesky stocks

Creeping deflation remains a key risk to corporate earnings. Mobile broadband and soft drinks occupy very different corners of the economic universe, but the specter of deflation haunts them both.

Today’s biggest loser was telecom provider AT&T, which lost nearly 4% after its lower-cost competitors Sprint and T-mobile reported higher subscriptions. The same saturated mobile phone market in which Apple foundered has a problem for AT&T and its better-run, more profitable competitor Verizon: with few exceptions, mobile broadband is a commodity whose price can only go down, while consumers have cheaper options than premium providers who don’t offer much in return for higher costs.

That’s what crushed Apple, whose appeal to bourgeois-Bohemian cool has faded while its innovations lagged. That’s also what concerns the market about AT&T and Verizon (down a bit more than 2% today).

The crumbling telecom monopoly was one of our seventeen reasons to hate the stock market (Dec. 18, 2018). As I wrote then: “Verizon is more like a bond than a stock. It pays a 4.3% dividend, and trades at a modest 12.5 times future earnings. The trouble is that mobile phone rates are falling (the cheapest competitor to Verizon offers basic service for free), and the monopoly may not be sustainable.”

I could have added Coke (-2%) and Pepsi (-2.5) to the seventeen stocks I trashed last December. These consumer staples have been super-safe portfolio building blocks for generations, but the market now thinks they are risky. The cola duopoly swooned as a challenger, Monster Beverage, jumped.

The difference is that upstart Monster has a market capitalization of just $30 billion while Coke is worth just under $200 billion. That’s about the same as the relationship between Sprint ($30 billion) and AT&T ($219 billion). It’s the Apple phenomenon: A well-established brand trading on customer loyalty finds its market share slipping as challengers offer a competitive but cheaper product.

The biggest disrupter in all of this, of course, is Amazon. It offers streaming video to compete with Netflix and Hulu (which is owned by AT&T, and which AT&T now wants to unload). It offers a pharmacy to compete with CVS (down 4% today, another victim of creeping deflation). And every time you order a product from the established consumer staples companies, it will show you the Amazon house brand at a lower price. The impact of Internet grocery shopping extends far beyond the supermarket industry as such: It opens the gates of the citadel to challengers that can take down the Cokes, Verizons, Proctor and Gambles, Johnson and Johnsons and Pepsis of the world.

Despite its dividend yield of nearly 7%, AT&T is a high risk play, not the safe stock it used to be.

As I noted yesterday, the bounceback in the S&P 500 is a reflex reaction to the easing of financial conditions (otherwise known as a dovish Fed). There are some actual winners, to be sure. Today’s top performer was Ford Motor (+4%), buoyant after reports that Volkswagen is planning an alliance with the American automaker. That’s a case where synergy actually might add value. But most of the structural changes in the stock market are negative rather than positive for valuation.

On the back of yesterday’s bounce in Hong Kong, H-share ETF’s traded strongly in New York. I think it’s time to wade back into Chinese equities.

• Pessimism about Chinese economic growth is fading. It never should have been there, to be sure; Chinese manufacturing orders took a hit from the trade war, but China’s non-manufacturing economy diffusion index is running above 54%, and investment is picking up in part due to government action. China’s growth will come in at around 6%, at worst half a percentage point below the consensus estimate of six months ago, but hardly shabby. An important data point for market sentiment today was the Conference Board index of leading economic indicators for China, which showed a definite uptick.
• The US and China appear more likely to settle rather than fight out a trade war. There are lots of good reasons for this. First, as US business leaders continue to warn the Administration, the trade war hurts the US as badly as it does China. Second, China appears ready to include a settlement of the nuclear issue on the Korean peninsula in a package along with the trade deal, which would make Trump look like a winner. Third, America’s ability to punish China by withholding key high-tech components has diminished strongly over the past year. Huawei’s success in introducing its own Kirin chipset for handsets and its new big-data workstation chip are milestones in China’s independence from US components. And fourth, of course, is that China will go out of its way to let Trump claim victory.
• H-shares volatility (the implied vol of the large-cap ETF, FXI) has converged with VIX, after trading far above it late in 2018.
• Chinese stock valuations both on a trailing and forward-looking basis are as cheap as they ever have been.
• A dovish Fed takes pressure off China’s currency.

You can buy the SHCOMP today for about 9 times projected earnings