Why China Matters To U.S. Dividend Income Investors

Includes: DVY, FDL, HDV, SDY, VIG, VYM
by: Richard Shaw

The US is the current sweet spot among major stock markets. US dividend stocks are increasingly popular and attractive to an increasing retiree population in need of portfolio income. So why are conditions in China important to US dividend investors?

First there is the obvious impact on revenue and earnings of global companies with sales in China. However, more important may be the impact of China on US Treasury rates.

China and other emerging markets are important holders and buyers of US Treasury securities. How much of their maturing Treasury debt they reinvest in US Treasuries, and how much they commit new funds to the purchase of US Treasuries, will have an important impact on US Treasury rates. In turn, Treasury rates impact bond rates in the US generally. And finally, general bond rates compete with dividends for portfolio income seeking investors.

If foreign buying of US Treasuries declines, rates are likely to rise. If rates rise, then to a degree, dividend stocks become somewhat less appealing -- particularly to older investors.

Logic would say that in a world of declining GDP growth, and where China is slowing, there would be less foreign demand for US Treasuries.

Treasuries are an important means for trade surplus countries to recycle Dollar reserves. Countries with less trade growth means less reserve growth, which means less Dollar recycling need, which means less demand from those countries for Treasuries.

click to enlarge images

Figure 1:

China is slowing. Their reserves are not growing like before. They are not expected to buy as many Treasuries as before, and that will put some upward rate pressure on Treasuries.

The Fed can't buy all the Treasury issuance, at least not for long.

Figure 1 from a Hong Kong based firm AlsoSprachAnalyst.com shows slowing year-over-year growth in Chinese reserves of Dollars, and topping out of total Chinese reserves of Dollars.

We can see the China data here, and could plausibly assume that a number of other emerging market, trade surplus countries may be in similar situations. Europe certainly is not likely to be building reserves at this time.

Nomura has analyzed and forecasted balance of payments data and concluded that China will move to net negative US Treasury purchases by 2015, as shown in Figure 2. That would put upward pressure on US Treasury rates.

Figure 2:

JPM Short-Term Projections:

Without attribution to any particular inputs, JP Morgan anticipates US Treasury rates to change from now to June 30, 2013 as follows:

  • 3-months: 0.08% down ---> 0.05%
  • 2-years: 0.31% up ---> 0.42%
  • 10-Years: 1.66% up ---> 2.50%

Composition of US Treasury Holdings:

As of July 12, US outstanding public debt was $15.872 Trillion. The portion actually owned by parties or entities that are not classified as "intra-governmental" is less than 70%. The intra-governmental portion (the US buying debt from itself, in effect) accounts for a bit more than 30% of outstanding debt. Foreign holders of US Treasuries account for almost 1/3 of outstanding debt, but also nearly 47% of Treasuries that are classified as held by the public (see Figure 3).

Figure 3:

So we are not just waiting for the Fed to back off some in its Treasury purchases for rates to rise, but we also need to be aware of the Treasury buying of foreigners (overwhelming foreign governments).

Figure 4 gives the most complete breakdown available from the Treasury website on what emerging markets countries own.

Figure 4:

China accounts for 22% of all foreign Treasury holdings and 44% of all holdings among emerging markets.

The next biggest group is oil exporting countries. A global slowdown would reduce their recycling needs, and expected increases in self-reliance on domestic oil and gas in the US would further decrease the amount of Dollars oil exporters would have for recycling.

Figure 5 shows what foreign developed markets countries own (we classified "all other" as developed, but the composition is uncertain).

Figure 5:

We don't have data for Japan on their projected Dollar recycling needs, but it might be reasonable that with their flat economy and strong Yen, it is not growing strongly. Status quo or less might be a reasonable guess. Most of the rest are European nations, along with a few highly leveraged to China (Australia and Singapore).

Not A Dividend Bubble

We do not believe we are in a dividend bubble, but we do believe that some portion of the money flowing into dividend stocks is the result of bonds being unattractive to some income investors.

As interest rates rise (when they rise), those marginal switch-overs from bonds to stock will tend to rotate out of dividend stocks back into bonds. That would have some negative effect on demand for dividend stocks.

We think a larger impact would be for those investors who switched from growth stocks to dividend stocks rotating back to growth and momentum styles of investing.

The rapidly growing ranks of the retired have yet to fully express their long-term preference for bonds or yielding stocks, given the rate distortions caused by Fed interventions. We think that because they expect to live longer, and because they are likely to watch a coming bond bear market, they will own somewhat more in the way of stocks than in prior periods.

If Anything There is A Bond Bubble

In spite of all the talk about dividend stocks, bond funds have continued to attract increasing amounts of investor money compared to equity funds, as Figure 6 from Strategas shows.

Figure 6:

Figure 7 shows the allocation between cash, us stock, international/global stock, bond and hybrid mutual funds Mutual funds still massively outweigh ETFs in assets, and therefore a good barometer of retail investor behaviors. The data is from the Investment Company Institute.

Figure 7:

The combination of Treasury rates rising when countries such as China reduces purchases (driving up rates) in combination with the linkages between all rates and Treasuries, and the over-weighting of bonds in retail portfolios suggests that a careful eye should be trained on Chinese Treasury purchases, not just what helicopter Ben has to say from time to time.

A significant change in Chinese Treasury buying practices could signal rate changes that may create some negative adjustments in dividend stock prices --not necessarily large, but worth monitoring. The Fed is not the only key actor to watch.


Disclosure: QVM has positions in LQD as of the creation date of this article (July 14, 2012).

General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.

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