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China, The Untold Story

|Includes:Alcoa, Inc. (AA), STZ, VXX
By: Brian Sozzi, Research Analyst

Surely you have seen the increased amount of headlines during the last month about the U.S. pressing China to revalue the yuan. Treasury Secretary Geithner met with Chinese officials this week to state his case for a floating yuan, which the Chinese employed prior to the onset of the global financial tsunami. The Administration extended an olive branch of sorts by deciding to postpone a public flogging of the Chinese (you know, the same Chinese that hold a significant chunk of our debt and are for all intents and purposes funding our profligate spending) by not labeling our friends "currency manipulators." Fine, great, wonderful. We retain our global muscle in appearance by winning a war of words with the Chinese and the Chinese receive supposedly healthier, domestic driven growth and a reduced probability of an inflationary death spiral. What is the true story that goes untold in the media, however?

The real deal, as I think about, is that the U.S. is attempting in earnest to prevent an asset bubble explosion in China. If we couldn't prevent it from happening on our soil ("The Maestro" said as much this week) then why not look to regain credibility by interjecting in China. Note this, however; if China's economy buckles under the weight of the rickety lending standards that ensued in 2009 as the Communist government reignited growth, then who else in the developed or developing world would purchase our debt and help fund a deficit that is apparent as far as the eye can see. There is good reason to believe that the U.S. smells an impending bubble, so let's view the facts.

In order to get to GDP growth of 8.7% in 2009, China's doled out $1.4 trillion in new credit. Construction Bank nearly doubled lending in 2009. The result? Next week it will likely be reported that 1Q10 GDP growth in China will have hit 11.0%, on a trajectory to reaching 10.0% for all of 2010. Underpinning the growth is a continued migration of people to the cities in search of higher wages, exports of cheap goods, and investments in capital at rates that indeed are compelling when growth is do dang robust.

However, below the surface of what I think is a financial tinderbox are the same banks that loosened the lending spigots in 2009 going to market to try and raise capital. These companies are now deciding to issue new stock, new debt, or a mixture of both to shore up balance sheets that are likely riddled with sour loans. February home prices in 70 major cities in China rose 10.7%, the fastest pace in two years. So, we have home values through the roof and questionable lending (which is more than solely questionable as there are unknowns associated with a Communist regime), sounds similar to a country that I know so very well.

All I can hope for is that this yuan revaluation gets carried out in an amicable, timely manner. In doing so, American companies who source from China (retailers get close to 80% of their inventory from China) could sidestep a potentially unfavorable dynamic to their cost of goods sold. Moreover, many U.S. companies are only now developing in China, whether its stores or offices, at inflated costs. If the cost situation is not properly handled and domestic consumption doesn't usurp exports, U.S. companies may be contending with assets that generate surprisingly low internal rates of return.

Earnings Season
By: David Silver, Research Analyst

Next week brings us the always fun earnings season. This morning Constellation Brands (NYSE:STZ) reported earnings of $0.27 per share (excluding items) which beat the Street's $0.24 per share forecast, however, it was the outlook that is causing the stock to get hit this morning. The actual results fell short of my $0.29 per share forecast and I currently have a HOLD recommendation on the stock. The unofficial start of earnings season is on Monday with the likes of Alcoa (NYSE:AA). The stock received a downgrade this morning as most of the cost improvements and operational efficiencies will be more than offset by the increase in the cost of aluminum.

The path of the market over the past few trading days has been one of meandering, however, the Dow finished higher yesterday to break the worst down streak since the end of January. We spoke about the low levels of the VIX and after setting records at the end of March, the VIX has seen little increase. The VIX has been relatively range bound, and if the market follows the futures, the VIX could break through support at 16 and fall to levels not seen since the beginning of 2007.
 
 


Disclosure: None
Stocks: AA, STZ, VXX