The cohort of Chinese stocks available to U.S. investors, such as Tencent (OTCPK:TCEHY), Alibaba (BABA), and Baidu (BIDU), has been rocked in the past year. These three, along with others, have traded nearly in lockstep, as they declined over 30%. Factors such as a worsening trade war or a slowing Chinese economy have been proposed as the reasons for the declines, but I am here today to offer a relatively simple explanation which lies at the heart of not only the declines of these stocks but also the U.S.-China trade war.
As can be seen, Alibaba, Baidu, and Tencent have been bludgeoned since markets across the world peaked in January of 2018. Despite the bludgeoning in their share prices, their underlying businesses have indeed been humming along.
For example, Alibaba's revenues and free cash flow have soared as the company has continued to set records through its online business.
In fact, all three continue to grow their revenues at breakneck speeds, as can be seen in their most recent quarters' year-over-year revenue growth.
To be sure, these companies have experienced operating margin compression over the last few years; however, their revenues have made up for the loss on their bottom lines.
So the narrative for these companies remains exceptionally strong. Moreover, there's strong growth ahead, with only around 57% of Chinese people having access to the internet. So why have their share prices cratered to such significant extents lately?
A Tale Of Two Currencies
The answer lies in the relationship of the yuan to the U.S. dollar. In the early 2000s and following the Great Recession, investment in China grew so rapidly that the yuan began strengthening to such an extent that investment in the country was becoming unappealing to companies looking for cheap labor and capital, as well as those looking to source cheap goods. The Chinese worried that American companies, which were looking to expand their margins and grow their earnings via lower input costs, would lose interest if the yuan were to have risen too much.
Chart Produced by www.nytimes.com
"In the mid-2000s and the aftermath of the financial crisis, China's trade surpluses and the inrushes of investment from abroad were titanic - so big they would have driven up the value of the yuan. If its currency had been freely traded, that is." - Source: QZ.com
But it wasn't and hadn't been since 1994. Making China the manufacturing hub of the world, and specifically of American corporations that forsook many American citizens, enabled it to initiate this currency manipulation operation. The country's much maligned currency manipulation operation now rests at the heart of today's trade war and the cratering of Chinese stock valuations.
China ensures the weakness, or in some instances strength, of its currency through hoarding U.S. dollars taken in from exports and through purchasing dollar denominated assets, most commonly U.S. Treasurys on which it receives interest in dollars.
"Chinese companies receive dollars as payment for their exports to the United States. The firms deposit the dollars into banks. In return, they receive yuan to pay their workers. The local banks then send the dollars to China's central bank, the People's Bank of China. It holds them in its foreign exchange reserves. By stockpiling dollars, the People's Bank reduces the supply of dollars available for trade. It puts upward pressure on the dollar's value, lowering the yuan's value." - Source: TheBalance.com
China then turns around and buys dollar denominated assets, i.e. U.S. Treasurys, an act that further bolsters the strength of the U.S. dollar in relation to the yuan.
China's centrally planned economy allows it to preserve the artificially weakened state of the yuan against the U.S. dollar. It achieves this through the aforementioned mechanisms. When the yuan weakens to an extent that PBOC deems unfavorable, it simply use its U.S. dollar reserves to purchase yuan, removing a portion of the currency from circulation and driving up the value of it against the dollar. Or China sells some of its U.S. Treasury holdings, which it's been doing lately as the graph below illustrates.
Understanding this currency dynamic is vital to any investor considering the purchase of foreign stocks, especially Chinese stocks. A strong business model and massive addressable market may have little value if the currency in which the company does business is worth only a fraction of the currency in which you buy the stocks and expect to receive ROI.
Tightening U.S. Monetary Spells Disaster
The U.S. Fed's recent aggressive tightening of monetary policy has had a number of effects that are material for investors in Alibaba, Baidu, Tencent, and the like. I will share some financial effects, resulting from tighter U.S. monetary policy.
Strengthening U.S. dollar: The combination of quantitative tightening and higher interest rates has created a recipe for a stronger dollar, and by extension a relatively weaker yuan. This further weakens the financial performance of Chinese stocks for investors who expect to be rewarded in U.S. dollars, and as a result, their valuations get rerated as we've seen.
Importation of U.S. monetary policy into China: The impossible trinity is causing the importation of U.S. monetary policy (read: tighter credit conditions) into China, which is further constricting credit conditions in the country. Meanwhile China attempts to loosen its own monetary policy in response to weaker growth.
Weakening Chinese economy with significant debt burden: The higher the dollar goes, the more expensive China's dollar denominated debt burden becomes.
- "Property developers and other mainland companies and investors that have borrowed dollar-denominated debt at low US interest rates are now facing repayment problems due to Federal Reserve rate increases and stronger greenback."
The result is a PBOC that is forced to loosen its own monetary policy, further devaluing the yuan at a time when it is already at its weakest in years. This furthers the decline in valuations for Chinese stocks.
Interest rate spread has tightened between U.S. and China: Due to higher U.S. interest rates (and a closing spread between U.S. and Chinese rates), the "Carry Trade", which has created massive demand for the yuan is dying, furthering the downward pressure on the Chinese currency.
USD/CNY Reflected In Share Price
As the chart above illustrates, Chinese stocks are inversely correlated with the strength of the U.S. dollar as expressed through the USD/CNY exchange rate. That is, when the U.S. dollar goes up, the yuan becomes effectively weaker. As the dollar strengthens and the yuan weakens, the valuations of Chinese stocks are rerated because their revenues, which are in yuan, become less valuable to investors.
When To Buy Chinese Stocks
There's no doubt that stocks like Alibaba, Baidu, Tencent, etc. offer extremely compelling investment narratives. However, these stocks do not come without risk.
Should the Chinese resist concessions to the U.S. during the ongoing trade negotiations, I believe a very grim scenario could play out for China. In the event the U.S. levies 25% tariffs on all $505B worth of Chinese exports to the U.S.: 1) Chinese GDP growth would weaken, 2) the yuan would appreciate as a result of less dollars entering the PBOC's coffers, 3) civil unrest might occur as Xi Jinping's right to rule comes into question, and 4) neighboring Asian countries and India would likely see massive inflows of capital previously intended for China. These three factors could lead to economic calamity for China, a country which in many ways is still developing and could be very vulnerable to such economic shocks.
Such a scenario would obviously be extremely negative for investors in Alibaba, Baidu, Tencent, etc.
Granted the above does not play out, and the U.S. and other western nations (that have taken issue with China's behavior) continue to nurture the development of China, Chinese stocks could easily generate market-beating returns for decades to come, especially as the Chinese economy matures and its currency strengthens in relation to the dollar, which is an inevitability at some point.
So when is the right time for investors to buy these stocks? Well, the best time would likely be when the U.S. Fed is the most hawkish, the dollar the strongest, the yuan the weakest, and trade talks most aggressive. We may be at that point now, as the USD/CNY exchange rate hovers around 7, a level past which the PBOC will likely not allow the yuan to fall.
China currently finds itself balancing the strength and weakness of its currency so as to, on one hand, ensure its exports are competitively priced, and on the other hand, ensure its currency retains credibility as it takes its seat as one of the world's preeminent reserve currencies. So the likelihood that the yuan completely implodes is pretty low, which means we probably have seen the worse from a weak yuan... emphasis on probably.
I will close this article with the following quote:
"The time to buy is when there's blood in the streets." - Baron Rothschild
Disclosure: I am/we are long BIDU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.