China is the Key for Dividend Investors, Not Europe

Article of the Week from Investing Daily

by Roger Conrad

All eyes are on Europe’s economic and political crisis these days. And no matter how Greece’s vote goes on Sunday, the Continent’s woes are unlikely to lessen any time soon, as attention turns to fiscal problems in Spain, Italy and elsewhere.

Ironically, emerging Asia, particularly China, is far more important for many income investors. And happily, the outlook there is considerably more optimistic.

When the US real estate bubble burst and triggered a systemic global economic crisis in 2008, it was China that helped stabilize the world economy. The Middle Kingdom’s demand for natural resources kept Australia out of recession altogether. Meanwhile, Canada had only a mild downturn, and even the US was able to return to growth by mid-2009.As a result, the historic crash of 2008-09 was over by early March 2009, and the next three years have proved to be some of the best ever for dividend-paying stocks. As long as companies held their businesses together during the crisis, their stocks fully recovered and then some.

China is even more important for global economic health now. Adjusted for inflation, the country’s economy grew by 8.7 percent in 2009, 10.4 percent in 2010, 9.2 percent in 2011, and then at an 8.1 percent annualized rate in the first quarter of 2012. Because of such robust growth, China’s economy is now more than one-third larger than it was during the 2008 crisis.

A stable and growing China makes it difficult for Europe’s woes to drag the whole world into a 2008-style crisis. Consequently, positive news from the world’s second-largest economy would go a long way toward quelling current market uncertainty.

At this point, the consensus on Wall Street is China’s slowdown over the past year is intensifying. That’s mainly based on the country’s gross domestic product (GDP) growth rate, which has slowed markedly from last year. If the soft landing becomes a hard one, that would all but ensure a global slide into recession and much more downside for stocks this year, including most dividend payers.

That, however, is not the view of my long-time colleague Yiannis Mostrous, editor of Global Investment Strategist. In his recent article “China: Stronger Than You Think,” Yiannis makes the frequently overlooked point that the country’s slower growth has thus far been by design. That’s a far different situation than in Europe, where austerity in the name of correcting fiscal imbalance has depressed growth and government revenue, pushing budget deficits even higher.

For the past year, Chinese monetary authorities have been trying to stamp out speculation in sectors such as residential real estate, as well as contain rising inflation. These efforts have now largely succeeded, even as falling commodity prices have curtailed inflation. As such, the government has returned to stimulus to spur growth and employment, relaxing investment rules and project permitting.

Yiannis’ longer view is the era of double-digit growth in China is over, “as the country tries to stabilize and increase the number of people that can participate in economic growth.” He believes “any growth above 7 percent should be seen as a positive for China’s future, because it reflects sustainable growth.”

I strongly urge anyone interested in investing in developing Asia to check out Yiannis’ research. But if he is right about China, there are huge implications for global investment markets later this year, and by extension for income investors.

First, China has become the world’s largest consumer of many key natural resources, such as copper. And while the huge infrastructure projects of the past few years have slowed, there’s still plenty of demand growth for resources in a massive economy that’s growing 7 percent to 8 percent a year.

Such “moderate” growth would be a major plus for stabilizing volatile global commodity markets later this year. That in turn would be very positive for dividend-paying stocks of energy producers and mining companies that have been hit hard since early May. It would also be a big plus for currencies of commodity-producing countries such as Canada and Australia, whose currencies have lost substantial ground to the US dollar since early spring.

A strengthening Chinese economy should also do wonders for many dividend-paying stocks in the US. The optimism at the outset of the year has faded to profound pessimism, as investors try to position their portfolios to avoid damage from a reprise of the 2008 crash.

A handful of stocks such as Southern Company (NYSE: SO) have soared to new heights, as investors have accorded them the same safe-haven status as US Treasuries. The 10-year Treasury now yields less than 1.6 percent, barely 16 basis points above its all-time low of 1.44 percent, hit June 1.

Meanwhile, most dividend-paying stocks have been losing ground. And a handful have faced selling pressure that’s been especially volatile, as investors assume fallings price mean greater risk, and sell shares rather than hunt for value.

Still boasting the world’s largest economy, the US has continued to plod along this year, posting consistently anemic growth numbers, just as it has since the recovery began in mid-2009. Nevertheless, US equity markets are selling off due to the emerging narrative that Europe’s troubles will stall this rate of growth, and possibly throw the US back into recession, particularly if taxes and spending cuts slated for January 1, 2013 aren’t amended and create a “fiscal cliff.”

Against this backdrop, investor confidence that China’s economy can grow at least 7 percent to 8 percent the rest of the year would provide a significant psychological boost. That won’t necessarily help all US companies or industries. But it will calm worries that a meltdown of the eurozone could trigger a systemic event along the lines of 2008. And since many stocks and sectors are starting to price in that kind of risk, an apparent rebound in the Chinese economy would produce a solid recovery across the board.

How long will it take for the global markets to recognize that China’s economy is more resilient than anticipated? Unfortunately, that could be several months away. The European debt crisis and a possible US fiscal cliff are dominating the headlines. And China itself is deliberative when it comes to enacting policy. Policymakers have no real reason to move too quickly, as the country is benefitting greatly from the recent drop in global commodity prices, particularly for oil.

The sectors and stocks most at risk until there is a shift include almost all energy producers. The Organization of Petroleum Exporting Countries (OPEC) has apparently failed to agree to reduce its frequently flouted output ceiling. As a result, any price recovery is going to have to come from the demand side, which in turn is quite dependent at present on perceived risks from Europe.

We’ve already seen a number of dividend-paying producers cut their payouts over the past few months, due to the steep drop in natural gas prices. This week, former Canadian income trust Enerplus Corp (TSX:
ERF, NYSE: ERF) chopped its dividend in half to shelter cash flow to keep its development program on track. And it’s unlikely to be the last company to pare its dividend, as other firms are forced to adjust their capital deployment during a period of falling revenue.

If Europe’s woes do spread to these shores, the most likely form of the contagion will be in much tighter credit. That makes it more critical than ever for companies to get a handle on the debt they have to issue over the next several months.

Preferably, I want any companies I own to have little or no debt maturing between now and the end of 2013. That greatly reduces the chance they’ll be forced to come to market to borrow at a bad time, say if Europe’s debt crisis leads to a temporary freeze in credit markets. Fortunately, most companies have been able to use record-low corporate borrowing rates the past several years to cut interest costs, raise low-cost capital and eliminate near-term maturities. But there are still some companies potentially at risk.

Finally, companies whose prospects rise and fall with the economy should also be viewed with a healthy dose of caution. That definitely applies to any producer of natural resources right now. But any smaller company in a cyclical or intensely competitive business is also at risk of revenue erosion, should the US economy slow markedly from here.

Again, I remain very skeptical about the potential for a meltdown along the lines of 2008. Too many people are looking for one and there’s just not anything close to the amount of systemic leverage to precipitate a downturn of similar magnitude.

But in an environment like this one, there are going to be crackups in individual stocks, and even in some whole sectors. And there’s no assurance a company with a busted business will ever recover fully, no matter how bullish overall conditions become. The key is to stay focused on high-quality names.