China-Proof Your Portfolio Now, Before Sino Debt Hits the Fan

NEW YORK (TheStreet) -- It’s China’s turn for a debt crisis, so keep your eyes open for the unexpected. There are signs to look for, and certain equities are most likely to be affected.

China’s total bank debt has grown from $14 trillion in 2008 to $25 trillion today -- more than double the total size of the U.S. commercial banking sector. To support this massive growth in credit, China’s central bank has more than doubled its cash supply by printing more money.

While this may have softened the blow of the 2008 financial crisis, history has never seen such a colossal ramp-up of both money and credit without a subsequent period of financial chaos.

Moreover, that new money was borrowed primarily by state-owned businesses and municipalities -- entities that are not focused on economic profit, but rather on driving employment and meeting the growth targets tied to the nation’s Communist legacy. (For a more in-depth study of the subject, I recommend James Rickards’ book The Death of Money: The Coming Collapse of the International Monetary System.)

In 2008, U.S. investors could point to one clear moment when financial institutions’ absurdly levered balance sheets exploded into global disaster: September 15, 2008, when Lehman Brothers declared bankruptcy.

In watching for signs of a crisis in China, however, investors should expect no such clarity. In fact, as China’s growth is slowing, and labor costs are rising, the situation is more analogous to the frog in a pot of water that is slowly heating up.

Investors will need to be closely attuned to particular signals that could indicate oncoming trouble, since the country’s leadership would likely try to keep a crisis out of view for as long as possible.

One sign could be an announcement by the central government of higher GDP growth targets. In China, doubling down on growth -- in effect, a much larger and systemic stimulus package than the one the Obama administration introduced post-2008-- would likely indicate that the problem of bad loans has grown so widespread that the only hope for repayment is to artificially drive up domestic demand as a means of soaking up excess capacity and potentially “inflating away” regional and corporate debt burdens.

Second, investors should be on the lookout for any move by China’s central bank to devalue the country’s currency. Such a move would be another step or a precursor to achieving the higher growth targets mentioned above by boosting exports and would help to reduce debt burdens by introducing inflationary pressure. China could devalue its currency relatively easily by expanding its purchases of U.S. Treasuries.

Third, any erratic behavior by the Chinese government-- for example, military moves against Taiwan-- may also indicate that the country’s leaders hope to shift attention away from more deeply rooted and thorny domestic economic issues by playing on regional tensions.

Ironically, the type of event that U.S. investors typically associate with the onset of a debt crisis -- the insolvency of a major financial institution -- would likely be a positive indicator in China’s case, since it would suggest that the country’s leaders were confident enough in the stability of the rest of the system to allow a single institution to fail.

In today’s global economy, investors have a particularly difficult time reducing exposure to China simply by reducing their holdings in specific stocks or fixed-income instruments. We would expect most risk assets (e.g., equities, high yield) and commodities to struggle during such a crisis.

Nonetheless, U.S. Treasuries might serve as a defensive bulwark. Another move may be divesting or reducing your portfolio’s share of commodity producers and internationally based emerging market-focused firms.

Many large U.S. companies -- often considered safe -- may suffer from a China crisis as well. These include YUM! Brands  (YUM) , Kimberly-Clark  (KMB) and Coca-Cola  (KO) , which not only derive a high percentage of their revenue from Chinese markets but have seen heightened results due to strong demand there.

Investors could be caught off guard if these companies miss earnings and/or cut dividends in the event of a Chinese credit shock.

In short, keep an eye out for subtle or overt signals from China. Know when to pull the trigger on shifting to a more conservative strategy and minimizing the effects of a China-driven debt crisis on your portfolio.

At the time of publication, the author held no positions in any of the stocks mentioned, although positions may change at any time.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

 

Now let's look at TheStreet Ratings' take on some of these stocks.

TheStreet Ratings team rates YUM BRANDS INC as a Buy with a ratings score of A-. TheStreet Ratings Team has this to say about their recommendation:

"We rate YUM BRANDS INC (YUM) a BUY. This is based on the convergence of positive investment measures, which should help this stock outperform the majority of stocks that we rate. The company's strengths can be seen in multiple areas, such as its revenue growth, increase in net income, good cash flow from operations, growth in earnings per share and notable return on equity. We feel these strengths outweigh the fact that the company has had generally high debt management risk by most measures that we evaluated."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • The revenue growth came in higher than the industry average of 5.8%. Since the same quarter one year prior, revenues rose by 10.3%. Growth in the company's revenue appears to have helped boost the earnings per share.
  • The net income growth from the same quarter one year ago has exceeded that of the S&P 500 and greatly outperformed compared to the Hotels, Restaurants & Leisure industry average. The net income increased by 18.9% when compared to the same quarter one year prior, going from $281.00 million to $334.00 million.
  • Net operating cash flow has significantly increased by 56.70% to $514.00 million when compared to the same quarter last year. In addition, YUM BRANDS INC has also vastly surpassed the industry average cash flow growth rate of -26.36%.
  • YUM BRANDS INC has improved earnings per share by 19.7% in the most recent quarter compared to the same quarter a year ago. This company has reported somewhat volatile earnings recently. But, we feel it is poised for EPS growth in the coming year. During the past fiscal year, YUM BRANDS INC reported lower earnings of $2.36 versus $3.37 in the prior year. This year, the market expects an improvement in earnings ($3.60 versus $2.36).
  • Return on equity has greatly decreased when compared to its ROE from the same quarter one year prior. This is a signal of major weakness within the corporation. Compared to other companies in the Hotels, Restaurants & Leisure industry and the overall market, YUM BRANDS INC's return on equity significantly exceeds that of both the industry average and the S&P 500.
  • You can view the full analysis from the report here: YUM Ratings Report

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