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When Will Apple Stop Screwing the US Economy?

By | economics, economy, statistics | 42 Comments

Ty Cobb was a famous baseball player. Infamous, really. He set 90 Major League baseball records, some of which continue today. He was skillful but also mean; he had a reputation for playing dirty. Cobb was known for spiking other players: sharpening his cleats and sliding into them. Nobody much liked playing against him.

Apple is the Ty Cobb of corporate America. Like Cobb, Apple has set some impressive records. Nine years, a trillion dollars in sales, and almost no taxes paid. Apple risks having a legacy of tainted success and isolation.

 The Apple Way

There’s a story I heard about electronics company Sharp. The company was about to go bankrupt and default on some major debt. This put Apple at risk, since Sharp was a major source of Apple’s LCD screens. The story goes that rather than come to Sharp’s aid, Apple instead approached the bankers and offered to buy the factory assets after bankruptcy – for pennies on the dollar of course. Talk about kicking someone when they’re down! True or not, when I share that story with others who have dealt with Apple, they shrug their shoulders and say that they aren’t surprised. That’s the Apple way.

Business is not a popularity contest, but when the winner-take-all, cripple-the-other-guy approach goes too far and begins to damage the economy, it’s time to rein things in.

The issue at hand is the way Apple’s relentless greed has undermined the US economy and damaged its future industrial competitiveness. All so Apple can make $5 more per phone.

After oil and cars, smartphones are the US’ biggest import. Almost $100B of phones was imported in 2014 (per the Census Bureau). Half of them were Apple iPhones.

The trade in smartphones cuts two ways:

  • It is singlehandedly keeping afloat the economies of China, Taiwan, Korea and Vietnam.
  • The flip side is that it is steadily hurting the US economy, as I’ll show in a moment.

The Winners’ Circle

Korea: Roughly half of Korea’s IT exports are cell phone handsets or semiconductors. Thus Korea’s total exports are growing only as long as IT exports do. For Korea, with a slowing economy, the smartphone is the only thing standing between them and a big recession.

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Taiwan: It’s the same story but even more so because Taiwan’s portfolio of exports is more tied to high-tech (unlike Korea which also sells ships and cars). Taiwan’s economy depends on exports which in turn depend on smartphone sales.

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China: While China has a much larger and more varied economy than Korea or Taiwan, its growth is also now driven by smartphone exports to the US. China’s total exports to the US now rise and fall on the US consumers’ appetites for the next phone.

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The US’ Loss is Everyone Else’s Gain

It’s like an unintended Marshall Plan for the 21st Century. The US is transferring $100B a year to three Asian economies, creating over a million jobs and helping them accelerate up the high-tech manufacturing ladder so that US jobs are now in jeopardy. In other words, the standard complaints about corporate America off-shoring production. But there’s a twist: the high-tech competitive advantage that we are losing has bigger, costlier consequences.

“Hold on a minute!” you might say. Assume that handing a $100B+ high-tech industry to Asia can’t possibly be in the US’s long-term economic interest. Why blame Apple? For starters, because Apple started the hollowing out of American semiconductor dominance and made certain that the critical jobs and manufacturing went offshore. Secondly, with 50% of the US smartphone market, Apple is the only company which can make an impact, but it won’t because that means losing $5 per phone.

Apple Undermining US Manufacturing

Nine years, a trillion dollars in sales, and almost no taxes paid. That’s just the starting point for wondering about Apple’s actual contribution to the US economy.

Apple’s success drags down the US GDP.  The behemoth that is Apple sold almost 200M phones last year, none of which were made in the US or used components made here. Instead of exporting $100B in iPhones, the US imported $50B. That $150B swing matters in terms of balance of trade, GDP and jobs. If you wanted to improve the US economy, there’s no better place to start than with Apple and smartphones.

Apple undermines the US manufacturing base. Assembly matters and manufacturing matters more. There was a time when Apple could have assembled phones and tablets in the US, but that would mean spending an extra $5 per phone since that’s approximately the extra labor cost to build that $700 phone here instead of in Vietnam or China. Assembly may not be a competitive, value-add step but it does employ a lot of people.

Unfortunately, it would also cut Apple’s profits by $1B, shrinking the company’s annual net income from $45B to $44B. Apple wouldn’t notice a drop in profits of $1B because it’s not putting its cash to use: Apple has $200B in cash conveniently parked outside of the US, not doing anything. On the other hand, assembling in the US would employ tens of thousands of people. A bit more productive use of capital, I believe.

Semiconductor manufacturing is more important in the grand scheme of things. It’s a fact that higher-skilled high-tech jobs create more wealth for an economy because they lead to innovation and new product development. Again, Apple could have its chips made in the US, by Intel for example. Instead, Apple turned to Samsung (Korea) and TSMC (Taiwan), going offshore to save another few dollars.

With a healthy dose of Schadenfreude, one notes Apple’s struggles to compete with Samsung, its past and present chip manufacturer. When Apple turned to Samsung to manufacture chips, the company also transferred vital intellectual property. Samsung learned everything it needed to know to design its own chips and phones. Apple saved ~$2B per year. In return, Samsung gained $100B a year in smartphone market share.

But while Apple’s greed makes it penny wise and pound foolish, it’s the US that pays the price. Shifting manufacturing of the most cutting-edge chips has permanently eroded our manufacturing base and high-tech competitive edge.

Should the US offer a $1B annual manufacturing subsidy to Apple? Well, it actually already does, except the amount is closer to $15B. As part of Apple’s ‘Zen and the Art of Freeloading,’ Apple has found arcane tax rules that funnel sales through Ireland and dodge US taxes. The Senate found that in 2011 Apple paid the IRS just $2.5B in taxes on $128B in sales. Before someone points out that Apple’s success boosts US employment by a few thousand workers, the US economy would get much more of a boost if Apple didn’t work so hard to dodge its fair share of taxes.

Intel and US Economy Struggle Together

Intel, on the other hand, is a positive contributor to the US GDP. Intel’s factories are largely US based. Its $50B in annual sales means more US exports and fewer imports, the exact opposite of Apple.

Sadly, Intel is struggling. Its sales have been flat for four years in a row and the company’s product line doesn’t fit consumer demand. The PC world continues to stagnate and Intel’s semiconductor offerings are not used in the tablet, smartphone and wearable device world.

A big part of Intel’s problems is that it faces competition from the very companies that Apple directly employs (Samsung, TSMC). The result is falling production and a loss of competitive edge, both of which directly reduce the US economic strength. Last year Intel canceled a new factory in Austin. That was the first tangible sign that market share loss to TSMC and Samsung was taking a toll on Intel: lower demand for Intel products meant no need to expand production. Fast forward to this month: Intel’s latest earnings announcement included a steep reduction in capital spending – a 15% cut.

Intel tried to spin the CAPEX cut as a harmless thing when in fact it is a big blow to the company’s future. Intel’s entire competitive edge is determined by its ability to out-produce the competition and to be the technology leader. Ultimately Intel is just a manufacturer. Its issues are the typical problems plaguing economies of scale that come with improving production yield.

In the semiconductor world, yield is a real estate game. Semiconductors are built on 300mm silicon platters (aka wafers) and the manufacturing process follows a modern form of the lost wax casting technique: light-sensitive chemicals are layered on the silicon and ‘melted off’ via light. This creates channels that get built up like a layer cake and eventually become the transistors and resistors. The smaller you make that wavelength of light, the smaller the channels and the more transistors you can pack on that wafer. I call it a real estate game because it’s the equivalent difference between building 10-story and 40-story apartment buildings: same land, more money.

Intel has always been ahead of the pack when it comes to shrinking the light wavelength. It can crank out more chips per wafer, and has more factories to do the cranking. This enabled Intel to control the pace at which the industry shifted to smaller wavelengths. For Intel, it meant profit maximization because the company effectively dictated pricing and timing.

Well, not any more. Today, Intel faces stiff competition from Samsung and TSMC, both of whom can produce at similar volumes and using similar cutting-edge technologies. That’s really what the CAPEX cut meant: Intel has lost control. It’s incredibly difficult to regain control when you have not one, but two aggressive rivals.

How the US Has Fallen Behind

The big problem here is that the US lacks an industrial policy. China, Taiwan and Korea’s governments very clearly understand the economic importance of high-tech design and production. The US government… not so much. China fully understands the importance of high-tech jobs and especially semiconductors: it has ear-marked $10B in direct subsidies (or investments, as they euphemistically deem them). This isn’t steel or cement. Whoever produces the semiconductor chips has an edge with high-tech devices, and that means trillions of dollars.

I’m not suggesting that the US become protectionist. In some ways this is just another industry where our trading partners subsidize and incentivize local design and development and penalize foreign imports and production, all while the US government does nothing.

Except this time it is different. The US’ ability to make more or fewer cars was an economic and jobs issue. The US’ ability to stay competitive in the semiconductor space is a national security issue. Semiconductors are the engines for high-tech products, like super computers. Having the most powerful super computers is the linchpin of the US national security platform. (This is why it’s also an area of prime focus for the Chinese government.) With high-tech determining the economic growth of every country, enabling another nation to be more competitive makes no sense.

What is the burden of having Apple be the best it can be? Nine years, a trillion dollars in sales, and almost no taxes paid. And while Apple helps Samsung and TSMC build factories in China, Intel is shuttering factories in the US.

I have no issue with corporate greed per se; more often than not there’s a balance with the public good (lower prices, better products and services). When things become imbalanced, it falls on us, as a society, to re-align things. We need to step in here.

What to Do?

First, boycott Apple products. If you buy an Android phone you can take comfort in knowing that some of that money comes back to the US via Google, which does a lot to support the US economy. Second, let’s encourage Congress to close the tax loopholes that let companies like Apple hide from taxes. Third, don’t support a one-off tax moratorium on cash brought in from offshore. These companies are dying to bring the money back anyway. They dodged taxes to get it offshore, and now they want to continue dodging them to bring it back? No way.

The Gold Bubble in Context

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In an economic bubble, at a certain point pricing gets emotional and disconnects from whatever the original reasons were that kicked off the trend. Add easy money and the bubble gets really bubbly. The price movements attract attention and generate media play and then things really cascade upwards.

I’m not a gold bug and probably the last person to give guidance about gold. Though I know a thing or two about bubbles and this one is no mystery.

Asset Bubbles 12 Year

Gold has been bubbly in a special way.

The housing market boom and the NASDAQ dotcom boom bubbled up because of positive sentiments like, “Housing can never crash!” and “There’s no dotcom bubble because Alan Greenspan sees no signs of Irrational Exuberance!”

Gold on the other hand got bubbly because of negative sentiments like the fear of inflation and economic uncertainty.

Gold is traditionally a hedge against inflation and fear, or fear of inflation, which is precisely what the various rounds of QE kicked off: massive expansion of fiat currency.

Fear and panic were under the surface during and immediately after the recession. For the first time since the Great Depression, the US saw bank runs. Americans were having to line up for gas. Unprecedented unemployment and personal bankruptcies were rampant. Greece, Spain and Italy were close to collapse. Defaults loomed while fiat currency was reaching unprecedented heights. This was all happening AFTER the Great Recession ended.

In response to the persistent and extreme economic instability, gold prices continued to race up. From 2009-2011, the two years following the Great Recession, gold prices shot up 75% and they kept rising.

By late 2012, however, global economic crises were retreating. Central Bank coordination succeeded in calming markets. Since then gold prices have drooped 30% from $1800 to $1200.

What Happens Next? The Fear Trade Unwinds

Gold prices remain elevated – up 3X since 2005. Very little of this comes from inflation.

Quantitative Easing (QE) did not lead to unusual inflation. For proof, fans of the Federal Reserve like Paul Krugman regularly point to the CPI (Consumer Price Index) which has averaged ~2% per year since QE began. Critics jump up and accuse the Fed fans of cherrypicking data. Specifically that the CPI strips out precisely those things that would reflect inflation like food and gas.

So let’s take the critics’ concerns into account. Looking at inflation in meat, poultry, fish and eggs (per the Census Bureau), we can see the change in prices for the last three business cycles (from the end of the previous recession to start of the next recession):

  • 1991-2000 (9 years): 22%
  • 2001-2007 (6 years): 22%
  • 2009-2014 (5+ years): 22%

Ah-ha! The critics were right about higher inflation. It took 10 years for prices to grow 22% in the 1990s and we hit 22% in just five years from 2009-2014. That’s 2% annualized inflation in the 1990s versus 4% over the last five years. The pace has doubled.

Is that so worrisome? It’s nowhere close to the fear of hyper-inflation, much less major inflation.

Additionally, the faster pace of food and gasoline inflation comes from a general global trend towards competition for basic resources. Indian and Chinese diets and purchasing power have expanded. They are eating more meat and burning more gasoline (China is now the biggest auto market in the world, for example). The rise in non-US demand pushes up prices. Today’s inflation is about the same as it was in the previous cycle. Adding to that global trend is the 2014 California drought, further boosting prices.

Looking back we can say that QE created no unusual inflation, but nobody knew that at the time. What we knew was major financial panic.

All this boils down to one key point. Gold has been a fear-based trade, and fear is dropping.

The Retail Market is Propping Up Gold… For Now

From 2008-2012 the Federal Reserve initiated three rounds of QE. Asset prices surged following each round. Loose money has a way of doing that.

Gold prices began to fall in early 2013 as talk of QE tapering picked up. Monetary tightening was now on the horizon.

For the gold-inflation trade, the bets had to shift. An end to QE meant a tilt away from an expanding fiat currency and against owning gold. Tighter monetary policy is anti-inflation and anti-gold for the gold-as-inflation-hedge crowd. Suddenly many top hedge funds began to reduce gold ETF holdings. (Some might say that they were anticipating a drop in gold prices, but it’s more likely they created the price drop simply by exiting the market.) Hank Paulson stuck around to hold the bag while George Soros and others began to exit.

For the gold-fear trade, the end of QE was an official proclamation that the Fed had slain the bad-news economic dragon. As big (smart) money left the table, retail (dumb) money kept buying.

Google Trends is Your Friend

Google Trends is a tool to analyze everyone’s web searches. Type in a word or phrase and Trends will report the frequency that it appeared in Google searches. It turns web searches into a gauge of interest and sentiment, which is another way to predict consumer and household behavior. Trends let’s anyone track thousands and even millions of people’s interest and concerns and it can be fine-tuned for a particular time period and location in real-time.

Google Trends says people are much less afraid. Start with general interest in gold.

Google Trends Gold

Gold searches are a coincident indicator. People searched on the word “Gold” in response to the media and a surge in gold prices. Back in 2008, when gold prices began to jump, so did Google searches on the word. Big jumps in searches accompanied big moves in prices.

Peak Google interest in late 2012 corresponded to peak gold prices.

Interest today has fallen to 2011 levels and below, which corresponds to a gold price far below $1200. It was closer to <$1,100.

Positive Household Sentiment is Bad for Gold

Google Trends shows no support for the fear-based trade.

Searches for key words like ‘Recession’, ‘Unemployment’ and ‘Bankruptcy’ are down sharply. Fear is down to pre-recession levels when gold was $600. That would be a 67% drop in price, about what happened to the NASDAQ. With QE gone, more sellers than buyers (in the form of hedge fund positions) and with fear of economic uncertainty down, why wouldn’t gold prices return to near 2006 levels?

Recession Unemployment Bankruptcy

Inflation and Interest Rates: This is Where it Gets Interesting

Until recently, searches were dropping for the words ‘inflation’ and ‘interest rates’. Though it is rising again as concern is increasing.

Apparently inflation expectations are rising. Apparently interest rate growth expectations are rising.

Inflation Interest Rates

Some of this may be self-fulfilling. The media has been spinning the specters of inflation and rising interest rates for almost a year, since the end of QE was announced. It could provide some near-term support for gold as an inflation hedge.

However the lack of follow through from inflation and interest rates may find that this support wanes.

An investor’s best bet is to continue watching the trends. That should be a key indicator on any future large moves in gold.

Why Consensus Is Wrong About 2015

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US GDP Forecasts: Mainstream Economists Will Be Wrong Again

You can’t fault positive thinking, but in economic and investment terms realistic expectations are the most valuable.

Back in January, I estimated that 2014 US GDP would be ~2.2%, far below Consensus which was thinking 3%+. Consensus has caught up and is now predicting 2.2% (down from 2.5% in May).

Turning to 2015, Consensus is again pie-in-the-sky hopeful at 3%.

Sluggish Inflation Today, Sluggish Inflation Tomorrow

The traditional and conventional view is that inflation drives economic growth by forcing producers to buy today before prices get more expensive. Inventory stockpiling boosts the economy.

Looking around, is there inflation and are producers stockpiling? The answer to both is a whopping no.

Some amount of wage inflation is creeping in as minimum wages grow and as labor continues to tighten. Businesses will sometimes bump prices opportunistically. Paul Krugman recently pointed out something that is actually useful and relevant to the 21st century economy. He said businesses that are local and don’t face competitive pressures are raising prices, like airlines and restaurants.

However most producers do face competition and they are not raising prices. Producer Price Inflation (PPI) for goods has been negative two months in a row. On a year-over-year basis, PPI is up a tepid 1.6%. What little inflation we’ve seen comes from food price hikes in the face of drought.

Low inflation has been the trend for over a year, stemming from less pressure to raise prices because margin pressures have eased in the face of low energy prices (thank you cheaper oil) and a stronger dollar. The strong dollar is lowering inflation expectations since the US has emerged at the cleanest shirt in the global economy.

Global Oversupply: The Real Reasons for Low Inflation

Producers are struggling for pricing power. The economy may be on better feet than at any time since the recession ended, but there is still a major supply glut. Chinese supply has overwhelmed demand, leading producers like Alcoa to close factories and steel makers to walk away from purchases. Many commodity prices are in free fall. So much for the super-cycle in commodities.

Manufacturing Capacity Utilization is a great way to evaluate slack on the production side of life. The Federal Reserve Board measures capacity utilization by considering how much production is possible and sustainable and how much is actually being utilized. It considers available labor and equipment, among other things.

Supply constraints point to inflationary pressures as well as demand trends. Buyers bid up prices when supplies are tight.

Capacity Utilization

The good news is that capacity utilization is at a cyclical high, indicating solid demand and some price strength.

The bad news is that capacity utilization remains below the peaks of the previous cycles. We are almost four months into the sixth year of recovery and still lagging the previous cycle.

This business cycle is continuing for a while and with it capacity will get tighter, which is good for producers. Although the primary reason for higher capacity utilization is that producers are expanding slower than the pace of demand growth.

This undermines the entire conventional expectation that inventory stockpiling should be happening – right now – and pulling GDP up with it. Listen to earnings calls and you’ll hear producers in the supply-chain complaining that their customers’ inventories are too lean.

It’s not true that inventories are lean, though. They are leaner than the 1990s but right about where they were in the previous cycle and higher than ever this cycle. Business inventory-to-sales are actually rising.

Business Inventory to Sales

If anything, inventories have grown too much. They have grown while sales have been flat. Some form of inventory cutbacks is likely in the 4Q as businesses right-size their capital.

Business Inventory to Sales Year to Year

The key point in all of this? Producers have sufficient capacity to meet end-user demand, which itself looks likely to soften a bit. Against this background, prices are not likely to rise much and growth will probably weaken a bit.

Semiconductor Sales: The Crystal Ball for 2015 Growth

Consider semiconductor equipment spending. Everything being manufactured either includes semiconductor chips or uses machines that require semiconductor chips. As such, expansion in production of any kind automatically translates into more semiconductor chips.

Semiconductor sales today are tomorrow’s industrial production. Right now, semiconductor producers are looking out and expecting minimal increase in demand.

Look at semiconductor factory expansion. While they are spending more on re-tooling capacity expansion is barely above 0%, about the same as this year.

Fab Equipment Spending vs Change of Installed Capacity

Semiconductor makers are migrating to a new technology and that’s causing massive spending. Despite significant growth in the auto and mobility (smartphone) spaces as well as general global demand for stuff, semiconductor companies see no reason to greatly expand supply.

All that follows other fundamental data points. Consumer spending is steady but relatively mild. Most new jobs in 2013 and 2014 have gone to secretaries and bartenders. Retailers expect organic growth only, and without Y/Y increases.

With demand cruising along at organic levels (low single digits), of course producers will expand cautiously.

Fed Actions Will Slow Growth

Retailers and producers are positioning for low growth in 2015. Earlier this year there was talk about an escape velocity, meaning weather had caused some near-term sluggishness from which the economy was poised to surge and get back to some higher level of growth.

This idea of some mean reversion to higher growth made no sense. Growth is mild because demand is mild. US consumers spend what they earn, and no more. The wage picture doesn’t reflect a surge. Global demand is slowing. Producers expect prolonged subdued demand and are keeping a lid on expansion plans.

Into a low-growth environment, now add in rate hikes. David Shulman, Senior Economist at UCLA’s Anderson School, recently reflected the consensus view when he said that rates will go up for good reasons; because of a strong economy.

That’s not exactly true. One could argue that a stronger economy is what’s enabling both the end of QE and the reduction in treasury borrowing. The absence of pressure to keep rates low is far from being the presence of pressure to boost rates.

It’s an important distinction. If the economy is actually poised to slow and real interest rates rise, GDP will drop fast.

Household Wealth Will be Hit

The first blow will be felt in the housing market. Housing has already entered a slower stage. July home sales fell 4.3% Y/Y. During the most recent earnings calls, homebuilders reported a drop in unit sales and banks aren’t stepping in to chase the marginal buyer and create some type of escape velocity. Wells Fargo CEO John Stumpf recently said, regarding loans to low-income borrowers and poor credit holders, “We’re just not going to make those loans.”

Prices will come under some pressure as inventory grows. More owners are above water and can sell. Into this slower growth market, add higher mortgage rates.

Beyond the housing market, the stock market won’t like the impact of higher rates on leverage. A hit to stock prices is a hit to household wealth, contributing to further slowdown in spending.

We are likely entering a period of disinflation where prices don’t rise. That’s great for consumers; not so great for producers.

Prologue to Recession

Without inflation and pricing power, without growth in demand, companies stop hiring and start firing. A rate hike hastens the advent of a recession.

Right now, jobless claims are at 14-year lows. That’s actually a sign that a recession is coming within 12 months because once claims hit bottom, they can only rise. A rise in claims is the turn in the wheel for the economic cycle as it begins to slow and then contract.

So take economic indicators, conventional wisdom and consensus estimates with a grain of salt. Realistic expectations are far more valuable than overly positive ones.

East Meets West: How the Valley Effects China

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iPhone Sales: Evidence of Online Spending

Moneyball Economics visited a few local stores selling iPhones for the big, long-awaited iPhone 6 release. There were lines but not that deep and none reaching outside the store.  Wait times were no more than two hours. Photos of lines going around the block – like in NYC – reflect unusual circumstances, far from the norm elsewhere.

Apple Store Line

(photo source unknown)

The evidence was certainly not enough to drive the 6.5M figure being whispered for in-store sales. In this case, online sales become much more significant.

Apple hit the whispered 10M unit sales, about $5B worth. It’s hard to find any company that can expect $5B in sales for a week, much less $5B a year, and that’s just a kickoff for the smartphone holiday spending. This promises to be a $60B+ global event over the next few months.

It’s quite possible. A real iPhone release has been two years in the making (the iPhone 5 was a placeholder). A massive and loyal user base is waiting to upgrade.

China’s Struggle for Growth

The Chinese economy is in trouble. The domestic consumer economy is a pale shadow of the export economy, and exports are sluggish and slowing. According to the Port of Hong Kong, total exports grew 2% Y/Y on a rolling average basis, but August contracted (-3%) Y/Y.

Hong Kong Exports

The smartphone will push up the figures in the next few months, but not for long.

It’s hard to be positive about China’s prospects for growth over the next year. As an export-dependent economy, China has no reason to feel positive. The EU is tipping back into Recession. US demand for Chinese goods has matured. None of these things will be countered by growth in the emerging economies.

Surveys of China’s producers (Markit’s Purchasing Managers Index or PMI) indicate production is one cold breeze away from contraction. (Markit surveys 420 manufacturing companies each month.) Production is 50%+ of the economy.

Additionally, new products simply aren’t appearing fast enough. It’s a post-smartphone world. US and EU markets are saturated. The Chinese domestic market has a lot of growth potential, but the total global growth that Chinese manufacturers have been serving is slowing down. Replacing the production is critical to maintaining growth.

The promise of the next high-volume consumer product is centered on connected devices. The idea is that every smartphone owner will want at least two or more peripheral gadgets; glasses and a watch, at the very least.  These devices aren’t taking off though. Instead of a few billion smartphone users and billions of connected devices, we’re seeing a few million connected devices. Apple had to delay the release of their watches into 2015, causing some delay in pick-up. Samsung has theirs ready but sales have been puny at best.

Desperation and Distribution Channels

If Chinese companies can’t grow out of the slowdown, then they can expand out of it. Instead of manufacturing for other companies, many Chinese companies are looking to sell under their own labels and some are looking to move into local markets and participate in the distribution channel. This requires massive infrastructure investment and the payoff is not happening anytime soon.

Chinese manufacturers are starting to seek growth outside of their traditional areas of expertise. High tech companies now entering the ice cream space, for example.

Predicting this slowdown back in 1Q, SouthBay Research said that – despite official Chinese government assertions – some stimulus would be needed by Summer 2015. Indeed, the PBOC just stepped in with some big monetary help and it won’t be the last.

There’s a reason why Caterpillar expects sales to China to collapse (-10%). Global demand is slowing. At the same time, domestic demand has relied on the property bubble, and we all know how spectacularly it burst.

Capital Flight From China to the US

Faced with slowing global demand, a sluggish domestic economy, a collapsing real estate market and a seriously under-performing stock market, Chinese investors are looking for better performance. The US stock market is calling like an oasis in the desert.

While investments in gold have more downside risk and US real estate seems to be peaking, the US equity markets are liquid and seem to have gas left.

Alibaba is a juicy example of capital flight in action. The #1 company in China had the biggest IPO of all time. However Alibaba did not IPO in China and that’s serious loss of face. The likely reason is that important Chinese investors (insiders including government officials) could maximize their returns and, more importantly, keep the money outside of the reach of the Chinese government.

It will be interesting to watch the carrots and sticks the Chinese government puts up to slow capital flight.

Expect Stimulus to Combat Slow Growth

The housing market is crashing, pulling down domestic consumption. Look for some action here in the form of lower down payments or moves to lower interest rates.

Expect monetary stimulus in the form of extra lending.

With slower global demand, China’s consumers are the key going forward. The Chinese government will attempt to keep the yuan flat. A cheaper yuan helps exports but hurts consumers.

This is all good for US equities. A boon in Chinese demand will lead to greater US company sales and a flat yuan keeps the dollar-denominated profits stable (most US companies price in dollars to avoid the yuan trap but there is still exposure to a falling yuan and the erosion of dollar-denominated profits).

Normally a strong dollar is bad for the stock market as it reduces value of offshore profits, slows exports and moves money into alternative investments like bonds. However trends like a Chinese capital flight into the US equity markets will add some tailwind.

This all leads back to our anecdote about iPhone 6 sales. Growth in the mobile phone market is stagnant and other mobile device growth sluggish. The strongest company in China had the largest IPO of all time, but in the US equity market. The Chinese economy is in major need of a kick-start if it wants to keep up with the world.