Notes from the road: An equity investor’s lens on China

Tony DeSpirito |Jun 12, 2019

Markets tend to focus on one risk at a time, and it’s fragile U.S.-China relations that are front and center now. New blog contributor Tony DeSpirito offers up two potential takeaways for equity investors.

Headlines over the U.S.-China trade dispute have been practically inescapable. On the heels of a recent visit to China, I can say this is as true there as it is in the U.S. If timing is everything, ours was very good (or bad), as our visit came just as high hopes for a trade deal had collapsed to a deep mutual mistrust.

Are we concerned as active investors?

We take a bottom-up approach to stock selection and that remains the key driver of our investment decision-making. We fully expect headlines related to U.S.-China to persist. The issues go well beyond trade, and so a protracted period of discord is likely in the cards. The news will ebb and flow, and as it does, we will remain vigilant in our stock-by-stock analysis.

Taking a step back, however, reveals a couple of potentially important takeaways for U.S. investors at the industry and sector level―one shorter-term and one longer-term:

Near-term positive for health care stocks.

History tells us financial markets can focus on only one risk at a time ― and right now it’s U.S.-China. That may take the heat off the U.S. health care sector, where stock prices had weakened under the looming cloud of increased federal oversight and regulation.

While the S&P 500 Index returned 10.7% in the first four months of the year, health care stocks, as measured by the S&P 500 Health Care Index, returned just 1.3%. In May, as trade discussions turned south, health care outperformed the market by 4%.

Health care is typically a high-quality sector that exhibits solid free cash flow and low sensitivity to global growth ― a combination that historically has provided resilience in late-cycle periods. After a 10-year run, that is where this business cycles appears to be headed now, even as few ominous signs have yet to emerge. The macro picture generally appears supportive of the sector, and to the extent markets turn their attention away from the regulatory threat and toward the risk du jour, that could be a short-term positive for U.S. health care stocks.

Health care stock valuations currently stand at 15x forward earnings, below the 16.7x average for the S&P 500. The sector’s earnings outlook is attractive too. Consensus estimates for forward one-year earnings growth, currently at 8% for health care, are on par with the broad index but well above other defensive sectors, including consumer staples (2.6%), real estate (4%) and utilities (5.5%).

Rougher long-term road for U.S. semiconductors.

We’re keeping a close eye on the U.S. semiconductor industry. China was already intent on achieving self-sufficiency. It’s Made in China 2025 plan set a goal of ramping up semiconductor output and meeting 80% of domestic demand by 2030. The recent cooling in relations with the U.S. could increase China’s resolve on this score. This could have long-term implications for U.S. chip makers, a key supplier to the Chinese. Of course, the situation remains very fluid and could be years-long in its evolution. To the extent existing global supply chains are disrupted, a rebuild to a “new normal” could take up to a decade. We continue to like the tech sector, but our emphasis is on software and services over hardware and the supply chain.

Overall, after a strong four-month run that sent valuations higher, the May downturn sparked by U.S.-China tensions has restored some value in U.S. stocks. While valuations are above their historical average, they are not stretched, in our view. We remain risk-on, but prudent in our approach. We believe times like these are when fundamental stock-by-stock investing can make a meaningful difference in investor outcomes.


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