Taking a Bite Out of Cat

Rodney Johnson | Monday, October 28, 2013 >>

My father often said that children exist to make a liar out of you. No matter what you think they will do or say, they tend to do something else.

I used to be among the deluded that thought mostly boys wanted to drive big machines. Then I had daughters. While they’re older now, I can still remember them sitting in front of the TV, totally engrossed in Bob the Builder, a show about really big machines.

In real life these girls love to hop on riding lawnmowers, tractors, ATVs… anything I let them drive. I guess that’s part of the reason I see big tractors and machines a bit differently now, and why I root for the manufacturers like Caterpillar (CAT)… even when fortune turns against them.

Caterpillar can’t make a business out of building machines as play toys. It instead provides the world with large earth-moving equipment for construction and mining.

The company had to be licking its chops as the 2010s began. China had rebounded from a shallow downturn, commodity prices were shooting higher, and world demand for its big yellow machines was on fire.

Meanwhile, here at home, the company was playing hardball with unions, holding the line on pay and benefits, pointing out that there was a long line of people waiting to get good jobs.

High demand for your product, worldwide brand recognition, cost containment at home… what’s not to love?

Then came that pesky slowdown.

In 2012 the bloom was off the Chinese rose. The continued lackluster demand from the U.S. and the euro zone for gadgets and trinkets meant that the Chinese exporting miracle was suffering through a period of stagnation.

In fact, this has continued through 2013, with the Chinese export market moving in fits and starts. It’s not as if demand has evaporated, but growth is minimal if it exists at all.

As we’ve written many times, the slowdown in China doesn’t stay in China. It backs up to those who supply the red dragon with goods and services, like the mining companies in Australia.

The reduced trade velocity meant falling demand for raw materials so less demand for mining.

And it doesn’t stop there.

The miners then slow down their own orders and buy less equipment and supplies. This is where CAT enters the story…

As a main supplier of large mining equipment, the company is a poster child for what can go right – and wrong – as trade moves up and down. For a couple of years it looked like CAT was invincible. It was a sign of U.S. strength as the company exported heavy equipment around the world.

Now, the fierce roar of the company sounds more like a whimper.

CAT recently announced a dramatic drop in earnings, with its mining business off by 70%. Its outlook for the rest of the year was none too bright either. But this makes sense, of course.

Chinese exports are off from a year ago. Yes, the company is still exporting, and yes, the country of China is trying to grow its internal demand. But will China continue its rapid capital expansion? Will the country ramp up imports of raw materials again? That remains to be seen.

The tried and true method for economic growth in China has been to move rural villagers to cities where factory jobs are plentiful. This specialization of labor pays dividends by raising wages and therefore demand, while also fueling exports. 

With hundreds of millions of people still in the hinterland, it might look like the country has years of easy growth left, but that’s not the case. China is constrained by what happens elsewhere as well as its own use of debt.

The combination of rising wages in China with a slowdown in trade means there isn’t the same unquenchable thirst for new laborers. 

At the same time, the Chinese method of financing internal capital spending through massive local debt looks like it is starting to break apart.

Yes, urbanization will continue, but not at the same breakneck speed, and not with the same, double-digit GDP growth results. There could be massive dislocations ahead for the Chinese economy.

China has defined its place on the planet as the low-cost producer of small, mass quantity things. As wages go higher, the lower-cost mantle is being passed to countries like Vietnam. At the same time, the euro zone is still stuck in an economic quagmire while the U.S. is growing, but just barely, with most of that growth at the top of the income ladder.

The point is that China is getting squeezed at both ends of its production line. The clients are not buying like they used to and the manufacturing costs are rising. And with more deleveraging to come in the developed nations of the world, the trend of weaker external demand could last a very long time.

Meanwhile, there’s that little matter of debt…

Local Chinese governments are the main drivers of construction, where they trade land to developers for hefty fees and financially backstop the buildings themselves.

While by no means an epidemic yet, there have been defaults and bad-debt write downs. And there’s simply no way to know how much bad debt Chinese banks are carrying, as the government doesn’t release reliable numbers. The best estimate I’ve seen so far is that private debt is more than 200% of GDP. That’s a hefty figure for an emerging economy.

So while Caterpillar is still a strong company and still enjoys global brand recognition, it could be a while before its sales forecast turns higher. The company is in the unfortunate position of having to wait and see what happens in that large country on the other side of the planet.

At least the company is still adored by kids – both girls and boys.

Rodney

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About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.