Chinese economic growth is vital for the earnings growth of S&P 500 companies.
Unlike many other stock market indices, the S&P 500 is often thought of as being very domestically focused.
In part, this is due to index inclusion rules. However, it is also reflective of the very domestic orientation of the US economy. Whereas some countries such as Japan and Germany are highly reliant on global trade, the US has a large internal market.
As a result, usually about 60% of earnings for companies in the S&P 500 are derived from domestic sales. Therefore, a key driver for the performance of the index is usually the overall health of the US economy. As a result, many investors perhaps believe that their US share holdings are largely shielded from the political and economic shocks coming out of China, be it the regulatory crackdown or the collapse of Evergrande (SEHK:3333).
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However, new data from Bank of America Merrill Lynch (BoA) suggests this is not necessarily the case. According to a note titled ‘Common prosperity could mean uncommon pain for US multinationals’, US companies in the S&P 500 have become increasingly dependent on China.
To be clear, direct sales exposure for S&P 500 companies is still low, at around 5%. However, the paper notes some key facts to illustrate the growing dependence.
First, the correlation between earnings per share growth in the S&P 500 and Chinese economic growth has gone from 0% in 2010 to 90% now. Therefore, Chinese economic growth is vital for the earnings growth of S&P 500 companies.
As BoA notes: “China GDP growth has increasingly mattered to S&P earnings, more so than US GDP, pointing to China's growing share of the global ecosystem. About 30% of global GDP growth over the past two decades has come from China (versus 21% from the US).”
Economists from BoA estimate that a China GDP growth cut of 0.9% in 2022 would result into a 3% hit to S&P 500 earnings per share, based on the relationship over the past five years.
Of course, dependence on China’s growth varies per sector. Materials and technology are the most vulnerable to a slowdown in China. Earnings in these sectors have a greater correlation with China GDP than US GDP.
Investors have already seen that ‘what happens in China doesn’t stay in China’, with European and other Asian indices taking a hit when China growth scares arise. But it would seem that even US-focused investors are not immune to a slowdown in China.
Historically, the US has – and indeed still does – drive the global economy and therefore stock market prices. ‘When the US sneezes, the world catch a cold’ has become a cliché. But increasingly, as China becomes ever more vital to the global economy, it is also playing this role. Investors with exposure to US shares need to keep this in mind.
Not just China
China’s importance to corporate America is also part of a wider story about the global interconnected nature of economies, firms and their fortunes.
As noted above, around 60% of S&P 500 earnings tend to come from domestic sales. While that is relatively high, it is lower than has historically been the case. As Cullen Roche notes in his book Pragmatic Capitalism, in 1990 the S&P 500 generated 22% revenue from abroad, compared to today’s roughly 40%.
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He notes: “The S&P 500 is no longer a US index. It is becoming a global index, and understanding its constituents requires a global picture. The big picture matters to market participants because US stock markets are becoming increasingly dependent on a stream of foreign revenues as they tap into foreign markets for business expansion.”
This also means that the S&P 500 moves increasingly in tandem with global equities. Roche notes that between 1990 and 1995, the average correlation between US and global equities was 29%. Between 2005 and 2010, the average correlation had risen to 73%.
The above mentioned note from BoA also points to the importance of globalisation to US shares. It notes that “close to 80% of the S&P 500's margin expansion since 1990 has been driven by globalisation (tax, labour arbitrage, supply chain efficiency gains).”
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