One of the Biggest Misperceptions in Finance Today

The trade war, Hong Kong, and more... Getting a different perspective on the markets... One of the biggest misperceptions in finance today... Why this China-related issue isn't as bad as it seems... Don't let 'China-phobia' scare you away...

On the surface, it seems like investors should avoid China at all costs today...

There will always be a reason not to buy as an investor. And lately, many folks have focused their reasoning on a few macroeconomic concerns in China's market...

Regular Digest readers know all about the country's trade war with the U.S. We've covered the latest twists and turns in the seemingly never-ending saga over the past year and a half.

And in Hong Kong, millions of people have marched in protests over the past several months... Fears of the local government passing a bill that would have allowed extraditions to mainland China drove the protestors into action.

These protests broke out in Hong Kong's major airport, halting travelers and delaying flights for days at a time. In some cases, protesters turned violent in the streets.

Look, I (Chris Igou) hear you... Most of the recent news about China has been negative. But if we dig deeper, these types of "world ending" scenarios aren't as bad as they seem...

Since the trade war began, analysts have predicted it would devastate China's economy... But the two sides seem to have made progress recently.

Even more, Hong Kong's government is taking steps to settle the unrest. Just this week, it formally withdrew the bill that originally started the protests.

If you haven't bought Chinese stocks this year because you're worried about these issues, you've missed out... China's Shanghai Composite Index is up roughly 18% in 2019.

I joined Steve Sjuggerud's team four years ago...

Since then, my friends outside the finance world love picking my brain about stories in the news... Whether it's about the trade war or something happening here in the U.S., they want to know what I think will happen next.

For example, during the bitcoin craze in late 2017, I received several text messages about the crypto's big move from less than $1,000 to more than $17,000 that year.

My friends asked questions like, "Could bitcoin really reach $50,000?" and "What about alternative coins like Ethereum?"

Not surprisingly, those texts stopped coming after bitcoin's price collapsed throughout 2018.

Sometimes, it's good to see these messages coming in from my friends... It gives me a rough feel of what people outside of finance think about the markets.

The questions I've received lately all revolve around China...

As you might expect, many relate to the trade war and what's going on in Hong Kong.

However, several questions have touched on another China-related topic. And in my mind, it's one of the biggest misperceptions in today's financial markets... China's debt.

You see, China's debt has swelled since the 2009 global financial crisis. It's now at the largest level in recent history. And I've been getting questions like this as a result...

"Isn't China overloading on debt to support its struggling economy?"... "Are you ignoring China's debt problem when talking up its stock market?"... "Is China's debt out of control?"

If you've been reading the headlines, you might be wondering the same thing...

The mainstream media has pushed this narrative time and time again over the past decade. Take a look at this headline from financial news network CNBC in August...

That headline makes it seem like China is a ticking debt bomb that's about to go off. And you're not alone if you've avoided investing in the country because of what the media says.

But I want to make one thing clear... This perception of China is flat-out wrong. Today, I'll show you why China's debt isn't on the brink of collapsing its economy as many believe.

In fact, the reality is so different than perception in this instance that I believe we could see a massive rally in Chinese stocks over the next few years because of it...

Now, I'm not predicting a total return of 450% like we've seen in U.S. stocks since 2009. But this misperception could easily lead to triple-digit gains in Chinese stocks from here...

Let's start with the debt from Chinese households...

It's true that household loans in China have doubled since 2008. And household debt is not a small fraction of the economy, either. To be clear, in this calculation, I'm talking about both consumer debt and mortgage loans...

As of the end of last year, China's outstanding household debt equaled 44% of the country's total gross domestic product ("GDP"). That's a solid chunk of GDP, but it's nowhere near the level of household debt to GDP in other advanced economies right now...

In the U.K., this debt-to-GDP ratio is 87%. And it's a solid 79% here in the U.S.

So as you can see, the ratio of China's household debt to the country's GDP looks relatively low compared with other global powers. And remember, China is the second-largest economy in the world... Yet its household debt to GDP is much less than its peers.

China is also much more strict on mortgage down payments than we are in the U.S...

The average down payment on a house is 6% in our country. And in many cases, people pay even less than that... If you get a Federal Housing Administration ("FHA") mortgage, you can put as little as 3.5% down when buying house. That requires a low upfront cost.

Last year, China cut its minimum requirements for a down payment from 25% to 20%. But that's still more than five times higher than the minimum needed in the U.S. today.

Let me say it again... You need to have at least 20% of the home's cost as a down payment in China. In comparison, 72% of first-time homebuyers in the U.S. put down 6% or less.

The truth is, China's household debt isn't at a tipping point today.

Now, I know what you're probably thinking... "That's just a piece of China's debt puzzle." I get it. But let me show you more proof that China's debt isn't out of control right now...

We can see this through what's called 'non-performing loans' ('NPLs')...

NPLs are exactly what they sound like... They are loans that the borrower can't pay back. And the lending bank takes the hit on the loan as a result.

In the middle of the last financial crisis, the ratio of NPLs to total loans in the U.S. reached a peak of 5%. The ratio sits at about 1.5% today, according to economic data provider CEIC.

Meanwhile, China's ratio of NPLs to total loans is 1.9% right now. While that's higher than the U.S. today, it's not far off. And it's similar to the U.S. ratio in January 2017 (2.1%).

My point is, China's NPLs aren't through the roof today. They haven't skyrocketed higher.

But even if the NPLs do keep increasing in the months ahead, China's banks are prepared...

It's not just about how much debt you take on. More important, it's about your ability to pay that debt down over time... and how you can cover bad loans when they surface.

At a minimum, Chinese banks must store 150% of impaired losses. So they must set aside $1.50 in cash for every $1 in bad loans. But many Chinese banks save more than that...

Two of China's major banks – the Agricultural Bank of China and China Merchants Bank – go well beyond this measurement... They have "provision-coverage ratios" of 278% and about 400%, respectively, according to a recent South China Morning Post article.

So even if bad loans increase for China's major banks, these financial powers have put plenty of money aside for a rainy day. And it doesn't stop there...

China's required reserves are also higher than in the U.S...

One way you can measure this line of safety for banks is through the "required reserves ratio." China has cut its required reserves ratio down seven times since 2017.

On the surface, so many cuts in a short time frame might seem like China is being too lax on its regulations. And headlines like this one from Reuters in September might scare investors...

China is cutting these required reserves to increase loans in the economy. But if we take a closer look, we can see that this situation is nothing to lose sleep over...

In the U.S., the required reserves ratio equals 10% of deposits. That means banks in the U.S. must set aside 10% of what they bring in as cash to handle tough times.

But here's the thing...

Even after China cut its required reserves ratio for the seventh time, it still stands at 13%.

That's right! Banks in China still must set aside more in reserves than major U.S. banks.

Sure, China's debt has grown over the past decade...

And yes, the country has used cheap debt to help fund its expansion. But this debt isn't crippling China's financial system. It's one of the biggest misperceptions in finance today.

Investors are scared to invest in China because of its growing debt. But they shouldn't be...

In reality, China isn't at the tipping point in the debt cycle. And as this becomes more evident, it could be a major tailwind for Chinese stocks over the next several years.

Don't let "China-phobia" stop you from being a part of the next big rally...

Again, I'm not predicting a decade-long rally in Chinese stocks. But a triple-digit move higher wouldn't be surprising given how far off from reality the perception is today.

The easiest way to gain exposure to the space is through a China-focused exchange-traded fund. But if you want to take your investments to the next level, I encourage you to check out our research in True Wealth Opportunities: China... We have more than 15 actionable recommendations in our model portfolio today. Learn how to get started right here.

New 52-week highs (as of 10/23/19): Celgene (CELG), Americold Realty Trust (COLD), Digital Realty Trust (DLR), SPDR Euro STOXX 50 Fund (FEZ), and JPMorgan Chase (JPM).

In today's mailbag: Two readers weigh in on the "fallout" from the ongoing opioid crisis. Send your notes to feedback@stansberryresearch.com. As always, we can't provide individual investment advice, but we read every e-mail.

"[Regarding the] opioid crisis: These big monetary fines are okay, but what we need to see are executives in prison. [Executives] are generally not impacted by a corporate fine. The individuals who intentionally created the opioid crisis deserve prison sentences. That will get the industry's attention." – Paid-up subscriber Frank H.

"What about the responsibility of the doctors who were bribed and kicked back to? Any lawsuits against them coming up in your view? Letting them off would be more criminal. A bribe and kick back are offers – like someone soliciting a hit. Ultimately, the doctors accepted the nefarious deal." – Paid-up subscriber Gary S.

Bill McGilton comment: For years, law enforcement agencies across the U.S. have been going after doctors who clearly abuse prescriptions. This is nothing new.

But it's not a cut-and-dry area for doctors... Many of their patients are in severe pain and need relief – which often comes in the form of opioids. A doctor is qualified to make that decision. It's an issue when doctors abuse their power to write prescriptions.

In our research, we haven't focused on doctors' roles in this crisis. We're not in the business of determining who's morally culpable for this situation. There's plenty of blame to go around – from patients to doctors to pharmaceutical companies and distributors.

Instead, our focus is to take a realistic look at what's happening... and more important, see how to best help our subscribers profit from the litigation. That's our role.

When distributors are supplying 67 pills per person in West Virginia and 63 per person in Kentucky, for example, there's no way to justify those amounts for pain control. It's practically impossible for distributors to say they were unaware opioids were being abused.

Remember, opioids are heavily controlled narcotics. The U.S. Drug Enforcement Administration requires these companies to have sophisticated software to track shipments – making it even more implausible that they didn't know what was going on.

Now distributors and manufacturers will pay tens of billions of dollars in penalties. We've already recommended to subscribers ways to profit from the litigation. And we will continue to do so as it unfolds.

Good investing,

Chris Igou
Jacksonville, Florida
October 24, 2019