Above the noise: What FedEx tells us about China - and vice versa

China, an economy largely dependent on exports, and FedEx, a company that makes a significant part of its income shipping those exports, are both suffering from the global economic slowdown.

China's export growth YoY has decelerated since summer 2010 and is currently standing at 7.3 percent YoY measured by the rolling 6-month average (see chart below).  

FedEx delivered yesterday Q1 EPS of 1.45, beating estimates of 1.40, but the worrying part lies more in its downward adjustments of forward earnings and sales, in addition to some interesting thoughts on China during the conference call with analysts. This is what Fred Smith said on the conference call:

"I can tell you this on China. The locomotive that has driven China’s growth is its export industries... I've been somewhat amused watching some of the China observers, I think, completely underestimate the effects of the slower exports on the overall China economy." 

Source: Bloomberg L.P.

Europe's troubles are having an impact on Chinese growth, and lately an uncertain trade relationship with Japan has added to questions about the future of Chinese exports. 

The slowdown in exports is not comparable with 2008-09, but it resembles other slowdowns from periods before the financial crisis. The issue this time is partly driven by the Eurozone and US economies' below-trend growth, as well as rapidly rising wage inflation, which eats away at the competitiveness of the Chinese economy.

Reports continue to surface that companies are "reshoring" - bringing manufacturing back to the U.S. and to a larger extent Mexico - to avoid the rising costs of producing in China, and to lower transportation complexity and supply chain risks. 

Adding all this up China faces some tough headwinds going into its political transition period.

What does the FedEx/China syndrome anticipate?

FedEx's comments adds to the earnings season risk picture. We know China has slowed, but FedEx emphasises that it will continue, and given their insight into global trade their word is more trustworthy than most other sources.

The slowdown is likely to impact the coming quarters negatively and we have thus become slightly more pessimistic on the coming earnings seasons. And no, it will not be an EPS disappointment as this figure always lags due to the accrual principles in accounting. Yet sales and cash flows, which management has less discretionary control over, may very well disappoint and that is the crucial part.

On this basis, we think it worth considering some downside protection which can be acquired rather cheaply due to the recent volatility compression with the VIX Index closing at 14.18 yesterday (see chart below). Put options on the SPY ETF (Spider, S&P 500) with expiration on 31 Dec 12 and a strike of 145 (at-the-money) is currently selling for 4.53 in the market. In our view this is a low premium, taking into account the risk picture going forward and the recent run-up in major stock markets.

Source: Bloomberg L.P. (VIX Index since 2007)