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Why I’d avoid BHP Group amid a slowdown in China

The US-China trade war brought dark clouds over the markets in 2018. Then later in the year, investors began wondering if the cracks in the Chinese economy were wider than initially anticipated.

Recently, China released data that showed a slowing economy and President Xi Jinping highlighted the fact that as the country moved towards a consumer-led economy, it faced deep and complicated changes.

The past few weeks saw market giants like Apple and Nvidia issue earnings warnings, mostly due to deteriorating macroeconomic conditions in China. And analysts are highlighting that if China catches a cold, many other stocks and the rest of the world will not be left unscathed.

Therefore, I believe investors should not rush to purchase the mega-miner BHP Group  (LSE: BHP) due to short-term macroeconomic risks.

China’s woes affect commodities

Headquartered in Melbourne, Australia, BHP has diversified operations in four segments: coal, copper, iron ore and petroleum.

It purchases and operates long-life, large commodity-producing resource assets such as coal mines or iron quarries. The volatility in commodity markets affects the prices of these resources that the group later sells. In other words, the group’s operations that spread across various commodities means that it is subject to cycles and that the company’s cash flow can vary widely from one year to the next. Since the last financial crisis of 2008/09, these commodity cycles have become mostly China-driven.

Its shares have recovered well since August 2016 when the company recorded its worst annual loss. However, since early 2018, trade war concerns between the US and China have affected commodity markets and brought headwinds to bear on the share price of BHP Group.

On January 21, the International Monetary Fund (IMF) warned of a global economic decline as China, the world’s second-biggest economy, has been slowing down considerably. It revised down its forecast for the second time in three months, from 3.7% to 3.5%.

Cyclical bust

As Chinese demand for commodities, including iron ore and coal decreases, BHP’s bottom line will be affected. Its four segments have reached record production levels and cooling economies mean an oversupply of these commodities, translating into decreased revenues and earnings for BHP.

In the second half of 2018, volatile energy prices also pushed oil prices to close to the lows of 2016 when oil was less than $30 per barrel, and Wall Street is now wondering if oil is in a bear market — which would have increased negative implications for the global economy.

If the slump in oil prices also continues well into this year, BHP’s profitability would come under further threat. As a result of these macroeconomic developments, analysts have been cutting down on its earnings estimates for 2019.

Although its P/E ratio of 15 and the dividend yield of 4.5% make the company look attractive on paper, I would not hit the buy button yet. I’d find better value in the shares if they had a P/E ratio of 10 or less. If the global risks lead to a commodity crash, BHP’s share price, cash flow, and even dividends could suffer considerably.

The bottom line

In the next few weeks, price action in the shares is likely to be choppy, but I will re-evaluate the company’s balance sheet and growth prospects later if the broader markets stabilise and we have a better idea about the state of the Chinese economy. For now, I am staying away.

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tezcang has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Apple and Nvidia. The Motley Fool UK has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.