Don’t Forget About Big Red

in Investing by

[dropcap]N[/dropcap]ot long ago, one topic seemed to infiltrate every conversation: China. I could be wine tasting, at work, watching college football – it didn’t matter. The topic continuously surfaced and the conversation was always the same:

“China will take over the world.”

“The United States is at China’s mercy given all the U.S. debt they hold.”

“China is a currency manipulator.”

And on and on – you remember the headlines.

As it turns out, China isn’t going to take over the world. The same fears surrounded Japan in the 1980s. Instead of Chinese, worried U.S. parents forced their children to learn Japanese since it would obviously become the dominant language in global business affairs. Clearly that didn’t turn out as expected. Don’t get me wrong, I love Japan and it would make visiting a whole lot easier if I knew the local language – but it’s not a necessity.

So while many fears surrounding China are proving to be irrational, the country is still an extremely important economic player and investors would be well-served to keep it on their radar. A severe downturn could wreak havoc on certain economic sectors.

Cracks in the Economy

China has faced a difficult challenge: sustain its high economic growth while keeping inflation under control. Following the global downturn in 2008 and 2009, the government injected stimulus to rejuvenate the economy and prevent a U.S.-like meltdown. This proved successful, and while slower than previous years, GDP growth returned to a double digit pace in 2010 from a little over 9 percent in 2009. Bank lending was surging once again.

Not surprisingly, however, there were consequences. Inflation reaccelerated back above the 5 percent level and it became clear government action was necessary to prevent overheating. In addition to the typical monetary tools of raising interest rates and reserve requirements, the government instituted a loan quota which capped the amount banks could lend in a given month. This forced the country’s shadow banking system, or unofficial private lenders, into an ever more important role. They served as a successful crutch, but cracks began to emerge. Over the last year a string of bankruptcies in the western city of Wenzhou has left large amounts of private debt unpaid – business owners simply walked away. This fueled fears of an impending liquidity crisis. Sound familiar?

Potentially more important, China’s efforts to cool the economy resulted in weaker real estate demand. According to Xinhua News, commercial housing sales in Beijing fell almost 18 percent in the first 10 months of the year, coupled with falling prices. Moreover, recent land auctions yielded dismal results with many plots failing to generate a single bid. Was this the government’s intention? Many believe the Chinese real estate market is a bubble given the rapid speculation and price increases over recent years. Perhaps a little cooling off is warranted. But how much?

This is the trillion dollar question: is China’s real estate market cooling or bursting? If credit remains constricted one could easily make an argument for the latter. The government hasn’t taken any large-scale steps to reignite growth. So as it stands, the risk of a Chinese downturn appears to be increasing.

What Are the Likely Ripple Effects?

For years China has been the 800-pound gorilla with respect to infrastructure spending. It was the primary force behind record price increases in commodities like copper and iron ore (primary input in steel production) during the last economic expansion. A reduction in infrastructure spending would place pricing pressure on many raw materials. In other words, it could inflict serious damage to the global basic materials sector, as well as certain industrial companies (think Caterpillar). Even firms not selling directly into China are at risk. Just as a rising tide lifts all boats, the same boats can sink when the tide retreats. There would have to be a significant increase in demand from Europe and the U.S. to offset any downturn – this seems unlikely.

The effects could be wider spread with a decline in household wealth. This is especially true if real estate prices continue falling – a significant portion of Chinese wealth is tied to property values. China’s burgeoning middle class has fueled demand for items such as netbooks, cell phones, and electronics. The country has become a significant sales driver for technology firms. In fact, Asia Pacific, of which China is the dominant player, is now the world’s largest consumer of semiconductors at over half of global sales, according to the Semiconductor Industry Association. The tech sector would almost certainly be impacted by a downturn.

Beyond these global effects, we can’t forget about China itself. A recession, or even slower growth, would mean weaker advertising demand which could knock down high-fliers like Baidu. Cash strapped consumers might think twice before buying a cell phone – China Mobile, China Telecom and China Unicom would feel some pain. And there are countless other areas.

Point being, a potential downturn in China shouldn’t be taken lightly. It would have a material impact on several areas of the global economy. Even though Europe has captured the lion share of front page news, investors should always keep China on their radar.

The following two tabs change content below.
Brendan Erne, CFA
Brendan Erne serves as the Portfolio Management Team Leader with Personal Capital Advisors. He has over 15 years of industry experience, spanning almost all levels of the investment process, including several years at Fisher Investments as an equity analyst covering the Technology and Telecommunications sectors. He also co-managed a large cap growth portfolio and co-authored Fisher Investments on Technology, published by John Wiley & Sons. Brendan is a CFA charterholder.

Leave a Reply

Your email address will not be published.

Disclaimer. This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.