The investor’s checklist for a slowdown in the Chinese economy
China’s economy is bound to lose steam, says this British advisory, which explains what might happen and how investors should react.
What if the Chinese economy can’t keep it up indefinitely?
What if it can’t keep on pulling the world’s economy with it?
Here’s how one British investor put the question.
“There is much talk of China’s growth rate being reigned in by their government. Do you see their growth rate reducing so significantly that their appetite for coal, ore and copper will collapse?”
A pertinent question for Canadian investors, to be sure. China’s thirst for commodities plays no small role in Canada’s prosperity.
This query, however, was e-mailed in to the chief economist of a British advisory, The Fleet Street Letter. Mr. Brian Durrant does not consider the question a hypothetical one.
China’s jaw-dropping growth must inevitably slow down, he insists. But when, and by how much? Mr. Durrant examines the possible consequences and proposes a checklist of six “global investment ideas” to consider.
He also has four “domestic investment themes” for his readers. One highlights a major British stock that Canadians may find a bit more interesting in light of the proposed Toronto-London exchange merger.
Fashionable predictions
There can be no doubt that China is a success story of major proportions. Last year it surpassed Japan as the world’s second largest economy. It will overtake the U.S. sometime in the next 40 years.
In 1980 it accounted for 2 per cent of the world’s economic output. By 2008, that figure was 12 per cent and rising.
“Nevertheless, one of the big mistakes analysts make is to draw a line between two points and extrapolate the future thereafter,” writes Mr. Durrant. In the 1960s, there were “fashionable predictions” that the Soviet Union would overtake the U.S. based on Russia’s rapid industrial growth.
And in the 1970s, many were predicting Japan would pass the U.S. by 2000. Now it’s China’s turn.
The author admits that China’s case is persuasive. Its output has grown 10 per cent per year since 1979. But it can’t last forever.
Much of China’s growth comes from a “catch-up effect,” according to the Asian Development Bank. Labour and capital were very poorly used before 1978 and have been put to work much more efficiently since then.
“In China now we are seeing signs that the next generation of industrial workers are less willing to work so hard for so little pay,” observes Mr. Durrant. Minimum wages are rising quickly.
Falling by half
Soaring food prices helped spark the civil unrest that led to the Tiananmen Square tragedy in 1989, the author reminds his readers. China’s authorities have certainly not forgotten.
As food and property prices reach uncomfortable levels, the government is pulling away from easy money. The People’s Bank of China has raised rates twice recently — after doing so six times last year. There’s a fine line between containing inflation and pulling the reins so taut that a property crash and banking crisis occurs. We know that story very well.
Mr. Durrant doesn’t pretend to know precisely how this will play out, but slower growth is coming. Investors should be aware of the possibility that growth in China could fall by half, he states.
A study by England’s Fitch Ratings estimates that if China’s annual growth fell from 9.2 per cent to 4.7 per cent it would cut world GDP growth by 0.5 per cent. But Asia would slide even more, some 2.25 per cent.
This loss of growth “would not plunge the world into recession,” says the author. “The big impact of a Chinese slowdown is on commodity prices, with industrial commodities hit the hardest.”
Two checklists
Curiously enough, this study leaves Canada out of the list of countries that would be most hard hit by a slowdown in China. Chile, Peru, Kuwait, Russia and Australia would be the main victims, it says.
In fact, says Mr. Durrant, the carnage in commodities could be even worse if China, instead of suffering a temporary slowdown in growth, was hit by a full banking crisis.
Either way, he writes, the implications are pretty straightforward. Cut down on risk. This is his six-point global checklist for British investors.
First, sell commodities, commodity index funds and industrial commodities in particular. Second, sell shares in mining and oil companies and companies that service those industries. Third, sell emerging market stocks, especially in the Asia Pacific region.
Fourth, sell Australian dollars (nothing said about Canadian dollars, which would seem to be in the line of fire). Fifth, steer clear of emerging market sovereign debt. Sixth, buy German government bonds.
His second checklist deals with the home front. First, he says, the Bank of England would have good reason to keep interest rates low.
That would naturally lead to step two, which is to buy “gilts,” or high quality bonds. A Chinese slowdown “is mildly contractionary while commodity price inflation pressures will also abate.”
Number three we’ve already seen. Sell cyclical mining stocks and other resource companies.
Fourth, buy stable, high yielding dividend stocks like Vodafone (NASDQ/LSE-VOD). This big wireless firm earns only 12 per cent of its profits in Asia Pacific and the Middle East.
A month ago, when this advisory was touting Vodafone as a great “buy and hold” dividend stock, it was trading at US$28.64 in New York. After getting bounced around a bit in the market sell-off of the past few days, it sits at $28.21. It yields 3.2 per cent on its $0.91 dividend,
Fitch emphasizes that its study is hypothetical, Mr. Durrant points out. It is not predicting a Chinese slowdown of this magnitude in the near term.
“Nevertheless, it is refreshing for ratings agencies to be looking in the direction of possible negative outcomes, rather than downplaying risks as they did in the run-up to the financial crisis.”
That also makes it easier for investors to be prepared for the day when what goes up inevitably starts coming down.
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