Sunday, January 8, 2012

Houston, we have a problem! Part II - China

On Dec 23rd I said that my biggest worry is Italian 10-yr Bond Yield going back up towards the highs. It is just a matter of time (perhaps even this week) before new highs will be reached. While all market participants will be preoccupied with that "breaking" development, I would like to go one step further and talk about my second biggest worry - China.

China has an export-driven economy. EU is the largest customer of Chinese exporters. Therefore, health of Chinese economy revolves around the outcome of EU debt crisis. On top of European problems many other large customers for Chinese exports have fallen on hard times as well, as the world economy is grinding to a halt.

It is not surprise to many that Chinese GDP has been slowing down. Growth is expected to come in around 8% this year. While many countries would kill for that, it is considerable slowdown for Chinese juggernaut, and the trend is projected downward from here as well. Many economists are predicting further deceleration in GDP, with inflation still elevated above tolerable levels. Even China's Premier has spoken about the difficulty expected in the first quarter of this year.

The most important problem may be inside China itself. Domestic real estate has been crashing down and perhaps may lead to the biggest bailout yet. Speculators have bid up the prices to unreachable levels for vast population, which is unable to afford these lavish (by their standards) properties.
There are endless amounts of municipalities, which have been built in anticipation of growth and migration from poor rural areas. This urbanization of Chinese population has been the biggest reason behind the fast growth of second largest economy in the world. It resulted in enormous purchases of commodities and subsequent hoarding of them in local warehouses.
But how do you move 1.35B folks around the country without major dislocations and unfilled voids? At the end of this post I have provided a documentary about "ghost cities" inside China. Watch it, you will be amazed. How do you feel after seeing that? The most important takeaway (for me at least) came from the phrase by the interviewed analyst: "it's the quality and not the quantity of GDP that matters".

Since the beginning of post-Financial Armageddon recovery in March of 2009, investing community has developed a thesis that emerging world economies will lead the way. China, undoubtedly, has been the leader in the first phase, but now it may become the laggard, and I expect it to drag the world economy down if it does not bottom and turn around very soon. Many other emerging markets, like Brazil and India, have also been hit hard.

I decided to show a chart of Shanghai Comp over S&P 500 and CRB Commodity Index. While Shanghai Comp outperformed in 2009, it has deteriorated from there and has really accelerated its decline in the second part of 2011. More increasing divergence has developed over the last few months. Shanghai Comp Index has now completely disconnected from the risk trade. This, for sure, can not continue for too much longer.

Here is my conclusion. China has amassed $3T of reserves in its coffers. While everyone has assumed that they will bail out EU, China itself will probably need an enormous bailout to prevent hard landing at home. This fact may keep the risk trade in check, since there will be less money thrown by them at everything else around the world. I do not really know if we see this play out now or later in 2012, but we are heading for some turbulent times in Big Panda's backyard. Keep your eyes on Shanghai Comp.

click on charts to enlarge

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