For the last two years, I have stayed away from investment in Chinese based companies. My reason for this approach is simple: I do not invest in countries where I do not trust the government to act consistently and fairly. Russia is another country I consider off limits to investment. In recent days, however, I have been considering whether or not to expand the scope of my China-avoidance. I have concluded that it is time to stay away from companies that depend to any great extent on the Chinese market. With China being the great success story of the last decade, it may seem odd to move strongly away from this country. Supposedly, the Chinese economy is currently still growing at a rate of 8% (compared to a slight contraction in Europe and growth in the 2.5% range in the USA. Here are my reasons:
1) Chinese economic statistics are notoriously unreliable. The Chinese have no need honestly to report on their growth rate. This is particularly so since the Communist Party is about to select new leaders for the next decade. It would do no good for the current leadership to have the economy contracting at the same time it was trying to name a successor.
2) The actual accurate Chinese statistics that can be obtained all indicate that China is falling into a recession. Matthew OBrien has a good summary of these statistics here at the Atlantic. Other knowledgeable China watchers say the same thing.
3) If it turns out that China is actually in a recession, the fall of that economy will be much more of a shock than the recession in Europe. China has been in a 35 year growth trajectory. It has developed a major real estate bubble. It is reliant to an extreme extent on new investment as the growth engine of the economy. The Chinese people have gotten used to steady strong growth rather than a downturn, no matter how severe. The reaction in China to a downturn is much more difficult to predict that a similar event in other countries.
4) China has managed to supply an enormous portion of the world market for many key commodities and products. China uses more than half of the world's iron output. It has a voracious energy appetite. It uses copper to a much greater extent than any other country. This means that a Chinese slowdown or recession will cause havoc in all of these industries. Prices will plummet as the current output levels are no longer needed.
I realize that what I am describing is the basis for a world wide recession, not just a slowdown in China. Such a worldwide dip may well come to pass. For the moment, however, I am not recommending that one pull all investments from the markets. It is too far from clear that we are headed on a path to recession. Nevertheless, it is time to "get smaller" in China and for companies in the main Chinese affected markets.
Here are a few steps I recommend:
a) Sell your stock in Chinese companies. These companies are the most likely to get hit hard if the Chinese economy falls. Indeed, it remains possible that the Chinese government could impose some sort of controls or take some other action which would make stock in these companies tank.
b) Stay away from basic commodity stocks. Companies like Vale of Brazil, Rio Tinto or Southern Copper are heavily dependent on sales to China. Indeed, so are nearly all of the commodity stocks.
c) Stay away as well from financial stocks. The stress to the world financial system that will result from a Chinese recession will be extraordinary. Couple that stress with the problems that are underway in the Eurozone, and we may see a host of failures in this area.
d) Consider hedging steps to offset any losses that could be coming. Shorting the S&P 500 by buying calls on SDS is a possibility. Another possibility is small but leveraged investment in Gold.
e) Stay alert to further shifts in the wind. If a Chinese recession goes from a distinct possibility to a likelihood, you will need to move quickly to limit your downside risk.
DISCLOSURE: I own no interests in any of the companies mentioned, but I do employ the hedging methods described.
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