Could China’s Dragon Economy Lose its Fire?

Like clockwork every week, I can expect to open an e-mail or two that questions my investment enthusiasm for China. Those e-mail critiques are generally along the lines of:

“You are a broken record.”

“All you ever do is recommend China.”

“You are oblivious to/ignorant of the problems in China.”

“When China crashes, people who listened to you will lose millions of dollars.”

Yes, it is true that I’ve been very bullish on China for a long time — in fact, going all the way back to the Clinton administration years. I absolutely believe that the long-term investment prospects for China and its Asian neighbors are substantially greater than those for the United States.

Note, however, that I said “long term.” Contrary to what some of my detractors might write in to say, I am not out-of-touch about the dangers and challenges that could derail the Chinese economic juggernaut in the nearer term.

There is no question that the Chinese economy is slowing, and there are some legitimate reasons to worry that China could tumble into something more painful than a soft landing.

Heck, even some of China’s top leaders are worried, and that’s saying something. Now, you may not have heard any signals coming from them, but trust me, I know they’re there. That’s because …

When Chinese Leaders Talk, I Listen!

You may remember brokerage firm E.F. Hutton’s slogan: “When E.F. Hutton talks, people listen.” Well when it comes to what leaders in Asia, and particularly in China, have to say, I’m paying very close attention.

The reason for that is simple. There is no such thing as impromptu comments by government officials in China — everything from speeches to newspaper articles to TV coverage is carefully orchestrated by its Communist Party.

And recently, China’s Finance Minister Xie Xuren warned that “There exists some downward pressure for the economic growth.”

He wasn’t specific about those downward pressures, but those few words said a lot.

Today we’re going to look deeper into this comment, through three key indicators that I will use to evaluate the health (or lack thereof) of the Chinese economy.

China Indicator #1:
Domestic Consumption Slowdown

China’s spectacular growth over the last three decades has been fueled by its juggernaut manufacturing/export industries. It became the manufacturing hub of the world, and it is hard to find very many products on shelves in North America and Europe that don’t have a “Made in China” label on them.

China’s economy has made a profound and permanent shift from export-fueled to domestic-consumption-fueled. The Chinese consumer is the KEY to China’s future, so any dramatic slowdown in consumer spending would tell me that the Chinese economy is headed for some serious trouble.

This chart shows us that it’s “so far, so good” on the consumer front, as China posted a 17.1% year-on-year growth in 2011 retail sales. However, there are some warning signs that consumer spending is slowing down.

The Chinese Ministry of Commerce reported that holiday sales during the Chinese New Year increased by 16% this year, which is the slowest pace since the 2009 financial crisis and 3% slower than 2011.

One jewelry store, Chow Sang Sang Holdings in Hong Kong, noted that customers are still buying, albeit they’re taking home smaller diamonds than they once did. Some other retailers report less impulse buying and more browsing, compared to prior years when it was a challenge to keep enough product on the shelves.

So, sales are still growing, but not at the speed that many anticipated. As one analyst said, “The momentum is not exciting.” But at least here there is momentum when it comes to consumer goods … something that’s a bit harder to come by in China’s real estate market.

China Indicator #2:
Real Estate Slowdown

The Chinese real estate market isn’t as bad as Las Vegas, Sacramento or South Florida, but it has not been pretty, either.

Over the past two years, China has implemented a series of measures to curb property speculation that includes higher mortgage rates, increased down-payment requirements, and restrictions on second- and third-home purchases.

Those measures have worked … maybe too well.

China’s consumers have been hurt by falling home prices, which fell for a fifth month in a row. In January, home prices dropped in 60 of the largest 100 Chinese cities.

Sales activity is also drying up. According to the largest real estate company in China, completed sales in China’s four largest cities — Beijing, Shanghai, Guangzhou and Shenzhen — dropped by 66% this Chinese New Year, compared the same period last year.

Other warning signs: A 25% drop in new housing starts and a 26% increase in the inventory of unsold property.

Lastly, falling real estate prices not only negatively impact a family’s net worth, but they also damage consumer confidence. That confidence is getting hit from two falling assets: Home prices and stock prices as the Shanghai Composite Index lost 17% over the last 12 months.

So far, the percentage decline in real estate prices is still an unwelcome-but-manageable single-digit figure, but I would get a lot more worried if that increased to double-digits.

So far we’ve looked at indicators that are consumer-driven. Now let’s take a look at how much capital is (or isn’t) coming in from outside China’s borders.

China Indicator #3:
Foreign Direct Investment Slowdown

Foreign Direct Investment (FDI) is the investment of foreign assets into domestic structures, equipment, factories and organizations. It does not include foreign investment into the stock markets.

Here’s how it works. Let’s say General Motors (GM) builds a new car factory in China, Apple (AAPL) opens a new retail store, YUM! Brands (YUM) opens a new restaurant or Microsoft (MSFT) opens a new research center. This creates jobs and grows the economy. And that’s why the Chinese Ministry of Commerce hopes to attract an average of $120 billion in foreign investment in each of the next four years.

FDI is thought to be more useful to a country than investments in the equity of its companies, because equity investments are potentially “hot money” that can leave at the first sign of trouble. Meanwhile, FDI is durable and is a long-term productive asset.

Foreign investment into China rose 9.7% in 2011 to a record $116 billion. Now, this may sound like a ton of money BUT:

• This 9.7% is far short of the 17.4% increase in FDI that China enjoyed in 2010.
• FDI decreased in November and December by 9.7% and 12.7%, respectively, over the same period a year ago.

Many experts continue standing firm in their belief that China is a — and perhaps “the” — major destination for multinational corporations. Money is the fuel of economic growth, so I will start to worry if FDI fund flows don’t turn around … FAST.

In the meantime, this is simply a figure that bears careful watch — just like domestic consumption and real estate — but not action at this time. In other words, don’t go cashing out of China just yet!

2 Ways to Play a China Pullback

Don’t get me wrong. I am NOT ready to throw in the towel on China and run for the hills. I am, however, intensely monitoring economic conditions there and ready to take pre-emptive action if and when it is needed.

If and when the time comes to run for the hills, there is an easy way to profit from falling Chinese stock prices: Investing in inverse ETFs.

There are two inverse ETFs that are designed to go “up” when Chinese stock prices go down: ProShares Short FTSE/Xinhua China 25 (YXI) and the ProShares UltraShort FTSE/Xinhua China 25 (FXP).

These two funds, respectively, offer single- and double-inverse exposure to the Chinese market.

Now, I’m not suggesting you rush out and buy either of these ETFs tomorrow morning. As always, timing is everything so I recommend that you wait for my buy signal in Asia Stock Alert. (Not yet a member? Take my service for a risk-free trial today — start here!)

If you are a China bear, however, these two ETFs should be at the top of your radar screen.

Best wishes,

Tony

P.S. China is definitely part of the Asia profit story, but it’s just one chapter in a growing encyclopedia of stock opportunities. To learn what’s working today … what to buy as Asia’s growth continues to ramp up … and when to cash out to protect your gains — join my Asia Stock Alert service today. Click here to get started right away!