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Recent Purchasing Managers' Index (PMI) data from HSBC and the Chinese government suggest that the country's manufacturing activity is expanding. HSBC's PMI is now at a 13 month high, while the government's PMI is at a 7 month high. This improvement has largely come through direct government investment. HSBC and the Chinese government's PMIs have now reached 50.5 and 50.6 respectively - with values above 50 indicating expansion and vice versa.

Some of the slowdown in the Chinese economy over the past year was attributable to modest economic growth in the U.S. - also the result of government spending - and the Eurozone debt crisis, two of its primary export markets. At this point both the U.S. and the EU have economic indicators which are, in the aggregate, deteriorating so the increases in China's activity is due to both internal expansion and growing regional trade. How sustainable this recovery in manufacturing is a very good question when one considers the full weight of these global fundamentals and the rapidly contracting Japanese economy - due as much to its fundamentals as the collapse of Sino-Chinese relations this fall.

Where is the manufacturing growth coming from? Well part of that answer was supposed to come from the China Association of Automobile Manufacturers who reported that vehicle exports have increased by an impressive 22.9% in the first nine months of 2012 as compared to 2011. The world's largest vehicle manufacturing country exported 760,000 cars in this period and its total automobile sales increased by 2.9% to 9.6 million - though there are reports of very high channel inventories plaguing the industry all year. China set itself a target of exporting 1 million cars this year and achieving production and sales numbers of more than 19 million units. However, domestic growth remains modest with production and sales for the first ten months increasing by just 4.6% and 3.6%, respectively.

General Motors (NYSE:GM) is the biggest foreign player in the Chinese market where it operates in conjunction with Chinese automakers SAIC Motor Corp. and Wuling Motors Holdings. After opening their $252 million vehicle testing facility near Shanghai, the companies have now agreed to start work on GM's third vehicle plant in the country with an investment of $1 billion through their joint venture SAIC-GM-Wuling. GM has an ambitious target of producing 2 million cars per year in the country by 2015, and with its massive capital investment plans coupled with rising demand, it looks like it is on track to achieve its objective. This year, the JV of the three companies is expected to touch sales of 1.4 million vehicles while they have achieved sales of 1.21 million in the first 10 months of 2012, up 13% from last year. They currently have 47.5% of the small commercial van market in China.

The vehicle sales of the two leading American firms, GM and Ford (NYSE:F) in China for the month of October rose by 14% and 48% respectively as compared to 2011. This is excellent news for Ford, who has a lot of catching up to do. However, these increases have come at the expense of Japan's major automakers as Chinese consumers continue to boycott Japanese cars. Toyota's (NYSE:TM) sales in China fell by 49% in September and 44% in October from last year. Similarly, Honda (NYSE:HMC) and Nissan (OTCPK:NSANY) also reported record drops. Although the anti-Japan protests have now subsided, in November Toyota's sales again fell by ~25% YoY.

The three manufacturers believe that this trend is likely to continue until April 2013. And I'm sure they are trying to put the best spin on this they can. In the run up to the changes at the top of the Communist Party, a lot of Chinese nationalism was stoked and was directed at Japan. That anger will not dissipate overnight. Toyota was planning to sell 1 million cars in China in 2012, but that is clearly not going to happen now.

The overall improvement in the auto industry reflects the tenuous nature of the gains in manufacturing output. HSBC noted that although PMI has improved, but it showed "marginal improvement of operating conditions in the Chinese manufacturing sector." The iShares FTSE/Xinhua China 25 ETF (NYSEARCA:FXI) and iShares MSCI Hong Kong ETF (NYSEARCA:EWH) have been up 3.24% and 22.7% year to date. FXI tracks 25 of the biggest and most liquid Chinese companies, while EWH focuses on the Hong Kong equity markets. Note how strongly investment funds (see chart below) have been flowing into these two ETFs since the PMI figures began to turn. FXI, in particular, has retraced its entire drop from earlier in the year is now trading 3.2% higher for the year (through 12/3's close). The stocks in these ETFs are under heavy accumulation by western investors, while the SPDR S&P 500 ETF (NYSEARCA:SPY) has seen 6.0% liquidation since the beginning of October.

On the strength of QE induced demand, a resilient SE Asia, the political season behind us and major players like Blackrock moving into Asian property markets, this is likely a good time to begin tentatively adding China exposure to your portfolio for the long term, despite the mixed signals.

FXI

EWH

SPY

YTD Stock

+3.24%

+22.70%

14.3%

Flows YTD

+$538.9M

+$648.2M

+3.32B

Stock 10/1 to 12/3

+4.01%

+4.29%

-2.9%

Fund Flows 10/1 to 12/3

+$1.62B

+$689.4M

-6.34B

% AUM Change

32.0%

30.9%

-6.1%

EPS

-9.36

0.39

31.03

Yield

2.51%

2.88%

2.01%

Source: China's Auto Exports Reflect Slight Manufacturing Growth