China's Manufacturing Crisis Deepens

| About: ProShares UltraShort (FXP)

China’s worst fears are starting to be realized. The manufacturing jobs which have brought opportunity to 150 million migrant workers are disappearing very quickly. And riots (or “mass incidents” as Chinese authorities have termed them) are starting to become more common.

Over the past couple of weeks, the frequency of reported riots has increased. A month ago, government officials would arrive at factories with suitcases full of cash and pass it out to workers after the workers were told the factory will be shutting down.

In Guangdong, 2,000 workers surrounded government buildings to demand severance pay from the government after the factories they worked at had been shut down.

In Zhongtan, 19 arrests were made as 500 protesting workers destroyed five police cars while looting and vandalizing their former places of work. Meanwhile, 1,500 onlookers (passive supporters) who also lost their jobs simply watched the bedlam.

There are dozens more similar riots and Chinese authorities are starting to see how bad China’s manufacturing sector is going to get hit.

As we’ve been watching for a while, China’s manufacturing crisis is continuing to worsen. A month ago, Cao Jianhai, a researcher at the Chinese Academy of Social Sciences, stated, “By the year's end more than 100,000 plants will have closed”.

But now conditions are deteriorating more quickly than expected. About 65,000 toy factories have been shut down so far during this downturn. That’s just toys. Once you add in all the other factory shutdowns, China is already at or near the previous expected closings of 100,000 factories.

It’s Going to Get Worse Before It Gets Better

Most of the downturn has already been priced into Chinese shares. The market is down about 70% from its highs of a year and a half ago, but it’s getting worse.

A few hours ago, China released the latest reading of its Purchasing Managers Index. The index, which tracks manufacturing activity, plummeted to 38.8. That’s down from a previous low of 44.6 in October. Since a reading below 50 means manufacturing is contracting, China’s manufacturing has contracted for four straight months.

Despite it all, China’s economy still grew at a 9% clip in Q3. That’s quickly starting to change. China’s economy, which really needs 6%-7% growth to sustain its “built for growth” economy, is watching growth decline quickly.

JPMorgan recently stated it expects China’s GDP growth could drop to a 4% annualized rate in the fourth quarter of this year. That’s not going to keep China’s still adolescent economy, which requires a lot of capital, growing.

The Bigger Picture

In the latest issue of the Prosperity Dispatch we took a hard look at the structure of China’s economy. We determined:

About 39% of China’s GDP is capital spending. That means a huge portion of China’s economy is building new factories, steel mills, mines, etc.

With the economy slowing down, you really can’t justify building a new factory while 10 others are getting shut down. Economies just don’t work like that.

That’s the bigger risk here. China’s economy is built perfectly for booms, but it will face a lot of trouble as more and more factories get shut down. Exports are a big part of the economy, but building the factories necessary to produce more and the housing needed to house the workers is an even bigger part of the economy.

The implications of further meltdown in China will be felt in many sectors in the rest of the world, namely oil and other commodities used to build infrastructure and production capital.

So far the oil markets have been propped up by hopes of a fairly quick recovery in emerging markets. Copper, cement, iron ore, and plenty of other commodities have experienced fairly significant price drops as well, but there’s a very real risk they could go down even further.

We’ve watched a few mining stocks revert back to 2002 prices in “Mining Stocks: How Low Can They Go” back in October. As the hopes of a quick recovery or a greater degree of immunity from the global slowdown for China fade away, there could be a good bit more downside ahead for the oil and other commodity-related stocks which have held up well.

For the time being, the world is waiting to see the impact of the $585 billion spending plan announced last month and other expansionary monetary policy changes made in the past month. But if no positive effect starts to show up, there is a lot more room to fall.

Disclosure: Author is currently long the UltraShort Xinhua/FTSE China 25 (NYSE:FXP) and Horizons Betapro S&P/TSX Global Mining Bear Plus ETF [TSX:HMD]