Beware of Underestimating China

Includes: FXI, PGJ
by: Dr. Stephen Leeb
We've talked a lot about China in recent years – about its miraculous growth, the strain it puts on the world's resources, and the fact that China's leaders seem to “get” the emerging commodity squeeze in ways that Western leaders do not.
Let's make something clear. We are not in love with China, so much as we are worried that complacency has led the West astray. Following World War 2, the U.S. economy was the envy of the world. To any American who lived through the post-war expansion, the fall of Soviet-style communism is more than sufficient proof that our system, based on individual freedom, capitalism, and democracy, is superior. The idea that a semi-totalitarian regime could possibly succeed for long is laughable. So every tiny negative event in China is taken by the Western press as proof positive the Chinese economy is about to implode. Worse, it becomes an excuse for ignoring the real global problem of resource depletion, which China's success is bringing into the open so much quicker.
So we see that some analysts took China's latest 0.25% hike in interest rates as another sign the sky is falling in Beijing, even though this will probably turn out to be a non-event. Let's remember that before the global financial crisis took hold Chinese interest rates were at 7.8%. The recent move back to 5.8% is hardly evidence the Chinese government is in a panic over a runaway economy. (If you really want an indicator of an economic disaster, watch for copper prices falling below $2.00. That would be a sure sign of a Chinese economic downturn, if not a global depression.) China raising interest rates to 5.8% means little, especially considering that other emerging economies have been far more aggressive in tightening.
As for the inflation problem which motivated China's rate hike, the only segment of the inflation figures that has looked “out-of-control” in recent months has been food prices – particularly vegetables. Prices of non-food items are rising at an annual rate of only 2%.
Of course, one might expect that rising food prices are painful China's working class. But we must note that worker unrest in China, though present, has been a relatively minor threat. In fact, most of the recent strikes have been directed against Japanese companies, such as Toyota, and have been actually encouraged by Beijing.
Compare that to Europe, where huge strikes have taken place in protest over austerity measures introduced to solve the financial crisis. In fact, were it not for the fact that the U.S. government has made it very difficult for workers to go out on strike or at least has passed bills making it next to impossible for unions to form, we might have seen similar labor problems at home.
Nonetheless, keeping a lid on inflationary expectations makes sense for China because the world will certainly experience higher commodity prices in the near future. Already, the broad commodity indices have exceeded their 2008 highs. In addition to raising interest rates, China will likely allow its currency, the yuan, to gain value. Such a move will allow the nation to control the prices it pays when purchasing commodities from other nations.
However, China is very reluctant let its currency rise simply because the U.S. wants it to. Much of the pre-war turbulence in China resulted from foreign interference, so when the yuan rises it will be on China's terms, not ours.
That's not to say China doesn't have its problems. There's no doubt the nation has a very tough transition ahead of it. Still, we must note that since the late 1940s China has gone through two major societal shake-ups: the Great Leap Forward and the Cultural Revolution. Both events were catastrophic for the economy. In fact, in 1961, China's year-over-year decline in GDP exceeded 27%. That makes China's collapse equal to the 3-year Great Depression in the U.S. The social unrest was massive. Yet, according to the most reliable data, China's growth between 1952 and 1979 (a period encompassing both shake-ups) averaged about 6%.
What's more, China's leaders have some important advantages today. Most of them experienced those previous economic disasters firsthand and are loath to see them repeated. That's also true for Xi Jingping, current First Secretary of China's Communist Party and the most likely successor to Hu Jintao. Incidentally, Xi spent several years doing hard labor in a rural village after his father was purged from the party and sent to prison. That makes him hardly the kind of person likely to crack down hard on civil liberties when he becomes leader.
Being less complacent, China has been first to recognize the danger of resource shortages down the road. Many of China's elite have backgrounds in engineering and science. Peak oil and Peak Coal have been seriously discussed by Chinese scientists in academic journals, which government leaders actually read. China understands its need to segue into alternative energy as it urbanizes 400 million people. The nation has gone from nowhere to having the world's largest production of wind and solar energy. Wind power growth has been increasing by 100% a year. If China realizes even a fraction of its plans, it will become number one in nuclear energy as well. China's emphasis on growing real industries is one reason it survived the 2008 financial crisis better than the West.
In the U.S., our leaders are mostly people who grew up insulated from economic crises and have no memory of hardship to draw upon. To them, energy shortages can be solved simply by forcing OPEC to cough up more oil. They continue to think that every other problem can be solved with faster computers and financial machinations. They have failed to recognize that the decline in median incomes over the past twelve years, coupled with today's high unemployment rate, are pivotal issues that every day seem more and more like inflection points. While China will spend close to $3 trillion on new energy-related industries over the next ten years, the U.S. government finds it cannot afford more than a token investment in such areas.
While we wait for Western leaders to “get it,” the silver lining to China's growth and development program is the opportunities it is creating for commodity investors to make money.
In a recent New York Times op-ed, “The Finite World,” Nobel Prizewinner Paul Krugman made some comments on the current bull market in commodity prices which to some extent echo our own sentiments. He points out that rising prices are not the result of speculation or even excessive money creation, but in fact:
“What the commodity markets are telling us is that we’re living in a finite world, in which the rapid growth of emerging economies is placing pressure on limited supplies of raw materials, pushing up their prices.”
In other words, commodities are in a real, secular bull market, not a bubble.
Where Krugman gets it wrong, however, is that he brushes off concerns that the commodity bull could eventually spell trouble on the stock market. To us, it seems pretty clear that rising commodity prices were a deflationary factor in 2008 (eating into corporate profits and contributing to the market crash) which the Fed erred in treating as an inflationary factor.
Our advice as 2010 winds down is that you should make the most of the current wave of rising commodities. Continue to accumulate shares in our recommended natural resource stocks, which will likely remain a major source of investment profits. We would not be surprised to see some excellent buying opportunities (i.e. dips) in the first quarter of 2011 which you should be prepared to take advantage of.
However, at the same time, you should continue to have a big stake in gold so that you can weather a repeat of the sell-off of 2008 without much pain. Those two strategies alone should help you achieve greater financial security in the New Year.