The China Surprise Is Lurking

Includes: CAT, DE, FXI, FXP, TEX
by: Glen Bradford

If you're an investor, and you think that things are getting better globally, allow me to introduce you to the China Surprise. The best part about the Chinese economy is that it is extremely predictable. The government says what is to be, and it comes to pass - at whatever cost. The government demands things to be built, and they are built, regardless of whether people ever will use them or live in them. If you compare this to America, the best way to price the American economy is to do a bottom up analysis and project the earnings of all the companies individually and discount those to the present time taking into account future inflation and interest rates. In China, you can't really do that.

The greatest part of the supply and command economy is that they can do whatever they want. If they demand 10% GDP growth, GDP growth comes in at 10%. If that means that they have to build an overcapacity in coal mines, to supply an over demand in steel plants, due to an edict to build empty cities --- that's perfectly normal in China. Can people afford to live in these cities? No? Don't worry about it.

Where I come from, there is a price where supply meets demand. In China, there has been this huge bonfire called real estate. The government in 2008-2009 decided to throw gasoline on this bonfire, which roared and brought the global economy back to life. Now, however, the government is throwing water on the out of control fire.

Yikes! Be ready to pull the rip cord if you are involved with companies that have become hugely involved with China's infinite growth parable. Where I sit, these companies include Caterpillar (NYSE:CAT), Deere (NYSE:DE), Terex (NYSE:TEX), just to get started.

The leading indicators that you're going to want to watch are the price of oil and the price of copper. As the price of oil and copper gradually increase and cut off the marginal demand for real estate in China by forcing people to choose between meals and a piece of vacant land that has been marked up to an unsustainable valuation, prices will fall. It's very similar to back when the subprime real estate meltdown started really picking up steam when people were forced to choose to either spend their money on gasoline so that they can get to work or pay their increasing variable rate mortgages.

When things aren't sustainable, the only question is at what point everyone else realizes that they aren't sustainable. Usually this point is when there is no turning back. Greece will probably default earlier than expected. The US will have its debt downgraded again probably twice before the end of this year. Chinese real estate appears to be coming back to earth at this point in time. I'm biased to the hard landing paradigm. Good news is that as all of this unfolds, it should cut out some of the marginal demand for commodity prices. The question is, are people going to run to the dollar and US Treasuries? I don't think so. I am not a supporter of the hypothesis that the dollar is forever the world's reserve currency. In fact, I don't think it is anymore.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.