2016 Outlook: Smoggy In China

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Includes: ASHR, EWZ, FXE, FXI, FXY, PBR, RSX
by: Ian Bezek

Summary

Chinese shares surged, then dumped in 2015.

The Chinese yuan, long thought of as undervalued, suddenly headed in the other direction.

2016 is likely to bring more troubles for the Chinese economy.

The direct effect on the global economy is somewhat limited.

Of more concern are the effects on China's suppliers, such as Brazil.

I ranked the top 10 stories of the year a week ago, when I started writing the 2015 recap/2016 outlook series. At the time, China's troubles came in at the fifth-most exciting story. Over the past week, you could argue that it deserved a higher ranking, but I'm sticking with my original picks.

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China is facing an increasingly grim horizon. And no, I'm not just referring to the recent spate of air quality warnings impacting numerous Chinese cities.

Economic growth in the country has been gradually slowing for quite awhile. China's PPI index notched its 46th straight monthly decline in December, indicating that the recent weakness isn't a new development.

However, in the latter half of 2015, gradually increasing concerns transformed into a full-blown panic. Problems began in the domestic Chinese stock market, where the rapid opening of the market to overeager retail investors drove a classic boom and bust. In the Chinese mainland shares (NYSEARCA:ASHR), we can see a textbook speculative frenzy play out.

ASHR Chart

ASHR data by YCharts

In late 2014, Chinese mainland shares started to take off. They'd ultimately end up more than doubling by the time they reached their June 2015 peak.

The traditional large-cap Chinese stocks (NYSEARCA:FXI) available to Western investors made a much smaller move up, now already trading below the 2014 levels. FXI primarily owns stocks available in ADR form, and is heavily weighted to both its top holdings and the financial sector.

The ASHR mainland ETF, by contrast, owns shares on the local exchanges and has a much broader holding of stocks, not just financials or large-caps. Stock investing fever took over in China, and iconic photos of vegetable vendors day-trading stocks spread. Chinese mainland shares went vertical.

As often happens in slowing economies, investment moves from expensive long-term investments in capital goods toward financial assets. Stocks often make one last echo boom higher, powered by excessively available capital and a lack of good investment opportunities in fixed assets. This last rally in stocks happens even after the economy clearly peaks and starts to slow.

However, since many people give the stock market too much credence in predicting how the economy will go, outsiders saw the Chinese market soaring throughout early 2015 and assumed the economy was performing well there.

Even into early 2015, people were saying the Chinese yuan was undervalued and should be allowed to appreciate further. In August, China shocked the world with an unexpected yuan devaluation. This was the likely trigger of the late August US stock panic.

China has continued to devalue the yuan further, with the latest moves lower contributing to the current plunge in equities to open 2016.

In hindsight, it makes sense that China would be forced to devalue. The country is heavily reliant on foreign trade, and the huge move upward in the dollar was undoubtedly causing trouble domestically. With both the euro (NYSEARCA:FXE) and yen (NYSEARCA:FXY) in free fall over the past two years, China's goods were becoming increasingly uncompetitive against top competitors such as Germany and Japan.

Just as the consensus was that the Chinese currency was undervalued until recently, now you find a huge number of people calling for a 15-20% drop in the yuan in 2016.

This may well happen, but I don't see it as a sure thing by any means. Inflation is very modest in China, with strongly deflationary pressure in the PPI, which usually shows up in consumer inflation sooner or later.

China shows the same sort of overbuilding and overleveraging of their economy that the US engaged in running up to the 2008 crisis. If you remember, the US dollar rose sharply during the ensuing panic. Deflationary pressure and falling monetary velocity played a role in boosting the dollar's value and squeezing people who'd been betting against the greenback.

Similarly, collapsing equity and real estate prices in China are unlikely to be inflationary or negative in the longer run for the currency. If anything, the deflationary pressure plus the forced buying driven by increasing yuan adoption as a reserve currency should keep a decent bid under the currency after this initial panic selling subsides.

A stable currency doesn't guarantee a stable economy, however. China is likely to see further deceleration of the economy (if not outright contraction. It's impossible to trust Chinese GDP figures). It would need to devalue a lot more to make its exports more competitive.

The long-awaited rising Chinese consumer class does not appear to have grown large enough to absorb the blow from diminishing industrial gains.

But it's not all bad news. China retains massive amounts of savings. Its government has an unusual amount of tools with which it can soften the economic decline. And the Chinese stock market is not nearly as important to the health of that nation's overall economy as would be the case in the United States.

For foreign investors, we're having to adjust to a new normal where China will grow more slowly. The torrid growth rates of the past decade simply weren't sustainable, a slower but more stable growth pattern may now emerge.

However, for investors in commodities that had bet the farm on a permanently high level of industrial demand, there's no going back to the salad days. As Caiman Valores astutely noted, China fueled one of the greatest commodity booms ever, far beyond an ordinary up-cycle.

The real story here isn't China, but its suppliers. The countries like Brazil that produced the iron ore going into the country's seemingly unlimited number of new skyscrapers - that's where the real damage lies.

China's mainland shares could dump another 50% this year, and the real effect on the broader global economy would be limited. While China is collecting plenty of attention, the real issue is the continuing destruction of the energy, mining, and agriculture industries that is crushing many secondary countries.

Emerging markets such as Russia (NYSEARCA:RSX) and Brazil (NYSEARCA:EWZ), unlike China, don't have the same reserves and economic levers to control their worsening situations. If you want to imagine a global recession in 2016 with the markets routed, the far more likely catalyst is a Petrobras (NYSE:PBR) or a nation of a South Africa-type bankruptcy rather than further (mild) yuan devaluations or Chinese share sell-offs.

Disclosure: I am/we are short EWZ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.