Market Reactions To Implications Of China's 2012 GDP Estimate

by: Tom Guttenberger

Often within the context of investing, I find it is appropriate to ask the question, "Are you sure?"

The market seems sure of the investment implications of China's downwardly revised GDP estimate for 2012 of +7.5% (from 8.0%). Well I am not. The action has been long anticipated, so too have its effects - commodity prices have been under pressure for months. While this market impact is likely warranted to a degree, it seems other possible outcomes of slowing Chinese GDP growth have been ignored.

An alternate view of the downgrade is that China sees its exports to Europe and America taking a large hit in 2012. In this article, I will analyze the strength of this argument and offer investment considerations to those who share this view.

As recently as 2010 exports have comprised roughly 30% of Chinese GDP according to the World Bank. By outspoken, China bear, Jim Chanos' own estimates, construction is responsible for 50-60% of GDP. Critiquing and reconciling these estimates is beyond the scope of this article (and probably beyond the transparency of data), but it is fair to say that both make up a significant portion of GDP and either could be the primary driver of the lowered forecast.

Only a matter of days after the revised forecast, China's trade ministry may have tried to add clarity to the situation. Wednesday morning they released a statement saying that they plan on increasing imports of energy and commodities. While this is no guarantee that the construction component of GDP will continue at its torrid pace, it does suggest that the revision is not entirely blamed on a reduction of this component, and the sell-offs in some commodities may be over-exaggerated.

Industrial production in China remains strong, as shown below.

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As the PBoC has taken measurements to gently lower banks' capital requirements, demand for real estate should be growing with presumably less tight lending standards and wage inflation. Also, while I have never been to China, people that I have spoken with tell me there is still a wide gap between living standards in cities and rural areas. If this is the case, there may still be a long way to go in updating the country's infrastructure. Long story short - I have my doubts that the built bevy and/or the commodity buying (and hoarding) is going to slow to the extent that the market does.

In addition to industrial production which remains robust, I think that other data series help support the hypothesis. First China's current account. As shown below, China's current account surplus to GDP is still ~5%.

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While their export strength is still evident, it has been declining steadily year over year. This is an indication of imports and consumption growing at a faster pace than exports. Considering two of China's main trading partners, the U.S. and Europe, are each experiencing respective debt situations. The Chinese revision may largely be a reflection of further slowing of exports to the west.

Another reason to expect a contraction in exports is currency appreciation. The CYN/USD exchange rate is now officially called a "managed float". Gradually the PBoC has loosened their "management", and as it has, the trend in the currency pair has become quite evident.

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So the downward revision could also be a statement that the PBoC continues to anticipate (and allow) a steady Yuan appreciation. Eventually when the exchange rate change manifests itself in the labor market, the costs of producing goods in China will rise. This will either cause its trading partners to consume less of these goods, or pay more and have their own margins squeezed - for either the consumer or corporations. Either of these outcomes would be bad for the domestic stock market.

More evidence still that China expects reduced consumption in the U.S. - it has recently been unloading USD holdings at a brisk pace. If they are to maintain a large trade surplus with the U.S., they have to continue to acquire dollars, at least temporarily. So a reduction of exports to America is consistent with this perceived goal of the central bank, and could lend insight to the reasoning behind the forecasting revision.

Interestingly, in spite a collection of somewhat contrary evidence, the asset price reactions have come to a definitive, one-sided conclusion - China will buy less commodities. In the past 6 months, the S&P500 has risen ~12%, the Dow Jones Consumer Cyclical index has risen by ~13%, the price of copper has fallen by ~10%, and the price of coal has fallen by ~25%. Shown below are the disparate price paths of a few select assets (SPX is white and green bars).

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It is my belief that the market's reaction to economic news from China has been too skewed toward the possibility of a construction slowdown, as opposed to an export slowdown. While both are likely contributing to the reduced GDP forecast, the price movements have become to disparate in my opinion.

On a long enough time frame, I feel confident that there will be a convergence and taking positions on miners with exposure to coal (my favorite), copper, aluminum, platinum, steel, etc., is a good way to play it. Some long positions that should capture this theme include: Aluminum Corp. of China (NYSE:ACH), Arch Coal Inc. (ACI), Allegheny Technologies Inc. (NYSE:ATI), Peabody (BTU), Freeport McMoRan (NYSE:FCX), James River Coal Company (JRCC), and Stillwater Mining Company (NYSE:SWC).

Disclosure: I am long ACI, JRCC. Long ACI and JRCC through March call options. Long SPY March puts. I know, my call is for a long-term convergence, but I seek risk.