These Stocks Could Leap On China 'Recovery'

by: ValueMax

China's leaders think the worst is over in terms of the economic downturn, and that a recovery is beginning. The nation's finance minister, Chen Deming, told reporters that he thinks his country's economy started turning around in June. Unfortunately, Mr. Deming did not provide any data to back up his assertion.

If China really is recovering, the biggest beneficiaries will be miners such as Rio Tinto (NYSE:RIO) and Freeport-McMoRan (NYSE:FCX). Both Rio and Freeport have invested heavily in large operations designed to supply copper and iron to China. China is the world's largest consumer of both of those minerals. Weak Chinese demand, spurred by a slowdown in manufacturing, has depressed copper prices in recent months.

The Chinese economy is continuing to grow at a pretty steady clip. Ken Peng, an economist at BNP Pribas SA in Beijing, told Business Week that he thinks the Chinese Gross Domestic Product grew by 7.4% in April and June. He estimated first-quarter growth at 8.1%, and predicted that growth in the last quarter will rise to 8%.

Mr. Peng based his optimism on a series of limited stimulus measures, such as increased spending on infrastructure and increased bank lending that the Chinese government has instituted. He believes that those measures will keep the economy moving.

If Mr. Chen is correct, China will experience good, but not spectacular growth. Continued Chinese growth will boost the stocks of mining companies such as Freeport, BHP Billiton (NYSE:BHP), Vale (NYSE:VALE), and Rio Tinto, which have bet heavily on future Chinese growth. Copper and iron miners, such as Vale and Rio, need continued growth in China to cover the cost of expansion projects. Rio is particularly vulnerable to the Chinese market because of its huge investment in iron ore and its gigantic OyuTolgoi copper mine in Mongolia.

The Chinese economy could falter again because it is heavily dependent on exports. Mr. Chen noted that the country has not been able to hit its goal of 10% growth in exports. The rate of growth in Chinese exports was still healthy, though it was 8.7% in May, but just did not hit the optimistic levels set by leaders. It is probable that Chinese exports will not reach the level its leaders want, but they should remain high.

One factor that might drive a slight increase in Chinese exports is increased demand from the U.S. Lower gasoline prices in North America should increase spending for some consumer goods. A slight increase in housing construction in the United States, driven by lower mortgage rates, could also increase Chinese exports and manufacturing. That move could boost copper suppliers, such as Freeport, Newmont Mining (NYSE:NEM), Anglo American (NASDAQ:AAL), and Southern Copper (NYSE:SCCO). Copper is one of the main materials used for electrical and plumbing fixtures in houses.

Any fall in Chinese exports could be bad news for miners because Chinese manufacturers are heavily dependent upon the export market. The Chinese government seems to be aware of this, and it is taking steps to encourage domestic consumption in order to make up the slack. That could indicate that Chinese economic officials fear that a continued global economic downturn has begun.

Mining stocks would certainly fall if Chinese exports start falling and dragging down Chinese manufacturing. China's current economic model is dependent upon large consumer markets in the U.S. and Europe. If those consumers stop buying, then Chinese factories will shut down and stop buying raw materials.

Increase in Chinese Domestic Demand Could help Mining Stocks

The Chinese government has taken a few steps to encourage domestic consumption. It not only has allowed mutual funds to invest in company bonds, but also is allowing the sale of high-yield bonds designed to fund business expansion. The increase in bond creation is designed to put more money in the market and give Chinese businesses more money to spend on manufactured products.

If these measures work, they should help mining companies because the manufacturers will need more raw materials to keep up with the added demand. If they fail, mining stocks could be hurt because Chinese demand will start falling.

Mining stocks would be hurt by any major contraction of the Chinese economy because it is their main customer. They have no way to make up the slack if China greatly reduces the amount of iron and copper it buys. There is no economy capable of taking China's place as the world's top consumer of metals.

The biggest beneficiary from a large expansion of China's consumer economy would be Rio Tinto, which has laid the groundwork for a massive expansion of its iron and copper production. Rio is in a good position to supply China with lower-cost copper from OyuTolgoi. Its heavy investments in Australian iron put it in a strong position to supply China's steel industry.

It should be noted here that iron miners such as Rio Tinto, Vale and BHP Billiton will only benefit if the Chinese recovery results in greater demand for steel. That seems certain because of the recent growth of China's auto industry. Chinese car sales in May 2012 were 22.6% higher than the year before. China is now the world's largest car market, and the Chinese government is committed to keeping its auto industry strong by providing tax incentives that could increase the demand for minivans and small cars.

The continued success of the Chinese auto industry could also help Freeport McMoRan, which is the world's largest molybdenum producer. Freeport just reopened its Climax mine in Colorado, which is one of the world's largest sources of that metal.

To significantly boost mining stocks, a Chinese recovery will have to be sustained. A few months of increased production would only relieve the current glut in minerals such as copper. It would take several months to a year of recovery to create a real increase in metals demand.

The excess supply in the current market is probably enough to cover any increases in demand. Another problem for miners is that an increased demand from China could be offset by falls in demand from Europe. The overall global demand for copper may not increase even if there is a significant recovery in China because of Europe's problems.

It should also be noted here that the Chinese government is implementing economic policies that could increase volatility in its financial market. By increasing lending and expanding the bond market, the Chinese are increasing the likelihood of bank collapses and swings in interest rates. This could resort in increased lending in the short term, but lead to riskier lending and bank collapses in the long term.

Increased Chinese Volatility-Long Term Threat to Mining Stocks

That means the Chinese government could actually trigger a bigger financial crisis and a major economic downturn with its policies. The policy of using loans and lowered banking costs to drive consumer spending is similar to that which led to the 2007-2008 U.S. economic meltdown.

Any sort of major financial crisis in China will lead to a major fall in Freeport and Rio Tinto's stock values because those companies are heavily dependent on China. Even if the crisis was short-lived, it could put Rio in a position where it would be unable to cover the costs of its recent expansion. Freeport would be in slightly better shape because it has large amounts of gold production.

The only benefit miners would get from a Chinese financial crisis would be a boost in gold prices. That would help gold specialists, such as Pershing Gold (NASDAQ:PGLC) and Barrick Gold (NYSE:ABX), but hurt larger miners, which are heavily exposed to copper and iron.

The bottom line is that mining investors are learning that China is not as reliable a market as it used to be. Chinese demand for metals is likely to fluctuate, which will make maintaining steady revenues harder. The result of this will be increased fluctuation in mining stock prices as Chinese manufacturing fluctuates. Mining stocks may no longer be the safe haven some investors thought they were, even with China's "recovery."

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