China: Why The Slowdown Is More Than A Hiccup

Includes: F, NKE, SBUX, SPY
by: Micah Dickson

Last year, I wrote about why I am a bear on China. You can read the article here. I laid out a case of why China has serious systematic risks that include corruption, questionable economic numbers, and unsustainable overexpansion. On July 15, 2013, China reported that its economic growth slowed to 7.5%. This number was in line with expectations, but that number does not tell the whole story of what is going on in the People's Republic of China. China's ugly problems are becoming evident. Its debt, corruption, and central planning pose serious risks to the Chinese economy. For these reasons, investors should start reevaluating their global allocations. Let's look at some of what is going on in Communist China.

China Is Seeing a Slowdown in Manufacturing

China is beginning to see a slowdown in its manufacturing sector. PMI in June 2013 fell from 50.8 to 50.1. Below 50 is contraction, and this number means that China is barely getting by. New orders fell from 51.8 to 50.4. Manufacturing has been what has driven the Chinese economy. This slowdown may not be a short-term trend either.

China is seeing its currency begin to appreciate at a rate that makes its exports more expensive. This is beginning to take away cheap manufacturing, which is the largest competitive advantage China's manufacturing sector has. It is already having an effect on the average Chinese consumer. Chinese consumers told The Boston Consulting Group that they plan on spending less. In fact, 29% told The Boston Consulting Group they plan on spending less compared to 21% in 2012. This will make it more difficult for the country to gradually transform into more of a consumer economy.

A long-term threat to China's manufacturing sector is additive manufacturing, also known as 3D printing. More and more industrialized nations are beginning to see the promise of this technology. It allows for companies to use smaller and more flexible local suppliers. Much like the explosive growth of blogging, the explosive growth of 3D printing may have a huge impact on manufacturing. Hundreds of smaller manufacturers will be able to enter the market and have many competitive advantages.

China's Debt Is Beginning to Catch Up With Them

China's private sector credit to GDP is about 17% over its 30-year average. According to Credit Suisse, when this ratio goes above 10% of its 30-year moving average there is a risk of a credit crisis. In fact, credit overall is outpacing economic growth and has been for the past five quarters. The growth of credit is well over 20% year over year while economic growth is under 10%. Worse is that debt servicing costs are now 29.9%. This number is also well over China's economic growth.

And even worse are the state-owned enterprises (SOEs) that now have balance sheets that would scare any junk bond investor. SOEs have tripled their leverage in the past few years. This is due to the fact that SOEs are receiving funds from state-owned banks. This conflict of interest is beginning to create zombie businesses. Instead of allowing businesses to fail, the central planners in China continue to make sure these businesses can receive loans.

All of these factors are making interest rates dangerously volatile. On July 15, 2013, the Shanghai overnight rate declined to 6.49% from that Friday's quote of 8.49%, which was down from the June 20, 2013, high of 13.44%. Those are huge moves in overnight interest rates. If rates go back up, it could spur a banking crisis that would cause serious damage to the Chinese economy.

China's Largest Problem Is Not Seriously Being Dealt With

Credit is really just a symptom of larger problems in China. Those problems are corruption and conflicts of interest. Companies have been able to overleverage due to the fact that those in charge of lending are oftentimes related to those they are lending to. The 70 wealthiest members of the National People's Congress are richer than the top 660 U.S. government officials. The reason for this is because the top executives at many SOEs are members of the People's Congress or are close relatives.

The conflicts of interest also make it difficult to make any necessary reforms. The new government has promised to crack down on corruption. This promise is starting to ring hollow as the government has begun prosecuting anti-corruption activists. The main complaint many activists have is the lack of transparency from government officials about their assets.

Corruption and conflicts of interests are the root of overleveraging. If China continues to not take these problems seriously, it will only make matters worse. The problem is that with a lack of democratic accountability and strong central planning, reform does not seem to be possible within the current political system.

What Does All This Mean for Investors?

Global diversification has proven to be a fundamental principle of portfolio construction. Still, asset allocation is important to performance. Investors should begin looking toward other emerging markets. Another idea is to start allocating assets to more U.S. markets like the S&P 500 or individual U.S. stocks like Ford (NYSE:F), Starbucks (NASDAQ:SBUX), or Nike (NYSE:NKE). These companies give investors global exposure across many markets, including the U.S. U.S. markets may pose a risk, but not as large a risk as China does at this moment.

China is beginning to reveal serious downside risks. While the most recent economic slowdown may not lead to a meltdown, it is still an opportunity for investors to examine the real risks in China. Investors should tread carefully around this giant economy.

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