American Investors Underestimate How Much Slowing Growth In China Can Hurt

by: Nigam Arora

Now it is universally accepted that growth in China is slowing. If a large number of communications that we receive are any indication, North American investors make two underestimations: first how much China's growth is really slowing, and second how much it can hurt their investments in stocks, bonds and commodities, including gold and silver.

After a careful study of the Federal Open Market Committee (FOMC) minutes released yesterday, my view is that the subject of China's slowing growth has become more important for North American investors.

China Is Slowing

The Chinese economy has been on a tear for a while but is now slowing. Economists measure an economy by its GDP. The GDP is a total measure of the value of goods and services produced by a country. The chart compiled by The Arora Report from the World Bank data tells the story of phenomenal growth of Chinese GDP over the last two decades.

Economic indicators can be broadly divided into three categories: the lagging indicators, the coincident indicators, and the leading indicators.

The focus of our research is leading indicators from 23 countries. As the name implies, leading indicators provide an early indication of the direction of an economy. Examples of such indicators are vendor delivery schedules, hours worked in a week, and new construction permits. Early last year, when the consensus was that the torrid growth in China was continuing, we were beginning to write that leading indicators were forecasting a slower economy. By August 2011, we were projecting a dramatic slowdown in the Chinese economy.

Further, in August 2011, we forecast that the peak growth period of the Chinese economy was behind us. At that time, our predictions of a slowdown in China were not shared by the vast majority of analysts. After all, the Chinese GDP over the prior two quarters had risen 9.6% over the same period in the prior year according to the National Bureau of Statistics of China.

Now the lagging economic indicators have caught up to the leading indicators.

It is now universally accepted that the Chinese economy may grow only by 7.5% - 8%. Gone are the heady days of 11% growth.

The chart compiled by The Arora Report from the data provided by the National Bureau of Statistics of China clearly shows the picture of slowing growth in China.

One of the most common themes in the communications we receive is a statement that since China is still expected to grow at 7.5%, it is of no concern. It is easy to forget that when an economy slows from 11% to 7.5% after accelerating growth over two decades, major unforeseen dislocations can happen.

U.S. Treasury Bonds

In recent years, China has been the biggest purchaser of U.S. Treasury Bonds. According to the Treasury Department, the Chinese held $1.146 trillion worth of U.S. government securities in April.

In the short term a China slowdown will not have much impact on the prices of treasury bonds. As China's growth slows, in the long run it simply will have less surplus to buy U.S. government securities. For the time being because of the policies of the Federal Reserve, the laws of supply and demand are suspended when it comes to government securities. However the Fed is not going to be able to maintain the status quo forever.

For the long-term investor, there is an opportunity in inverse ETFs such as (NYSEARCA:TBT) and (NYSEARCA:TBF) or in short selling the ETF (NYSEARCA:TLT).

Gold And Silver

Accumulating large amounts of gold and silver was not part of traditional Chinese culture. In recent years, as Chinese have become richer, part of the wealth has been going into gold and silver.

According to the World Gold Council, in Q1 2012 China's investment and jewelry demand was 255.2 tons, a 10% increase from Q1 2011. Investment demand grew to a quarterly record of 98.6 tons, an increase of 13% from Q1 2011.

Jewelry demand was 156.6 tons. China represents 30% of global jewelry demand.

The following simple statistic demonstrates the power of Chinese buying on gold prices. In Q1 2012, the total worldwide demand for gold was 1,097.6 tons; the demand from China was about one quarter or 255.2 tons.

As the Chinese economy slows, the pace of wealth increase among the Chinese will also slow. The result will be deceleration of buying gold and silver by Chinese.

Holders of ETFs such as (NYSEARCA:GLD) and (NYSEARCA:SLV) may consider being cautious.


Roughly one half of the earnings of S&P 500 companies come from foreign sources. A big part of the acceleration of earnings of U.S. multinationals in recent years has been related to China's rapid growth. As China slows, the pace of increasing earnings from China will also slow.

Large-cap broad U.S. ETFs such as (NYSEARCA:SPY), (NYSEARCA:DIA) and (NASDAQ:QQQ) are at risk.

Investors can also protect themselves by going long volatility through an ETF such as (NYSEARCA:VXX).

Other Factors

Obviously China is not the only factor that goes into investment decisions. ZYX Global Multi Asset Allocation Model is now showing that confluence of other factors from the U.S. economy and Europe with a Chinese slowdown is putting American investors at high risk even if they have not directly invested in China. It is time to be on the defensive in all asset classes on the long side and put in place protection by raising cash or by hedging. The premise behind the ZYX Global Multi Asset Allocation Model is that the most money is made with the lowest risk by successfully predicting change before the crowd.

For astute investors, underestimation of the Chinese slowdown by most market participants represents an opportunity.

Disclosure: I am long VXX, TBF.

Additional disclosure: Subscribers to The Arora Report have an arbitrage position in GLD and SLV. They are also long VXX and TBF.

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