What China's Slowdown Means For Your Portfolio

David Sterman's picture

Friday, August 16, 2013 - 3:11pm

by David Sterman

In China, the economic news is going from bad to worse.

  • The country's Purchasing Manager's Index (PMI), which in May dropped to 49.2, signaling contraction, has slipped further in the first three weeks of June, to 48.2. A key component of the PMI, new export orders, fell to just 44.0.
  • In May, imports fell to their lowest levels in roughly nine months, due in large part to growing commodities stockpiles.
  • Pricing power at key companies is dropping, thanks to chronic industrial overcapacity.
  • Weaker corporate profits are raising concerns for the Chinese banking system, as many banks have issued a tremendous amount of loans to manufacturers and real estate developers in recent years.
  • The era of easy money in China appears to be winding down as interest rates are quickly moving higher. (The seven-day repurchase rate shot above 8% this week, after being below 4% for much of the past few years.) Economists cite a liquidity crunch as the cause for the higher rates, which may be a sign that souring loans are stressing bank balance sheets.

Still, despite these emerging clouds, most economists haven't pressed the alarm button. For instance, Asia-based HSBC Bank is now forecasting the Chinese economy will grow 7.4% this year, roughly 1 percentage point lower than previous forecasts. But it's fair to wonder whether that's too optimistic.

These next few months will be crucial in determining whether China has a manageable slowdown, or an accelerating one.

A key sector to watch: Chinese retail spending, which has been growing at a double-digit annual pace. For years, we've been hearing of desires for Chinese domestic consumption to play a greater role in a mostly export-driven economy, and we will now see if such a transition can take place. Keep a close watch on upcoming retail sales figures in China.

One thing is for sure: The Chinese government is no longer inclined to pump up the economy with a big stimulus program, as it has done in the past. The new government stance: Market forces and key reforms will need to sustain the economy, and short-term spending measures will no longer be pursued.

Painful Ripple Effects
The commodities markets have already signaled the growing weakness in China. In the past three months, gold, tin and nickel prices have all slid 12% to 15%, while copper, aluminum and platinum are all off more than 5%.

Slumping demand in China has also hurt currencies and stock prices in Australia, Brazil and South Africa. Even considering China's role in their economies, however, I expect Australia and Brazil will avoid a major meltdown, in part because of sufficient domestic consumption.

Yet it is wise to grow more cautious about the "Asian Tigers," such as Indonesia, Malaysia, Thailand and Vietnam. Chinese trade -- in both directions -- represents such a huge part of these economies that a deeper slump in China would have a clear negative impact in the region. I'm a huge fan of these tigers, and if their markets slump badly in the next few months, compelling long-term bargains are sure to emerge.

Here's a quick look at how key exchange-traded funds (ETFs) in this region have fared recently. Notice that most have hit their 52-week highs in just the past few weeks or months.

A Quick Sell-Off, But Is More To Come?

Another Headache For Europe
U.S. companies are surely feeling the impact of a slowing China, as we shipped $122 billion in goods and services to that country in 2011 (which is the latest data available). Yet it's Europe that will feel even deeper pain, as the continent sent $211 billion in goods and services to China in 2011. 

These two trading partners may be locked in a vicious circle, as weakness in Europe weighed on demand for Chinese goods, and spreading weakness in China is now weighing down Europe. Still, as Europe struggles to regain its footing, China's slowdown is just one more headache. 

Remarkably, European stocks have fared reasonably well this year: The iShares S&P Europe 350 Index (NYSE: IEV) is not far from its four-year high of $45. Yet the China slowdown may lead investors to reassess their bullishness. 

Heading For U.S. Shores
What about American companies? Much of that answer depends on what kind of retail sales activity we see in the next few months. Both Ford (NYSE: F) and General Motors (NYSE: GM) have been delivering decent results in China this year, especially as Chinese consumers increasingly shun domestic brands. Yet a slowdown in auto sales would probably be felt overseas.

In addition, consumer electronics firms like Apple (Nasdaq: AAPL) and Sony (NYSE: SNE) all count on the Chinese market for solid demand. Don't be surprised to hear about emerging pockets of weakness in upcoming conference calls. 

As noted, the neighboring Asian Tigers are so dependent on China for trade that they're also witnessing an economic slowdown. Apple, Ford, Caterpillar (NYSE: CAT) and others U.S. firms with sizable sales presences in Asia would be affected.

Can We Avoid The Contagion?
One of the most notable economic trends of the past few quarters is the increasingly stable U.S. economy, even as its trade partners stumble. That may be a sign that the U.S. economic recovery is becoming insulated and self-sustaining. Still, considering U.S. exports of goods and services have from risen $1 trillion in 2003 to $2.2 trillion today, it's hard to see how a spreading China contagion wouldn't wash up on U.S. shores.

Risks to Consider: As an upside risk, China has had a few growth scares in the past five years and managed to rebound fairly quickly. However, those rebounds were aided by coordinated government stimulus, which does not appear to be an option this time around.

Action to Take --> It's important not to be overly alarmed by China's incipient economic weakness. It may only make a modest dent in our economy. Still, with many investors now beginning to look past the impact of the Federal Reserve's quantitative easing program, global markets may again fixate on the still-troubled international economy. Stay tuned to economic news in Asia and Europe as the next few months will determine how the rest of the year -- and perhaps 2014 -- plays out for investors.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.