Could China’s Dragon Economy Lose Its Fire? (YXI, FXP, FXI, GM, AAPL, YUM, MSFT)

Tony Sagami:  Like clockwork every week, I can expect to open an e-mail or two that questions my  investment enthusiasm for China. Those e-mail critiques are generally along the  lines of:

“You  are a broken record.”

“All  you ever do is recommend China.”

“You  are oblivious to/ignorant of the problems in China.”

“When  China crashes, people who listened to you will lose millions of dollars.”

Yes,  it is true that I’ve been very bullish on China for a long time — in fact, going  all the way back to the Clinton administration years. I absolutely believe that  the long-term investment prospects for China and its Asian neighbors are substantially  greater than those for the United States.

Note,  however, that I said “long term.” Contrary to what some of my detractors might write  in to say, I am not out-of-touch about the dangers and challenges that could  derail the Chinese economic juggernaut in the nearer term.

There  is no question that the Chinese economy is slowing, and there are some legitimate reasons to worry that China could tumble into something more painful  than a soft landing.

Heck,  even some of China’s top leaders are worried, and that’s saying something. Now,  you may not have heard any signals coming from them, but trust me, I know they’re  there. That’s because …

When  Chinese Leaders Talk, I Listen!

You  may remember brokerage firm E.F. Hutton’s slogan: “When E.F. Hutton talks,  people listen.” Well when it comes to what leaders in Asia, and particularly in China, have to say, I’m paying very close attention.

The  reason for that is simple. There is no such thing as impromptu comments by government officials in China — everything from speeches to newspaper articles  to TV coverage is carefully orchestrated by its Communist Party.

And  recently, China’s Finance Minister Xie Xuren warned that “There exists some downward pressure for the economic growth.”

He wasn’t specific about those downward pressures, but those few words said a lot.

Today we’re going to look deeper into this comment, through three key indicators that I will use to evaluate the health (or lack thereof) of the Chinese economy.

China Indicator #1: Domestic Consumption Slowdown

China’s spectacular growth over  the last three decades has been fueled by its juggernaut manufacturing/export  industries. It became the manufacturing hub of the world, and it is hard to  find very many products on shelves in North America and Europe that don’t have  a “Made in China” label on them.

China’s economy has made a  profound and permanent shift from export-fueled to domestic-consumption-fueled.  The Chinese consumer is the KEY to China’s future, so any dramatic slowdown in  consumer spending would tell me that the Chinese economy is headed for some  serious trouble.

This chart shows us that it’s “so  far, so good” on the consumer front, as China posted a 17.1% year-on-year growth in 2011 retail sales. However, there are some warning signs that  consumer spending is slowing down.

The Chinese Ministry of  Commerce reported that holiday sales during the Chinese New Year increased by 16% this year, which is the slowest pace since the 2009 financial crisis and 3%  slower than 2011.

One jewelry store, Chow Sang  Sang Holdings in Hong Kong, noted that customers are still buying, albeit they’re  taking home smaller diamonds than they once did. Some other retailers report  less impulse buying and more browsing, compared to prior years when it was a  challenge to keep enough product on the shelves.

So, sales are still growing, but not at the speed that many anticipated. As one analyst said, “The momentum is not exciting.” But at least here there is momentum when it comes to consumer goods … something that’s a bit harder to  come by in China’s real estate market.

China  Indicator #2: Real Estate Slowdown

The Chinese  real estate market isn’t as bad as Las Vegas, Sacramento or South Florida, but it  has not been pretty, either.

Over  the past two years, China has implemented a series of measures to curb property speculation that includes higher mortgage rates, increased down-payment  requirements, and restrictions on second- and third-home purchases.

Those  measures have worked … maybe too well.

China’s  consumers have been hurt by falling home prices, which fell for a fifth month  in a row. In January, home prices dropped in 60 of the largest 100 Chinese cities.

Sales  activity is also drying up. According to the largest real estate company in  China, completed sales in China’s four largest cities — Beijing, Shanghai,  Guangzhou and Shenzhen — dropped by 66% this Chinese New Year, compared the  same period last year.

Other warning  signs: A 25% drop in new housing starts and a 26% increase in the inventory of unsold  property.

Lastly,  falling real estate prices not only negatively impact a family’s net worth, but  they also damage consumer confidence. That confidence is getting hit from two  falling assets: Home prices and stock prices as the Shanghai Composite Index lost  17% over the last 12 months.

So far, the  percentage decline in real estate prices is still an unwelcome-but-manageable  single-digit figure, but I would get a lot more worried if that increased to  double-digits.

So far we’ve  looked at indicators that are consumer-driven. Now let’s take a look at how much capital is (or isn’t) coming in from outside China’s borders.

China Indicator #3: Foreign Direct Investment  Slowdown

Foreign Direct Investment (FDI)  is the investment of foreign assets into domestic structures, equipment,  factories and organizations. It does not include foreign investment into the  stock markets.

Here’s how it works. Let’s say General Motors (NYSE:GM) builds a new car factory in China, Apple (NASDAQ:AAPL) opens  a new retail store, YUM! Brands (NYSE:YUM) opens a new restaurant or Microsoft  (NASDAQ:MSFT) opens a new research center. This creates jobs and grows the  economy. And that’s why the Chinese Ministry of Commerce hopes to attract an  average of $120 billion in foreign investment in each of the next four years.

FDI is thought to be more  useful to a country than investments in the equity of its companies, because  equity investments are potentially “hot money” that can leave at the first sign  of trouble. Meanwhile, FDI is durable and is a long-term productive asset.

Foreign  investment into China rose 9.7% in 2011 to a record $116 billion. Now, this may  sound like a ton of money BUT:

  • This 9.7% is far short of the  17.4% increase in FDI that China enjoyed in 2010.
  • FDI decreased in November  and December by 9.7% and 12.7%, respectively, over the same period a year  ago.

Many experts continue standing  firm in their belief that China is a — and perhaps “the” — major destination  for multinational corporations. Money is the fuel of economic growth, so I will  start to worry if FDI fund flows don’t turn around … FAST.

In the meantime, this is simply a figure that bears careful watch — just like domestic consumption and real  estate — but not action at this time. In other words, don’t go cashing out of  China just yet!

2 Ways to Play a China Pullback

Don’t get me wrong. I am NOT ready to throw in the towel on China and run for the  hills. I am, however, intensely monitoring economic conditions there and ready  to take pre-emptive action if and when it is needed.

If and when the time comes to  run for the hills, there is an easy way to profit from falling Chinese stock  prices: Investing in inverse ETFs.

There are two inverse ETFs that  are designed to go “up” when Chinese stock prices go down: ProShares Short FTSE/Xinhua China 25 (NYSEArca:YXI) and the ProShares UltraShort FTSE/Xinhua China 25 (NYSEArca:FXP). [Related: iShares FTSE China 25 Index Fund (NYSEArca:FXI)]

These two funds, respectively,  offer single- and double-inverse exposure to the Chinese market.

Now,  I’m not suggesting you rush out and buy either of these ETFs tomorrow morning.  As always, timing is everything so I recommend that you wait for my buy signal  in Asia Stock Alert. (Not yet a  member? Take my service for a risk-free trial today — start here!)

If you are a China bear, however, these two ETFs should be at the top of your  radar screen.

Best  wishes,

Written By Tony Sagami From Uncommon Wisdom Daily

Uncommon Wisdom (UWD) is published by Weiss Research, Inc. and written by Sean Brodrick, Larry Edelson, and Tony Sagami. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended inUWD, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in UWD are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Roberto McGrath, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Marty Sleva, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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