While the S&P 500 is up 9% year-to-date in 2013, China has lagged significantly. Hong Kong’s Hang Seng Index is up just 2% since Jan. 1, and the Dow Jones Shanghai Index is up about 4%.
As a result, the iShares MSCI Hong Kong Index Fund (NYSE:EWH) is up less than half that, as is the iShares MSCI China Small-Cap ETF (NYSE:ECNS). The closed-end Morgan Stanley China A Share Fund (NYSE:CAF) is up less than 2% and iShares FTSE/Xinhua China 25 Index ETF (NYSE:FXI), a fund benchmarked to the FTSE China 25 Index, is actually in the red by more than 4%.
The reasons for the underperformance are multifaceted. The latest debate is whether January and February numbers mean anything thanks to the Lunar New Year holiday and its impact on government activity, consumer spending and … well, just about everything.
But in a host of articles lately, there seems to be a bearish narrative emerging — one that China investors should pay close attention to.
Here are some of the recent headlines of note:
Slowing GDP: In 2012, China still was growing briskly compared with the rest of the world. However, its 7.8% pace was its weakest in 13 years. So remember that talk about China’s growth has to be in the context of previous expansion — and most importantly, Wall Street expectations. The target for 2013? Just 7.5%. Furthermore, John-Paul Smith of Deutsche Bank has gone on record as saying that 2013 will be the year investors painfully come to grips with the fact that China’s growth rate will never be what it once was, and adjust expectations of the sustainable growth rate accordingly with a 10% to 15% selloff in emerging-market stocks.
Opaque Data: And that’s even if you can calculate the GDP accurately. As Craig Stephen posits, the roller coaster in Chinese credit has “spooked investors” and has raised serious questions about the numbers. For instance, how can China be a low-cost manufacturing hub even as real estate costs and growth rates are among the highest in the world? What about inflation? And of course, what about trusting Beijing on anything? There are far too many uncertainties — even when numbers are provided — for investors to know for sure what the score is.
Overreliance on Beijing: This Reuters report says it best: State statistics show that “state-mandated fixed asset investment (FAI) was the key driver of economic growth in the first two months of the year, up 21.2 percent and the strongest in 12 months, while annual retail sales growth of 12.3 percent was the slackest January and February combined since 2004.” In other words, Beijing is spending big, but actual Chinese citizens are not.
Services: The HSBC composite PMI for China’s manufacturing and service sectors eased slightly in February, according to recent data. But more telling is that the services sector PMI for China rolled back from recent highs in February. While it’s still in growth mode with a reading of 52.1 (anything above 50 is expansion and under 50 is contraction), it’s important to note that the services sector is almost half of China’s economy. Any softness here is significant, especially if the trend lasts.
Industrial Production: Both industrial production and, naturally, electricity generation have been in a steady multiyear decline. The latest data continues that slump — and in January-February, it not only contracted but missed expectations to the downside.
Inflation: The consumer price index data from the National Bureau of Statistic showed a 3.2% rise in prices vs. 3% expectations. That’s a 10-month high. China set a 3.5% inflation target at its annual parliamentary session last week — down from a 4% target last year — and the fact that we are already up against that mark is not a good sign. Tighter monetary policy to tamp down inflation would naturally have an adverse impact on exports. Furthermore, even modest inflation could seriously crimp consumer spending. Consider that pork, the most popular meat in China, is forecast to jump 16% in price this year, according to Standard Charter.
Housing Bubble: Year-over-year, property investment jumped a combined 22.8% in January and February. So the government is looking to cool off the market by requiring bigger down payments and taxing capital gains more significantly. The move caused China stocks to take their worst weekly tumble in almost two years. And unfortunately, this is just the latest in three years of efforts to curb runaway home prices, and it remains unseen if anything can stop the housing bubble — aside from popping it, of course.
Housing Bubble, Take 2: This deserves its own item: As Bloomberg reported last month, there is a term for heavily indebted Chinese who own properties they can barely afford: “housing slaves.” In other words, they are slaves to paying a remarkable mortgage that can be as much as 70% of their salary. Considering the pain that America went through with overextended buyers who eventually found themselves paupers when the myth of never-ending real estate gains imploded … well, let’s just say it doesn’t bode well for China consumers or banks.
Demographics: Amid all the fuss about immigration in the U.S. and Europe and a need for a growing labor force to drive economic expansion, China has perhaps the worst outlook of all thanks to the dangers of an aging population from its self-imposed “one child” policy. Last year, a government think tank floated the idea of permitting two children per family by 2015 … but it might be too little too late to stop the ticking demographic time bomb caused by low fertility rates in China for many years.
Shadow Banking: China has an enormous “shadow banking” network, which provides loans and other off-balance-sheet transactions outside of traditional financial institutions. China reportedly is cracking down on shadow banking because of obvious risks it poses to the financial system, but the result has been a big contraction in credit and lending nationwide. It’s a painful Catch 22 — the shadow banking system allows for very risky financial transactions to be performed off the books, but without it, many consumers and businesses don’t have access to credit to spend and grow the economy. Even more disturbing — off-balance-sheet cash is sometimes even used to finance government and infrastructure projects.
The bullish case for China can still be made, of course. While we did see a significant pullback at the end of February for Chinese equity, it doesn’t look like a collapse is imminent as the major funds and indices are seeing uptrends in both 50-day and 200-day moving averages. Furthermore, Standard Chartered’s Stephen Green and Wei Li report that demand for residential property is strong in 2013 — with new projects up 17.5% and space under construction up 12.8% year-over-year in February — values have not crashed yet and construction continues could be seen by some as a net positive, at least in the short term.
As you can see from this very long piece and the following laundry list of reading, China is not an easy topic for investors to grasp.
But there is more than enough information out there to urge skepticism and caution right now, even if a “hard landing” has been averted.
- One area where China has an advantage: Alternative energy. (The Slant)
- Long-term, it’s a question of wages and productivity. (Beyondbrics via FT.com)
- A great read with good data: Why Nomura expects GDP to cool off in 2013 for China. (Alphaville via FT.com)
- A great recap of China’s sluggish and narrow recovery (Alphaville via FT.com)
- This isn’t investable, but remains a horrible environmental story: as many as 3,000 dead pigs floating in the Huangpu River. This comes after Shanghai residents went days without tapwater in January thanks to benzene being leaked into a Huangpu tributary. Yuck on both counts. (WSJ and Shanghai.gov)
- How can lawmakers comparatively richer than Romney reform China long-term? (Bloomberg)
- For what it’s worth, investment in China’s economy remains strong — and I’m talking spending by the government and businesses, not hedge funds here. (FT.com)
- A big tell on the China slowdown — no fresh flowers. (Business Insider)
- China’s inflation starts to hit consumers hard. (Businessweek)
- China’s latest data shows an uneven recovery. (Reuters via CNBC)
- Tom Orlik says that while Chinese luxury developers aren’t going bankrupt, investors should be wary. (WSJ)
- On the other hand, why any housing curbs might not be bad for stocks. (CNBC)
- Specifics on China’s February service sector PMI. (Reuters)
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at email@example.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.