China’s Economy: Enter or Exit the Dragon?

On one side of the office, the bear.

On the other side, the bull.

Two analysts, same publishing company, two very different views on China’s economy. Their desks are probably no more than five metres apart.

Oh boy, this is going to be interesting.

One says the dragon is about to roar again and take commodities – and selected mining stocks – up with it. And that now’s your chance to buy in on a resources comeback after the market shakedown in 2012.

The other says the Chinese slowdown in 2012 will continue and the recent stock rally and the rebound in the iron ore price are false flags to suck in gullible investors, so watch out.

In today’s Money Weekend, we’ll explore the two sides of the great China debate happening right here in our St Kilda headquarters. Grab a cup of tea, lean forward, engage your brain, and see which of our top analysts you agree with…

The China Bull and the China Bear
 

In the blue corner, you have Diggers & Drillers editor Dr. Alex Cowie. His message for investors? ‘China bears are about to get smoked.’

In the red corner, Sound Money.Sound Investments editor Greg Canavan says the current rebound firing up the Chinese economy in the past few months is from an unsustainable burst of credit…and that contraction is assured.

Here’s what Greg says: ‘The consensus view is that China’s economy bottomed in the second half of 2012 and is set to rebound strongly in 2013. I must say I very strongly disagree with this view.’

For Aussie investors, the stakes don’t get much higher than this. China is Australia’s largest trading partner. Australian stocks and the Aussie dollar are proxies for international investors to play the Chinese growth story. China drives demand for oil and the base metals. China (and India) drives gold demand.

So where China goes, Australia follows. That means China bears mostly won’t want to own mining stocks, whereas bulls won’t be able to get enough of them.

That’s the way markets work, of course, and why buyers and sellers come together. But your view on China is a very important part of your investment strategy, and whether you’re defensive or aggressive in 2013. So which should it be?

The Dragon Will Roar
 

Well, if you ask the good Dr Cowie, his take is that the next leg up in resources is coming thanks to Chinese infrastructure spending.

Think copper, iron ore and coking coal. Copper because it’s the commodity with the broadest use across any modern economy, from infrastructure, to construction and manufacturing.

(By the way, Alex has put his reputation where his mouth is. He’s just tipped a copper stock in his latest issue of Diggers & Drillers.)

And iron ore and coking coal because they’re the main ingredients of steel. Actually, Alex’s position got a boost this week when iron ore miner Fortescue Metals [ASX: FMG] reported its biggest ever quarterly export figures, according to the Age.

But why now? Because the Chinese leadership transition is now in the can and Alex’s bet is this will trigger spending that will total trillions of yuan. With political certainty locked in, China will implement the next phase of its five-year plan.

If you take the position the new powerbrokers will spend big and early to cement their positions, 2013 shapes up as bullish for commodities driven by this spending.

Here’s an interesting chart Alex showed Diggers & Drillers readers recently. If history is any guide, Alex is on the right track:

 

Chinese Investment Growth Picks Up After a Leadership Transition

 

Chinese Investment Growth Picks Up After a Leadership Transition

 

Source: FT, Diggers & Drillers edits

 

This then is the catalyst for the cyclical mining sector to head back up after a tough two years. Alex wrote in his update this week:


‘This year is set to be a strong one for China. So the dozens of oversold, good-quality, mid-cap producers of industrial commodities look like a fantastic opportunity…there are bargains everywhere now.’

Infrastructure spending drives demand for commodities and rerates mining stocks. That’s the bull case in a nutshell. And according to Alex, the safest play is to focus on the producers, not the explorers.

That’s the bullish argument, but what about the bear? Read on…

Exit the Chinese Dragon
 

Greg Canavan wrote not one, but two reports in the second half of last year to warn readers about the coming crisis in China.

Here’s the problem, as we understand it: the Chinese economy is driven by state-directed investment. This has resulted in unproductive projects, misallocated resources and a lot of distortions inside the Chinese economy…

These distortions need to be corrected. The economy needs to be rebalanced away from investment to consumer spending. The problem is the transition won’t be pretty. In fact, Greg says it will be downright ugly with higher unemployment, social unrest and bankruptcies as the system cleanses itself.

But the Chinese elite keeps delaying the day of reckoning by creating more state-directed spending to juice-up the economy. That means the distortions increase rather than lessen. At some point, the system of expanding credit will crack and the slowdown will send a shockwave around the world, and knock the stuffing out of the Aussie economy.

Now, it doesn’t mean nimble traders can’t make money off the rallies and the dips.

But let’s be honest, most people aren’t nimble traders. Because of that, Greg says investors should focus on wealth preservation. Stock market rallies around the world are based on artificial stimulus and attempts to inflate the system. Eventually, you’ll get deflation when the bubble bursts…and that’s generally bad news for asset prices.

So his advice is to hunker down until the worst blows over. Be wary of the signals that come via stocks, currencies and interest rates because they’re all juiced and meddled with by central banks and governments. In short, the system is rotten.

But you have to do something with your money, so Greg recommends spreading your money across certain assets with different weightings. The Sound Money. Sound Investments portfolio is structured for this scenario.

This battle between the bull (yes, Alex is alone with his bullish stance in the office) and the bears has only just begun…but it looks set to be brutal.

This time next year, we’ll know who was right. In the meantime, the debate continues!

Callum Newman
Editor, Money Weekend

PS. Read on for our new weekly feature, the Money Weekend Market Digest

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Callum is a feature editor for Money Morning. He covers areas of interest arising from world markets and the global economy that could mean new investment opportunities for Aussie investors.

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