Is China's Economy About to Heat Up?

07/20/2012 9:46 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

As growth slows, China's leaders appear to have put economic reform on a back burner. And that presents investors with some interesting opportunities, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

China's leaders have thrown in the towel. Yep, they've decided to go for growth now and let reforms wait.

Remember all that rhetoric about the need to move China's economy away from export-driven growth and toward domestic, consumer-driven growth? Forget it.

Remember the pledges not to repeat the infrastructure and industrial spending that rescued the Chinese and global economies during the financial crisis in 2008? Toss 'em in the trash.

Remember the efforts to dampen-real estate speculation, and to cool China's overheated real-estate sector? Stamp them “rejected.”

A Reaction to Slower Growth
China's leaders have read the official numbers that show China's economy slowed to a 7.6% annual growth rate in the second quarter of 2012.

They've looked at the unofficial numbers—things like electricity consumption—that strongly suggest the official growth numbers are significantly overstated. And they have read the projections from the International Monetary Fund and others that Europe's slowdown will be even more pronounced than expected in the second half of 2012, and the recovery in 2013 anemic.

They've decided that the risk to their control of China is just too great. The implicit bargain between China's leaders and the Chinese population is that the Communist Party will deliver economic growth and a rising standard of living. That remains the government's priority. Reform of the country's economy will just have to wait.

Without fanfare, without any of the hoopla that accompanied the stimulus flood of 2008, without even a clear reversal of former rhetoric, China's leaders have gone back to the tried-and-true playbook. China has once more embarked on an investment-driven, infrastructure-heavy, government-financed effort to stimulate the economy.

In the short run, I think it will work. Growth will rebound in China, and that will push growth higher in the global economy, too.

In the long run, though, it will leave in place all the inefficiencies and misallocations that the now-abandoned program of reform was supposed to address. The fix has been put off to another day.

China is hoping that the problems won't be much worse by the time it is ready to deal with them. But I think down the road, it will be just that much harder for China to tackle its fundamental economic problems, from a crony-favoring banking system to zombie state-owned enterprises.

Reading the Tea Leaves
What has happened in the last few weeks to convince me that China has made this huge shift in policy—without a major policy announcement? Take a look at two important indicators: airports and railroads.

On July 12, the Web site of China's State Council reported that China will increase spending on construction of airports and other air-travel infrastructure. The statement was the second recent official notice of the government's intention to increase spending on air-travel infrastructure.

On June 11, the head of China's Civil Aviation Administration, Li Jiaxiang, told the online version of the People's Daily that China's major airports are now running at full capacity, and that China will build 70 new airports and renovate or expand 100 existing airports. That's a big increase from the plans for 45 new airports within five years announced in 2011.

On July 17, a document posted on the Web site of the National Development and Reform Commission's Anhui office reported that the government had increased its investment goals for China's railroad system by 9% from the previous 411.3 billion yuan ($64.5 billion) total. Full-year spending will climb to 448.3 billion yuan. That would require about 300 billion yuan of investment in the second half of 2012, up from 148.7 billion yuan in the first half of the year.

I think this expansion in railroad spending takes an ax to the argument that China wouldn't be able to pursue a 2008-style stimulus package because the country's banks, local governments, and government ministries have taken on too much debt.

 The new railroad spending total was preceded by a huge increase in the debt ceiling at China's deeply indebted Ministry of Railways. In February, the Ministry of Railways was brushing up against a ceiling that limited its debt to 40% of its assets. That limit would have allowed the ministry to issue just $2.1 billion more in bonds.

But on May 29, the State Council approved a proposal by the National Development and Reform Commission to increase the debt limit to 100% of the Railway Ministry's assets from the previous 40%.

It sure doesn't look to me as if the debt already on China's books will keep it from being able to stimulate its economy the way it did in 2008.

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Chinese speculators, traders, and investors, accustomed to reading the Beijing government's veiled hints about changes in policy, have concluded that the government has not only begun another round of stimulus but is also increasing the speed of that effort—no matter what officials say about policy.

A Look at Real Estate
You can see this most clearly in China's real-estate market. Premier Wen Jiabao, as recently as July 7, pledged that the government would continue its efforts to slow real-estate price increases and to stomp down hard on real-estate speculation.

But it's clear from recent data that the real estate market doesn't believe the official line any more. Sales and prices have started to climb again, and local governments are moving to relax some of their restrictions on purchases and mortgage financing.

In June, for example, prices of new homes in 100 mainland cities rose—granted by just 0.5%—for the first time in ten months, according to the China Real Estate Index System run by SouFun, China's largest real-estate Web site. Sales of homes rose in June by 41% from May, according to the National Bureau of Statistics. Sales were up even though developers have started to eliminate discounts to buyers.

Home prices are still down 1.9% from June 2011, and I think Beijing will try to keep enough controls in place to avoid a revival of the speculative fever of 2009. But with mortgage rates falling, the market certainly shows signs of a bottom.

There is always the possibility that the real estate and financial markets are misreading the tea leaves, and that China hasn't embarked on a program of increased stimulus. In that case, the current, so far modest rise in shares of China's real-estate development companies, airlines, and infrastructure companies will be reversed, or worse.

I don't think that's going to turn out to be the case, however. I think these tea leaves are indeed a reliable indication that China's government has decided to press down harder on the gas pedal.

If you agree that's the case—and if you agree, I think you're going against the current negative consensus that seems to favor a hard landing—what stocks should you look at?

Stocks to Buy
In the early stages, I think you go with shares of companies with the most direct exposure to the increased stimulus spending. Among airlines, the New York-traded ADRs (American depositary receipts) of both China Eastern Airlines (CEA) and China Southern Airlines (ZNH) look to have bottomed and to have begun to move higher on anticipation of increased stimulus.

I've not been able to find a similar US-traded play on railroads. China's two big railroad construction companies, China Railway Group (390.HK) and China Railway Construction (1186.HK), both trade on the Hong Kong market.

The commodity most sensitive to an increase in China's growth rate is copper. Unfortunately, the best China copper stock, Jiangxi Copper (358.HK), also trades only in Hong Kong. A decent US-traded substitute is Aluminum Corp. of China (ACH), which trades as an ADR.

I don't have a suggestion for a US-traded China real-estate developer. If you can buy shares in Singapore (ask your broker's foreign desk), take a look at Keppel Land (KPLD.SP).

If we get to September or October, say, and the evidence for the stimulus effort is clearer, I suggest moving on to stocks that are secondary beneficiaries of any increased growth in China's economy.

Those would include in China, Home Inns and Hotels Management (HMIN), Ping An Insurance (2318.HK), Tingyi Holding (322.HK), and Sands China (1928.HK). I'd also look to China-linked stocks such as Freeport McMoRan Copper & Gold (FCX) and BHP Billiton (BHP).

By all means, wait until September or October if you're not convinced. China is normally one of the world's more volatile stock markets, and at the cusp of a possible transition from slump to pickup, it's likely to be even more volatile.

The last thing you want to do right now is buy and then get shaken out by the next panicky day and then buy in and get shaken out again. That gets rather expensive.

Wait until you've got the conviction to stick out a slump or two, even if that means you have to worry that you've missed a bottom. You'll get plenty of buying opportunities from China's volatility.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Freeport McMoRan Copper & Gold, Home Inns and Hotels Management, Keppel Land, Ping An, Sands China and Tingyi Holding as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.

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