April 26, 2013

Should Investors Diversify from China?

By Benjamin Shepherd at Investing Daily

On Tuesday HSBC (NYSE: HBC) released its monthly China Flash Purchasing Manager Index (PMI), fueling concerns that China’s economy may continue slowing into the first quarter.

The PMI is designed as a diffusion index; any reading about 50 indicates growth while a reading below that red line number signals contraction. Consequently, while April’s reading of 50.5 is positive, it shows such tepid growth that there’s a real risk that China’s manufacturing sector could slip into a contraction. 

Particularly troubling is the fact that new export orders contracted sharply this month. China is working to retool its economy to be more focused on domestic demand, but exports still play a critical role in growth. If external demand for China’s exports remains weak, and it likely will as Europe’s PMI readings point to a deepening recession, China’s weak gross domestic product (GDP) showing in the first quarter could actually get worse.

Considering China’s usually insatiable appetite for raw materials, a slowdown there will ripple throughout the global economy, an effect we’re already seeing play out as equity indexes in resource countries around the world drift lower in recent days.

That said, I wouldn’t say that China is down for the count. The political legitimacy of the Chinese Communist Party (CCP) is largely predicated on its ability to generate economic growth and increase the material wealth of the average Chinese citizen. The government’s most recent five-year plan—the CCP’s roadmap of political, economic and development goals—is a tacit acknowledgement of that fact.

In March, the Chinese government pledged that it would increase fiscal spending by 10 percent, partially offset by an 8 percent revenue increase this year, to help stimulate the economy. That’s a fluid target, though, and likely to increase, particularly if employment in the manufacturing sector appears to be under threat. A rising unemployment rate would pose a serious challenge to the government and the manufacturing sector is one of the largest employers in China.

Given China’s propensity for stimulus in recent years, many investors are understandably hesitant to totally extricate the country from their portfolio allocation. If you primarily invest in either mutual funds or exchange-traded funds (ETFs), it might even been impossible.

Nonetheless, it’s probably prudent to focus on countries less exposed to China for the time being, until the Chinese government gives us a better idea of its game plan.

In terms of Asian nations, Japan is still extremely attractive, thanks to the aggressive stimulus measures taken by Prime Minister Shinzo Abe and his accommodative central bankers. While the Nikkei is already up by more than 55 percent since November, there’s no indication that its huge run will end any time soon, barring a regional conflagration involving North Korea.

Not only is the country benefitting from the government’s massive fiscal stimulus, the yen’s nosedive over the past several months is giving Japanese manufacturers and exporters a boost, as their output becomes more attractive in the global market.

South Korea also looks attractive despite its tensions with the North.

The country’s GDP grew by a better than expected 0.9 percent in the first quarter. Increased public spending played a role in that growth, but a 3.2 percent boost in exports also was a major contributor.

There were serious concerns that the weakened yen would ding Korean exports. The yen is down more than 20 percent against the Korean won over the past six months or so. However, strength in the country’s petrochemical and telecommunication equipment sectors has overcome that. While it will be tough to sustain that growth if the economies of the US, Europe and China remain weak, Korea looks like it might overcome those challenges.

Smaller Pacific Rim countries such as Indonesia, Malaysia, Thailand and Cambodia also remain attractive.

Despite weakened export markets, Indonesia and Malaysia are continuing to perform well, largely thanks to low debt loads and extremely attractive demographics. As a result, domestic consumption and development are picking up much of the economic slack created by tepid resource demand.

Thailand is benefiting from the growing exodus of manufacturers out of China. Despite China’s sluggish economy, labor costs remain elevated thanks to its rapid growth over the past decade, pricing many lower-end manufacturers out of the country. Thailand has stepped into that breach, in large part by developing an attractive corporate taxation scheme and offering an extremely cheap but well-educated workforce.

Cambodia, meanwhile, has become a hugely popular intra-Asian tourist destination.

Cambodia has long been a popular tourist destination among Europeans, but its relatively weak riel has made it an affordable hot spot for other Asians as well. It’s particularly attractive to Vietnamese tourists because of its visa-free entry agreement with Vietnam and its geographic proximity. It’s also become a Mecca for mid-tier gamblers who might not be able to afford higher-end casinos in Macau.

While weakness in China will be a serious headwind for the global economy, it’s not the end-all-be-all for growth investors. As with most other global governments, the CCP is ready and willing to take aggressive measures if China’s economy starts to slow at a worrisome pace.

Courtesy Benjamin Shepherd at Investing Daily - profitable advise for smart people (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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