The coming China super crisis

"Markets fear a slowdown in China's factories. They should also be concerned about possible government instability," wrote Tom Orlik in the WSJ.

The big X-factor for the stock market in the coming months will clearly be China. During periods when any of the major weekly or yearly cycles are bottoming and the market is vulnerable to a correction, there’s always a news headline event that serves as a scapegoat for the market’s weakness. Last year the scapegoat was Greece and the eurozone debt crisis. This year the void will be filled by China’s slowing economy.

Underscoring the growing worries over China, Tom Orlik wrote in the March 26 issue of the Wall Street Journal: “Markets fear a slowdown in China’s factories. They should also be concerned about possible government instability.” He went on to explain that China’s real estate investment showed no growth from a year earlier and that export growth slipped to 6.8% from 14.2% in the fourth quarter of 2011.

Moreover, a quarterly survey by China’s central bank showed demand for loans at its lowest since the financial crisis of 2008. The HSBC purchasing managers’ index registered a reading of 48.1 for March, below the 50 mark that historically signals contraction and suggesting that China’s manufacturing sector is shrinking.

China’s economic slowdown was preceded by a major peak in its stock market in July 2009 after the post 2008 global market rally. China’s Shanghai Composite Index was the first of the major global markets to peak following the post-credit crisis rebound, and it has been in a general slump ever since (see chart below). Charles Dow, of Dow Theory fame, asserted that the stock market typically discounts economic recessions by several months in advance.

In China’s case its equity market was discounting an economic slowdown by a couple of years in advance. This was due no doubt to the country’s stratospheric growth of recent years and the residual economic momentum which kept its GDP forging ahead long after its stock market peaked. Yet the downward trend visible in the Chinese stock market since 2009 was sending an undeniable signal that leaner times were and are ahead for the country’s economy.

Illustrative of the stock market’s leading indication over the economy, ever since China’s equity market peaked in 2009, China’s GDP growth rate has peaked and its economy has slowed. This has also had a measurable impact on the global market for commodities. Oil demand has fallen even though a number of observers continue to attribute high oil prices to China’s voracious appetite for fuel. The International Energy Agency (IEA) recently noted that oil demand has declined for the first time the global economic crisis of 2008. The IEA blamed mild weather, high prices and the likelihood of a global recession for the drop in demand, but a more likely culprit is China.

Gold and silver demand has also been in decline since last year. The sluggish demand is blamed by many traders on fears that China’s formerly voracious demand for metals may be waning, especially if its economy continues to slow.

China’s slowing economy can be attributed to the decision of China’s central bank to tighten liquidity. A series of interest rate hikes designed to cooling off the runaway property market has had the unintended (or intended?) effect of tamping down growth across the board. China has also increased fuel prices for the second time in just over a month. According to Reuters, benchmark diesel now costs about $1.22 per liter and gasoline $1.17 – about 20 percent higher than average U.S. prices, and 50 percent higher than pump prices in China three years ago. This is an extension of the tight monetary policy. And while China’s annual growth rate is still an impressive 7.5 percent, it represents a slowdown from recent years. The fact that China’s growth rate is still high has lulled investors into a false sense of security. That still-strong growth rate will be slowed even more significantly in the next year by the heavy-handedness of China’s political leadership.

Charles Dow’s postulate that an extended stock market decline sooner or later translates to an economic downturn is instructive in China’s case. The bear market for China stocks is at least three years old (four if you count the pre-credit crisis peak). The longer it persists, the more negative its implications for China’s industrial economy.

China’s cheerleaders made a critical lapse in judgment when they assumed the country’s runaway prosperity of the last 20 years signaled the birth of the world’s next super power. The clear lesson of history is that no nation ruled by Communist leadership can ever hope to become a complete super power on the global stage. An economy capable of bouncing back from adversity in short order requires a flexible free market financial system able to respond to the rigors and complexities of the reticulated global marketplace. A Communist superstructure is by its very nature rigid and unresponsive to subtle free market signals and can’t help but eventually be overwhelmed by the economic super cycles when they converge to the downside.

In many ways this is China’s first real test as a major economic power. The country will soon discover what an industrial recession/depression is like. How it responds to this critical test could well determine its economic and political future. If the Communist Party proves woefully inept in responding to the challenges of a deep economic recession, we may well witness a revolutionary uprising of the Chinese people demanding a more democratic and less authoritarian government. Throwing off the shackles of Communism would indeed liberate China’s economy, allowing it to reach heights previously deemed impossible under Beijing’s dictatorship.

The clearing of the financial and economic landscape after the 120-year cycle bottom in late 2014 will be, for many countries, the last chance for reform. China now finds itself on the outer periphery of a spinning vortex of global proportions – a whirlpool which will wreak havoc on the debt of developed countries when it reaches its climax in 2014. The countries that will be in the best position to assume leadership in the new 120-year cycle will be those which have the lowest debt burdens relative to their productive capacity, along with strong debt containment capabilities. China enjoys a distinct advantage in terms of its sovereign debt. Its autocratic government is a disadvantage, however, and could prove to be fatal to its long-term economic designs. How China responds to its coming crisis will shed light on its post-2014 future.

The coming China super crisis could prove to be the touchstone issue of the final 120-year down cycle between now and late 2014. It would certainty take most economists and asset managers by surprise. China is considered by many observers to be relatively immune to the vagaries of Western style deflationary cycles. Imagine their collective shock when they discover that the Red Dragon isn’t immune from the economic super cycles that have plagued the West for decades. China has done an excellent job of copying elements of Western capitalism into its state-controlled economy. But as Ian Bremmer recently observed in Reuters.com, “Ultimately state capitalism is just a pale imitation of the real thing.”

Gold ETF

The iShares Gold Trust (NYSE: IAU, Stock Forum), our proxy for gold, has been under selling pressure in the weeks since its Feb. 29 sell-off and made a slightly lower low on Thursday, Mar. 22. As we predicted in our commentaries of recent weeks, IAU has now tested the critical 60-week (300-day) moving average shown in the chart below. As previously stated, the 60-week moving average has turned back declines in the past, including most recently November-December 2011 correction.

IAU needs to show us that it has bottomed, which it can do in the next few days by re-establishing support above the technically significant 60-week MA, which intersects at approximately the 15.60 level in the daily chart. A short-term equity cycle is bottoming right now, which should take some of the pressure off gold. Before we have confirmation that gold has made a bottom, however, we need to see it confirm this bottom in relation to its dominant immediate-term 15-day moving average per the rules of our trading discipline. We remain in a cash position until this bottom is confirmed.