Legendary Swiss investor Felix Zulauf, president of Zulauf Asset Management and who has been a member of Barron’s Roundtable for more than 20 years, paints a gloomy picture for China in his latest note at Itau Global Connections newsletter. Last January he was spot on when he said the following to Barron’s:
“I assume the world economy is decelerating. China’s economy will slow more than expected… those looking for China to get us out of the doldrums are wrong… equity markets around the world will top out during this quarter and then enter the next down leg in the cyclical bear market that started last spring.”
Apparently, he maintains his call that we’re in the middle of a bear market. In the text below, an excerpt from his latest note on the world economy, he explains why China is in deep trouble and says that those who understand cycles and human behavior know the more extreme the upside, the more painful the downside.
“And then there is China. The designated new leader of the Communist Party told a foreign official that one should not take the official economic numbers at par value but rather look at changes of electricity production and consumption, rail cargo volume and bank loans (see chart below). Critical souls have known that for a long time, of course. Interestingly, these three series do indeed paint a different picture than 9% real growth.
Electricity production has grown a meager 0.7% year over year, down from 40% growth in early 2010. Rail cargo volume grew 3%, down from more than 20% two years ago. And bank loans grew 16% after more than 30% at the peak of the current cycle. This last series does not include the shadow banking system, which would most likely show accelerating growth after the official numbers peaked, but a more pronounced decline now. I suppose many of these loans are used to bridge serious financial problems and do not reflect strong final demand.
China’s real estate sector is in deep trouble, as sales continue to slump for all categories, from residential to commercial. As production keeps growing, at a slowing pace, inventories keep rising. Potential buyers are holding back as prices are now declining. Moreover, the home-ownership ratio in China is already at 80%, which hardly points to strong underlying structural demand but rather the opposite! Land sales are slumping, and this will eventually lead to a slump in real estate construction. In recent years, fixed asset investments amounted to approximately 50% of GDP, and real estate construction is a significant part of it. It also looks like foreign direct investment – if it doesn’t pick up considerably during the rest of this year – will decline decisively versus last year, pointing to either too much capacity or a less competitive China. Even if construction remained unchanged this year, it would deduct almost 3% from GDP growth and in case real estate construction declined 10%, it would reduce GDP growth by 5%-6% in real terms. A quick look at the cement consumption per capita (see chart below) shows how extreme the whole boom has been in recent years.
It is a classic turn of a cycle, just as happened in the US in 2007. Those who understand cycles and human behavior know the more extreme the upside, the more painful the downside. The Chinese are no exception to the laws of economics or greed and fear.
In my view, the Chinese slowdown is now on the radar screen of the markets, although the majority of investors have not realized, yet, what is going on there and how deflationary it is for the world economy. If China in reality grows only between 0-4%, as I suppose, the backlash to commodity and capital goods producers in the world, and the Asian intermediary manufacturers, could be painful. That is what I outlined early this year and what the markets’ message is now. Just have a look at some graphs of commodities and currencies of natural-resource exporters like Australia or Brazil if you don’t believe me.
Of course, the Chinese authorities will react. However, they understand now better what serious problems their stimulus program of 2008 has created. As a result, they will lag in their action and do less than markets are expecting.”
Source: Itau, Zulauf Asset Management