Money Morning Staff Reports

With China’s Shanghai Composite Index (SSE) now down about 20% from its Aug. 4 peak – a decline punctuated by a 4.3% drop yesterday (Wednesday) – the Red Dragon’s stock market is technically now in bear-market territory.

That has the China bashers out in full force and has traders worldwide debating whether or not that country’s economy is strong enough to fuel the global rebound as many have hoped. A key issue in the investor debate is whether the Chinese economy can continue to expand – independent of a U.S. recovery – and whether that market is actually too risky an investment, regardless of the long-term-growth forecasts that are always cited whenever a China bull is extolling the long-term profit promise of that country.

The most recent decline in the Shanghai stock index was touched off by worries of tightening credit conditions and a perception that Beijing is doing little or nothing to support the market.

To get to the bottom of this controversy, we turned to Money Morning Investment Director Keith Fitz-Gerald, a well-known Asia investing expert who is also the editor of The New China Trader. Fitz-Gerald, a former professional trade advisor, is one of the nation’s leading experts on China and on global market trends in general. Not only has he been a frequent traveler there for nearly 20 years, but he lives in Asia for part of each year. In addition, he personally leads an investing trip to Mainland China every year and in each of the past two years has actually written a multi-installment investment travelogue for Money Morning readers.

It’s that time actually spent on the ground in China – and the high-level contacts that he’s nurtured as a result – that’s enabled Fitz-Gerald to provide Money Morning readers with unique and independently conceived insights on China.

Money Morning Executive Editor William Patalon III asked Fitz-Gerald about China’s stock market decline, what it means for investors, and whether it could derail the global rebound. Here are the highlights of that discussion.

Money Morning (Q): Keith, let’s start out with a key point. A lot is being written right now about the risks that China poses for investors. In your view, what is the biggest risk that investors face with regard to that country?

Keith Fitz-Gerald (A): The biggest risk investors face is getting left behind – by not investing in China.

Money Morning (Q): That’s an interesting way to look at this controversy. What do you mean by that?

Fitz-Gerald (A): Far too many investors view China as a financial bubble – and now they view it as a bubble that’s bursting. In doing so, they miss the real point: China is probably the single-biggest profit opportunity of this generation – if not of our lifetimes. However, it’s a long-term opportunity, and one that admittedly will experience some ups and downs – and even some major bumps – along the way. But any near-term risks are dwarfed by the long-term growth potential China poses, particularly if those risks are managed appropriately through the use of trailing stops and with prudent stock selection.

Money Morning (Q): Can you quantify that opportunity?

Fitz-Gerald (A): Let’s begin by talking about it from an investment standpoint – after all, Money Morning is a global investing news service. If you had invested $100,000 into China’s Shanghai markets on Jan.1, 2000 and an equal amount into the United States’ benchmark Standard & Poor’s 500 Index on that same date, the results would be dramatically different.

By the way, I picked 2000 as a starting point so I could address all the grousing that’s going on about investment cycles. Since 2000, we’ve seen not one, but two global “up” cycles and two global “down” cycles, so both are equally represented.

Money Morning (Q): And the results?

Fitz-Gerald (A): As of Tuesday’s close, you’d be up 106.97% on the Shanghai, and down 31.6% on the S&P 500.Now, I’m using that as an example …

Money Morning (Q): Because – until recently, at least, — investing in Shanghai has been very difficult for individual investors?

Fitz-Gerald (A): That’s right – which is why I’m using that to display the disparity. But really this is a moot point.  Look at how the Hong Kong index – which is readily accessible to everybody, and has been for years – has done versus the S&P 500 over the same time frame.

Even though the Hong Kong and S&P 500 indices have a tighter correlation through 2003, Hong Kong still powered up to a greater degree than the S&P 500 did. What’s more, even after a spectacular tumble from late 2007 as part of the financial crisis, Hong Kong has posted a return of 16.9% over the same time frame. And you’d still be down the afore-mentioned 31.6% in the S&P 500.

If you look at it in terms of relative performance, the disparity is really eye-popping. Since the start of 2000, the Shanghai has outperformed the S&P by 138.57%, and the Hong Kong has beaten the S&P by 48.5%.

Money Morning (Q): The numbers don’t lie. So why all the controversy now?

Fitz-Gerald (A): Quantitatively speaking, China’s markets are developing at a speed that’s roughly double our own, which means that China will correct – on average – once every seven to 11 years, while the U.S. markets correct every 17 to 21 years. So this pullback is right on schedule. Shoot, even if these numbers wind up changing – and they probably will – the point is that financial markets worldwide are all subject to periodic corrections. In that sense, the short-term pullback we’re seeing under way in Asia now is not only expected, it’s necessary – even healthy. That’s what keeps truly real ruinous bubbles from developing.

Don’t forget, China is growing at an 8% annual clip – even after tapping on the economic brakes – while the U.S. will be lucky to see 2% growth this year. Europe may actually turn in negative numbers.

Money Morning (Q): During strategy discussions with staffers here at Money Morning, and in presentations around the world, you’ve made one very interesting point: While we view this financial crisis as a problem to be solved, China views it as an opportunity to bulk up economically, and to accelerate its development into a true global superpower.

Fitz-Gerald (A): That’s right. As I noted in a column earlier this week, China has gone on a global shopping spree in the commodities sector, and is locking up long-term supplies of everything from crude oil to industrial metals. Next we’ll see China’s companies start capitalizing on the weakness being experienced by their Western counterparts: Mainland China firms will start buying market share, strategic technologies, product lines with global profit potential – and even entire companies. Many already are and we’ve covered those here in Money Morning in the past.

With the U.S. dollar destined to get much weaker because of all the money the U.S. Treasury is printing, expect the next round of U.S. takeovers to be made by foreign firms, with China-based companies among the top suitors.

Make no mistake, China has the financial firepower to make this happen: It’s foreign reserves are an all-time-world record of $2.3 trillion, meaning it will be able to help its companies finance deals that are deemed strategic in nature.

The bottom line, and this is particularly difficult for Western investors accustomed to being at the top of the food chain to grasp, is that the global blue chips of the future may well be companies whose names you have trouble pronouncing, with corporate headquarters in cities that are on the other side of the world.

Money Morning (Q): But isn’t one of the big worries that China’s growth story will get trumped by a drawn-out economic malaise – or even worse, a “double-dip recession” – here in the United States? Isn’t that part of what’s causing U.S. stocks to catch a cold after China’s Shanghai index apparently sneezed this month?

Fitz-Gerald (A): Once again, this is a case of the West’s so-called China “experts” not really understanding the forces that are at work.

China’s leaders realize that they can no longer afford to allow their economy to function as an export-only machine – whose fortunes rise or fall in line with the economies of the United States or other top trading partners. In fact, China’s leaders have known this for years. So they’ve been actively transforming China’s economy into one where there’s actual domestic demand from China’s consumers. This is just beginning to dawn on Western leaders who are frustrated because China is both a critical link to Western companies and a perennial thorn in their sides.

Having stomped around in Asia for the better part of two decades, I’ve seen this coming for a long time and have repeatedly said so. What’s different is that the financial crisis has accelerated this process. What’s more, now that the genie is out of the bottle, the long-term profit opportunity is just huge for investors who understand what’s unfolding in front of their very eyes. Unfortunately, many investors have a tough time admitting that this is real.

China’s emerging middle class is already a major economic force. Estimates of its current size vary widely – ranging from 100 million to 247 million – but again it’s the long-term potential that’s key: One research paper predicts that China’s middle class could reach 600 million by 2015. That’s just five years from now.
To put this into perspective, consider this: The entire U.S. population is about 300 million. So we’re talking about a middle class alone that’s potentially twice the size of the entire U.S. market.

Right now, about 35% of China’s economic activity is consumer driven. But households there save 35% of their wages. In the United States, by contrast, consumer spending drives 70% of the economy and the household savings rate is in the low single digits most of the time. It’s rebounded recently, but there’s nothing in the West that even remotely resembles the savings buffer in China.

As China’s economy evolves into more of a domestic/consumer-driven market, there’s plenty of fuel to keep driving an economy that – even now, tempered a bit by the global malaise – is likely to advance at about an 8% clip through the rest of this year. And that’s considered a conservative estimate, by they way. Factor in the unofficial cash numbers and the numbers are probably a lot higher.

Money Morning (Q): And yet the “experts” continue to ignore this. Why is that?

Fitz-Gerald (A): A couple of reasons. Wall Street is all about the here and now. It lacks the patience to wait for some of these trends to develop – even though they’re some of the most powerful and high-percentage global investment trends at play today.

The second problem is that many of the China bashers – the gloom-and-doomers who say that China is a bubble that’s poised to implode have either never been to China at all, or have spent very little time there. They’re basing their “forecasts” on studies, or on research that’s been done by other “experts” of a similar ilk – and not on the “boots-on-the-ground” research that I do. I’ve been traveling to China, now, for 20 years. As you noted, I was just there this spring, and I’ll be heading back there again for a substantial investment-research trip in a few weeks.

Money Morning (Q): Does that lack of real understanding hold true for the issues of credit, lending and overbuilding  — three of the areas that seem to have investors spooked about China right now?

Fitz-Gerald (A): Absolutely.In fact, you could paint the same picture in Western markets right now. Generally, there is excess real estate capacity in most major markets and Class A space sits vacant across broad swathes of the world. Developers who bet the farm are now reaping the whirlwind, as the saying goes.

And the same is true when it comes to credit. China, like the rest of the world, is aware of these issues and is actively taking steps to deal with it.

However, there are differences. For instance, the Chinese government has a conscious plan to phase out excess capacity in the Eastern region of the country – which includes cities like Guangzhou, where some of the worst vacancies exist, for example. At the same time, the government is also shifting new development to the “Go-West” areas, such as Xian.

Areas like Chongqing – which I’ve written about extensively – are almost case studies that show investors why they have to invest in China and what they’ll miss if they don’t. That city, and cities like it that are all crucial pieces of the “Go-West” program, are spending billions on their new CBD’s (central business districts) among other things. I’ve seen buildings that are 100% leased before construction even starts. Obviously, this is a rarity in today’s markets, but the point is that this is a very different picture from the one that so many of the U.S.-based China experts are painting. It’s a reality you wouldn’t know about if you weren’t on the ground there.

It’s the same story with real estate loans. Some pundits have written that Beijing is forcing banks to make loans and that there is tons of unnecessary construction projects taking place. If that’s true, then so is most of the G8. But in reality, nobody is “forcing” anybody to do anything; credit conditions in the West stink. China’s simply taken a different tact and encouraged lending in their domestic banking system as a means of encouraging more spending. By its own admission, Beijing hasn’t been happy with the degree to which credit controls have been implemented, but they’re taking steps to mitigate that risk. Interestingly, because China’s domestic banking system was separate from the externally facing sovereign banks, there really isn’t the derivatives fallout to contend with inside China like there is inside the domestic banking system here. And that’s a very different situation to contend with.

As for the “unnecessary construction,” I respectfully ask the China naysayers who’ve made that allegation to define that term. By Western standards, anything that’s done absent a profit could be termed as “unnecessary.” This is a very Western concept in terms of what constitutes “unnecessary.”

But China doesn’t work like the West. It never has, and never will. In fact, in contrast to the “planners” in Washington – and I use that term loosely – China plans proactively, meaning it would rather construct buildings in advance of actually needing them even if many are “unnecessary,” no matter how one defines the term. This is no different from what happens over long cycles in any real estate market anywhere in the world. And what happens to those buildings in terms of eventual absorption, refinancing and occupancy rates is no different than what happens where there is over-speculation here in the United States or in Europe.

That said, I believe the bottom line is that a lot of these fears about credit and real estate are overblown.

Money Morning (Q): Those are some great micro-level observations. What about the macro picture there?

Fitz-Gerald (A): To me this is very simple – but I admit that I tend to be very blunt. So what if China stumbles a bit after decades of double-digit growth? A gigantic spending package, deep interest rate cuts and a carefully coordinated effort to drive things forward resulted in 6.1% growth in the first quarter and 7.9% in the second quarter. Our much larger “stimulus” package here in the United States has yet to really bear fruit. And, incidentally, I think China may turn in 9% growth for the current quarter. Maybe more.

Industrial output is up 10.8% this year and retail sales are up 15.2%. Goldman Sachs Group (NYSE: GS) recently noted that China could grow by 10% in 2010 – up from an earlier forecast of 9.4% and substantially higher than the government’s official target of 8%. Beyond that, 11.9% growth is not unreasonable. We’re going to be lucky to do 2% here in the United States. And we’ll be even luckier to maintain it.

Look, the bottom line is this: China’s economy has averaged double-digit annual growth every year for 30 years. And with the hugely developed and rural Western part of China badly lagging, they’ve probably got enough pent up need to drive the bus that way for the next 50 years.

Money Morning (Q): So what’s your ultimate message to investors here?

Fitz-Gerald (A): Ignore China at your own risk.

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